Accounting is an art of recording, classifying, summarizing and presenting financial transaction in a formal manner to serve the needs of the user of the accounting information. Over the time GAAP (Generally accepted accounting principle) was formed and accounting standards like IFRS, IND AS, IAS etc. were issued to develop a solid accounting framework. Accounting is focused on recording a business transaction with a view to prepare financial statements in accordance with the applicable financial reporting framework and regulatory framework. A financial statement prepared in accordance with GAAP shows the profit or loss during a period and the situation of assets and liabilities at a certain date.
Modern-day accounting practice follows three fundamental accounting assumptions namely going concern, consistency, and accrual. Consistency prescribes accountants to follow accounting estimates consistently every year while preparing the accounts. Changes in accounting policy are permissible if it facilitates better disclosure and presentation of accounting information. Accrual concept prescribes accountant to record income and expenses when they are due, unlike cash basis where income and expenses are only recorded when income is received or expenses are paid.
Going concern assumption prescribes an accountant to assume that an entity is going to be in the business in the foreseeable future only when it passes evaluation of going concern. Now, let’s understand the meaning of foreseeable future. Foreseeable future means succeeding one year from the end of the current financial year. An entity must be able to generate enough cash balance to pay its operating expenses and make appropriate payments on debt to qualify as a going concern. An accountant needs to do the evaluation of going concern assumption before establishing that going concern assumption is valid for the entity. Going concern assumption of an entity can be evaluated in the following manner.
- Negative trends in operating performance of the company, such as a series of losses in recent financial years
- Defaults made by the company servicing its debt obligation
- Denial of trade credit to the company by its suppliers
- Financially no viable long-term capital commitments by the company
- Legal proceedings against the company, outcome of which likely go against for the company
- Unfavorable results in ratio analysis(Current ratio, debt-equity ratio, Quick ratio etc.)
As we have discussed earlier, we prepare accounts on the accrual basis when going concern assumption is valid, but when going concern assumption is not valid we need to prepare accounts on the cash basis. In cash basis of accounting, assets are recorded in its recoverable value and liabilities are recorded with the amount which is actually payable to the creditor. When going concern assumption is not valid and financial statements are prepared in cash basis, the company needs to disclose the same appropriately.