What is the Going Concern Principle

Every theory is based upon certain basic assumptions, without which it would not be possible for it to be applicable to the real world or have any predictive power. Bookkeeping or accounting theory, is based upon 'Generally Accepted Accounting Principles (GAAP)'. One of the fundamental axioms of accounting theory is the 'Going Concern'.

Time is one of the most important of factors, when analyzing any system, which includes the financial management of a business. Accounting is studying the financial parameters and creating a realistic financial picture of a company, which enables future planning.

To put it in the simplest of words, the going concern assumption is as follows - 'A business will continue functioning consistently in the near future, as far as accounting is concerned'. It is an assumption that any business will sustain activity till all of its outstanding commitments are met with and goals are achieved.

This seems like a very trivial assumption, doesn't it? However, if you observe it closely, you'll know that it's not so simple. If you don't assume this principle as a fact, future economic calculations of the company are not possible and the value of investments as assets, drops down substantially.

If there was no such principle, the value of assets of a business, including machinery and real estate investment, would have to be calculated at their present liquidation value. Thus, creating financial statements would be impossible, as a business may never be solvent without considering future returns from investments.

This is because there are some assets like industrial machinery and investment in inventory, which become liabilities, unless they generate revenues in the future.

The sustenance provided by the principle of going concern in accounting, allows for the concepts of depreciation to be brought into the picture, which takes the progressively changing value of an asset into consideration over a period of time, instead of its immediate liquidation value being considered.

The concept makes it possible for accounting to take the income-generating value of an asset, when creating a financial statement. Thus, the current financial position of any company and a realistic valuation of assets is made possible, because of this principle. Assets are not valued at their liquidation price in a market, but instead, a depreciated value is considered.

Consider that a manufacturing unit has invested USD 100,000 in new machinery, with a predicted service life of ten years. If this concept is taken into consideration, the straight line depreciation value of the machinery for every year is USD 10,000 and hence the value of the asset after one year would be noted down as USD 90,000.

If the concept was not assumed, the asset's value would be determined at its scrap sale price, which would be considerably lesser. Hope this example has helped you grasp how this principle affects the valuation of assets and liabilities, when creating a financial statement.

Thus, this concept provides considerable predictive power to the practice of accounting and brings its theory into realistic perspective. Come to think of it, without the principle, accounting would lose its power of extrapolation, which enables the creation of realistic financial reports.