The concept of going concern and the 'life' of a company

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In this chapter, we’re going to get a little philosophical and get into a deep discussion with respect to the life of a company. Just like how every living being in this entire world ultimately faces an end to its life, a company is also capable of experiencing an end. The only difference is that the end of a company is usually brought about voluntarily by its owners either through liquidation or through mergers or amalgamations.

But just because a company can face an end at any time during its life, does that mean that the owners should conduct each business activity with the ultimate end in mind? Of course not! Just like how you conduct all your business expecting and assuming to be alive and well for the foreseeable future, companies also operate under the same assumption. This assumption is what is known in the world of finance as the going concern theory. And that’s what we’re going to focus on in this chapter.   

What is the going concern theory?

Getting back to finance, the going concern theory is essentially an accounting principle that assumes that the entity will continue to be in business for the foreseeable future. Unless and until there’s overwhelming evidence of a company closing down its entire business, the company is assumed to continue its operations and go about its business as usual. 

This assumption allows the accountants of a company to put off (or defer) the recognition of large expenses. These ‘deferred’ expenses are then accounted for over a long period of time. A very good example of expenses that are deferred over a significant period of time is the depreciation cost of an asset. Since the company is expected to continue to remain in operation for the foreseeable future, the depreciation costs of an asset are accounted for in increments over a period of time. The going concern theory allows the company to present a more accurate and fair view of its financials without any huge impact or distortions.

The going concern theory also assumes that the company’s business is stable enough and generates enough revenue to meet its debt and other financial obligations. Any evidence contrary to these assumptions would mean that the entity is no longer a going concern. The duty and responsibility to evaluate the ability of a company to function as a going concern falls on the auditors of the company.      

What affects a company’s ability to continue as a going concern?

Okay, so now that you’re clear about the concept, let’s take a look at some of the threats to a company’s going concern.

  • Worsening financial condition of the company, such as a string of losses year over year
  • Mounting debt pressure and defaults in repayments of loans
  • Severe deficit in the working capital
  • Expensive and loss-making long-term commitments
  • Trade credit denials from the suppliers of the company
  • Large and expensive lawsuits filed against the company 

Here’s something that you should know about. The worsening financial condition and the inability to meet financial obligations continues to be the number one threat for a going concern.

What happens when a company is no longer a going concern? 

The theory of going concern is all fine and well. But how does this theory apply in real life? You might recall that many companies that were in existence once, no longer exist. For instance, do you remember Kingfisher Airlines? Or maybe Satyam Computer Services Limited? What happened to these companies? Does the going concern theory no longer apply to them? In short, yes. These companies can no longer be categorised as going concerns due to irreconcilable issues such as severe financial distress and legal proceedings plaguing them. 

Now this brings us to the next logical question. What happens when a company is no longer a going concern? As a matter of fact, one of two things is likely to happen. 

  1. One alternative is that the company may try to get back on its feet by identifying the reason behind its going concern status being affected. Then, it may try to mitigate the problem through other means. For instance, if a company is not able to meet any of its financial obligations as and when they become due, it can borrow funds from other parties to meet the pending dues. This however, is a temporary solution and can help the company get back on track as a going concern.  
  2. Or, the company goes completely insolvent and becomes bankrupt. In such a situation, the company would most likely close down its operations and liquidate its assets. Then, the company uses the proceeds from such sale of its assets to meet all of its financial obligations and to pay off all its creditors and debts. At the end of it all, the company finally ceases to exist.   

Wrapping up

As an investor, it is essential for you to know what insolvency and bankruptcy are, since they can affect your investments in a company. However, since these two are very important concepts that require a separate chapter of their own, we’ll delve deeper into them in the upcoming chapter.

A quick recap

  • The end of a company is usually brought about voluntarily by its owners either through liquidation or through mergers or amalgamations.
  • The going concern theory is essentially an accounting principle that assumes that the entity will continue to be in business for the foreseeable future.
  • The going concern theory allows the company to present a more accurate and fair view of its financials without any huge impact or distortions.
  • The theory also assumes that the company’s business is stable enough and generates enough revenue to meet its debt and other financial obligations.
  • There are six major scenarios that act as threats to a company’s going concern.
  • Worsening financial condition of the company, such as a string of losses year over year
  • Mounting debt pressure and defaults in repayments of loans
  • Severe deficit in the working capital
  • Expensive and loss-making long-term commitments
  • Trade credit denials from the suppliers of the company
  • Large and expensive lawsuits filed against the company
  • When a company is no longer a going concern, it may try to get back on its feet by identifying and mitigating the reason behind its going concern status being affected.
  • Or, the company goes completely insolvent and becomes bankrupt. In such a situation, the company would most likely close down its operations and liquidate its assets.
  • Once the company uses the proceeds from such sale of its assets to meet all of its financial obligations and to pay off all its creditors and debts, it finally ceases to exist.
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