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GAAP – Going Concern
This discussion focuses on the objectives, description and application of this principle. Examples will be given to strengthen the understanding and capability to apply this principle at real situation.
Objective:
To guide the management / decision makers of using tight criteria to evaluate the position of the organization, apply appropriate accounting principles and concepts, so as to report true and fair financial information.
Description:
- A business will continue to operate for the foreseeable future;
- Assuming it‟s not going to …close down‟ in the foreseeable future.
Application:
When making assumptions for the business, it makes influential difference under the two situations that, i) the organization is going to stay in business; and ii) the organization is going to close down in the near future.
Example:
A machinery has been purchased at $24,000 cash. It is assumed that the machinery can be used for 2 years (i.e. 24 months).
Note: 2 sets of entries have to be carried out, a) at purchase & b) during each year.
At purchase:
For scenarios 1 and 2 below, the set of entries at a) purchase is the SAME:
Dr Machinery $24k
Cr Cash $24k
However, for the set of entries at b) during each year, differences for scenarios 1 and 2 are shown below.
End of every month:
Scenario 1: The company is going to stay in business.
Dr Depreciation Expenses $1k (Purchase cost/No. of months for usage life)
Cr Accumulated Depreciation $1k ($24k/24months)
Explanation:
a) Machinery is considered as a non-current asset.
b) All non-current assets have to undergo depreciation (i.e. spread the cost throughout the useful life of the asset) every period, except Land.
c) If the company is going to stay in business, by assuming that it can be used for 2 years (i.e. 24 months), $1k out the $24k of cost for the machinery will be recorded as expenses every month, which $1k will be removed from the purchase cost during the same period. Scenario 2: The company is going out of business after 6 months.
Dr Depreciation Expenses $1k (Purchase cost/No. of months for usage life)
Cr Accumulated Depreciation $1k ($24k/24months)
HOWEVER, since the company is going out of business after 6 months, this will mean that NO entry can be recorded after 6 months!
Explanation:
a) If NO transaction can be recorded after 6 months, there is NO reason why the original assumption on a usage life of 2 years (i.e. 24 months) is made, since a resulting amount of $(24k – 6k) = $18k will not be able to record!
b) In other words, the organization is not providing true and fair information, since $18k expenses has not been recorded.
Final comment:
Be noted, if management is already aware that the organization will only stay in business for another 6 months, they should only apply a usage life of 6 months. This is because the machinery will NOT be used “by the organization” after it close down. If applying a usage period of 6 months, it will actually mean that a depreciation expense of $4k ($24k / 6 months) should be recorded each month, rather than the $1k stated.
The captioned implies that if management has any hints that the organization is going to close down in the near future, majority of the assumptions for accounting have to be changed and otherwise applied.
Therefore, under normal situation, the assumption that the company is “going to stay in business” should apply at the development of the financial statements and this is the main spirit of the “going-concern principle”.
