Why is it assumed that the business entity will continue to operate indefinitely What is the effect of this assumption on accounting procedures?

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✓ Checked for updates, April 2022. Accountingverse.com

The basic accounting principles serve as bases in preparing, presenting and interpreting financial statements. They lay down the foundations to prevent misunderstandings between and among the preparers and users of financial statements.

Going Concern Assumption

The Conceptual Framework of Accounting, published by the International Accounting Standards Board (IASB), mentions the underlying assumption of going concern.

The going concern principle, also known as continuing concern concept or continuity assumption, means that a business entity will continue to operate indefinitely, or at least for another twelve months.

Financial statements are prepared with the assumption that the entity will continue to exist in the future, unless otherwise stated.

The going concern assumption is the reason assets are generally presented in the balance sheet at cost rather that at fair market value. Long-term assets are included in the books until they are fully utilized and retired.

Accrual Basis of Accounting

Another important basic concept is accrual. The accrual method in accounting means that "revenue or income is recognized when earned regardless of when received and expenses are recognized when incurred regardless of when paid".

Hence, income is not the same as cash collections and expense is different from cash payments. Under accrual basis, revenues and expenses are recognized when they occur regardless of when the amounts are received or paid.

For example, ABC Company rendered repair services to a client on December 9, 2021. The client paid after 30 days – January 8, 2022.

When should the income be recognized? – On the date it is considered earned (when the service has already been rendered). Hence, the income should be recognized in December 2021 even if it has not yet been collected as of that date.

Another example, suppose ABC Company received its electricity bill for the month of March on April 5 and paid it on April 10. When should the electricity expense be recorded?

Correct! – March. Why? Because, the electricity expense was for the month of March even if the bill has been received and paid in April. In other words, the "electricity" was used/consumed in March.

Accounting Entity Concept

The accounting entity concept recognizes a specific business enterprise as one accounting entity, separate and distinct from the owners, managers, and employees of that business.

In other words, it means that a company has its own identity set apart from its owners or anyone else. Personal transactions of the owners, managers, and employees must not be mixed with transactions of the company.

For example, if ABC Company buys a vehicle to be used as delivery equipment, then it is considered a transaction of the business entity.

However, if Mr. A, owner of ABC Company, buys a car for personal use using his own money, that transaction is not recorded in the company's accounting system because it clearly is not a transaction of the company.

Time Period (Periodicity)

The time period assumption, also known as periodicity assumption, means that the indefinite life of an enterprise is subdivided into time periods (accounting periods) which are usually of equal length for the purpose of preparing financial reports on financial position, performance and cash flows.

An accounting period is usually a 12-month period – either calendar or fiscal.

A calendar year refers to a 12-month period ending December 31. A fiscal year is a 12-month period ending in any day throughout the year, for example, April 1 to March 31 of the following year.

The need for timely reports has led to the preparation of more frequent reports, such as monthly or quarterly statements.

Monetary Unit Assumption

The monetary unit assumption has two characteristics – quantifiability and stability of the currency.

Quantifiability means that records should be stated in terms of money, usually in the currency of the country where the financial statements are prepared. 

Stability of the dollar (or euro, pound, peso, etc.), a.k.a. stable dollar concept means that the purchasing power of the said currency is stable or constant and that any insignificant effect of inflation is ignored.

It is to be noted however that financial statements of a company reporting in the currency of a hyperinflationary economy (an economy with very high inflation rate) must be restated, in accordance with applicable accounting standards.

Other Principles Derived from the Above Concepts

Some of the other principles in accounting include:

• Matching Principle – The matching concept means that expenses are recognized in the period the related income is earned, and income is recognized in the period the related expenses are incurred. In essence, income is matched with expenses and vice versa. Through the accrual basis of accounting, better matching of income and expenses is achieved.
• Revenue Recognition Principle – In accrual basis accounting, revenue or income is recognized when earned regardless of when received. It means that income is recorded when the service is fully performed or when sale occurs, even if the amount is not yet collected.
• Expense Recognition Principle – Also under accrual basis accounting, expenses are recognized when incurred regardless of when they are paid. In other words, expenses are recorded when used (incurred), even if they are not yet paid.
• Historical Cost Principle – Items in the balance sheet are generally presented at historical cost. Nonetheless, some accounts are measured using other bases such as fair market value, current cost, and discounted amount. You will learn more about these exceptions in intermediate accounting studies.

Key Takeaways

Going Concern - the assumption is that the entity will continue to operate in the future, unless otherwise stated

Accrual - income is recognized when earned regardless of when collected, and expense is recognized when incurred regardless of when paid

Accounting Entity - transactions of the business must be separate from personal transactions of the owner/s

Periodicity - reports are prepared for specific time periods

Monetary Unit - records are expressed in terms of money

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Fundamental Accounting Concepts

"Any organization will continue to run the business for a foreseeable future"

The going concern principle assumes that any organization will continue to operate its business for the foreseeable future. The principle purports that every decision in a company is taken with the objective in mind of running the business rather than that of liquidating it.

Breaking Down Going Concern

Going concern is one of the very fundamental principles of accounting. It assumes that the entity will continue to remain in business for the foreseeable future. Conversely, it also means that the entity does not plan to, or expect to be forced to, liquidate its assets. Under this accounting principle, it defers revenue and expenses according to other principles of accounting. If the going concern assumption did not hold true, then it would not be possible to record prepaid or accrued expenses as such.

The concept of going concern is relevant not only from an income statement perspective but also from a balance sheet perspective. All assets are depreciated and amortized as appropriate, with the same idea that the business will continue to operate.

Conditions for Going Concern

The concept is not clearly defined anywhere in the Generally Accepted Accounting Principles (GAAP), which leaves a considerable amount of interpretation regarding when an entity should report it. However, Generally Accepted Auditing Standards (GAAS) requires an auditor to verify an entity’s ability to continue as a going concern.

Without any significant information to the contrary, it is always assumed that the entity will be able to meet all its obligation without significant debt restructuring and continue to be a going concern entity.

Red Flags

Once an auditor examines a company’s financial statements to see if the operating conditions of the entity are suitable for the long-term continuity of the business, they will issue a certificate accordingly. Some of the conditions that create substantial doubts for the principle of going concern are defaults on loans, lawsuits, company plans to declare bankruptcy, continued losses year over year, etc.

In case the auditor decides to qualify their audit report, it may raise the issue of whether assets are already impaired, which may highlight the need to write down the value of the assets from their carrying value to liquidation value. However, a company can choose to justify their decisions and attempt to make the auditor believe that poor business operating conditions are only temporary. It can also get a third-party guarantee to mitigate existing risks.

The valuation of an entity, assuming it’s on a going concern basis, will be higher, as it offers the potential to earn higher profits in the future than its liquidation value.

Going Concern vs. Liquidation Value

The value of a going concern is basically the ability of the business to earn future profits. An analyst values the business after looking at the recent trend of the business and the company’s potential to earn profits. A going concern will be valued according to operational efficiency, market share, the ability to influence the market, technology advantages, and so on. It may be valued using the discounted cash flow (DCF) method, with the assumption of future profitability.

The valuation of a company is important from the shareholders’ and investors’ perspective. In general, all companies are run with a going concern assumption and, hence, projections and, more importantly, business plans are made considering what should be the next action plan.

Liquidation value, on the other hand, is relevant to a situation where the company becomes insolvent and is unable to pay its bills. An insolvent company may choose to sell its assets one by one or all of its assets together. The value received from the sale is usually the asset’s market value, less sale expenses. Liquidation value is very important for creditors and stakeholders, who would be paid out of this money.

Related Readings

Thank you for reading CFI’s explanation of going concern. CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below: