Continuity assumption in the financial statements and settlement basis (2023)

What's going on?

"Go" here means "continue" and "concern" is used in the sense of "organization" or "entity." then acontinuityis an organization that is expected to continue to operate normally for the foreseeable future.

What is the relevance of continuity??

Continuity is an extremely important premise when preparing thefinancial statementsof an entity; in particular, when preparing the balance sheet.

balance sheetit is nothing more than a list of the assets and liabilities of an entity with their respective amounts.

These assets and liabilities on a balance sheet are valued using different measurement methods, such as cost less depreciation, fair value, etc., depending on the nature of the assets/liabilities and what is required/permitted by accounting standards. However, all of these measurement methods assume that the entity will continue to operate for the foreseeable future.

The opposite of the continuity base would be "settlement basis“. Based on this, we assume that the entity will be liquidated in the next year. Assets and liabilities will then be valued on that basis.

How does continuity affect evaluation?

Balance sheet assets and liabilities are valued based on the assumption that they will be used/settled in the normal course of business.

In contrast, in liquidation accounting, the balance sheet will show assets and liabilities at or near their actual realizable values. These are the amounts you will receive/pay if you are closing trades.

Let's see what happens to the values ​​of assets and liabilities if we prepare the balance sheet in liquidation. This will give us a good idea of ​​the difference between the two evaluation bases.

We will do this using some common and easy examples:

Example: fixed assets

First let's take a common asset category on the balance sheet: "Property, plant and equipment." These include the machines, furniture and all other fixed assets that are in use in the business. These are normally measured at cost less depreciation on a continuing balance sheet.

What the 'cost minus depreciation' valuation model does is distribute the value of the assets over the useful life of the asset. The useful life is simply the period that the asset will continue to be useful to the business.

Thus, each year during its useful life, itsStatement of incomeyou will be hit with a depreciation rate. Depreciation is effectively a charge for the “use” and “wear and tear” of the asset.

A fundamental assumption underlying this valuation model is that the business will continue to operate; and that the entity will be able to use those assets during their useful lives.

Now, if you liquidate the business, you can't continue to use those assets for the business. You will need to dispose of these assets somehow. And those assets are highly unlikely to reach "continuing" value if you have to dispose of them.

So if we're accounting for liquidation, we'll have to reduce these assets to the amount we're likely to get in what's likely to be an "emergency sale."

Note that the amounts can also increase in settlement ledger. This happens when you are likely to get more value from an asset for sale compared to its value "in the future."

Suppose you own land that you purchased many years ago and it is shown on the balance sheet at cost. If you sold that land today, the value of the land is likely to be much higher than the cost.

Example: Other Assets

The same applies to all other assets on the balance sheet.

Now, some of these assets are already measured atfair valuein a balance of continuity. But keep in mind that there may be a stress component even for these assets when we are valuing in liquidation. So we may not even be able to follow what would normally be afair value.

furthermore, thefair valueitself can be calculated using various methods. For example, if fair value were calculated based on the income approach as a discounted cash flow method, this value would be different from the asset's market price.

Now let's look at other assets like accounts receivable, prepayments, etc.

On a rolling balance, you may already have some allowance for bad debts. This provision considers what you may not be able to collect when you operate your business normally. But chances are you'll have a hard time collecting more than that if you close the shop. Therefore, you may need to further reduce accounts receivable.

Advance payments are effectively advance payments for the continued provision of services for a specified period in the future. Examples include prepaid rent, prepaid insurance. It has held them as assets on the balance sheet assuming that the entity will use the underlying services during the agreed period. But if you close the shop, can you get back, say, the rent paid in advance? If not, you will also have to write them down.

Example: Liabilities and other obligations

Similar concerns would arise about liabilities, on or off the balance sheet.

For example, if you go out of business, will you have to pay the outstanding loan balances up front? If so, would there be a prepayment penalty? If so, this penalty must be provided for in advance payment.

Similarly, what happens if you terminate your three-year lease early? You'll be forced to pay all your remaining rent payments, or maybe the lease has a penalty clause that says if you bankrupt early, you have to pay six months' rent. Therefore, the amount you have to pay is an immediate liability for you.

On top of all this, you would also incur settlement costs. Therefore, provision will also have to be made for these costs.

Therefore, the valuation under the liquidation basis can be drastically different from the valuation under the going concern basis.

Furthermore, it is almost certain that any increase/decrease in valuation will affect theStatement of income. This means that, in the period that you apply the settlement basis, your income statement will most likely show some crazy numbers.

When did we stop using the going concern basis (or start using the liquidation basis)?

Continuity is the default premise during preparationfinancial statements. As you saw earlier, the balance sheet on a liquidation basis is drastically different from one on a going concern basis.

Therefore, it is now important to know when you will be forced to stop applying the going concern principle and start applying the liquidation regime.

Although continuity is the default assumption, it is not an automatic assumption. when you get readyfinancial statements, you should always consider and address the risk that continuity may not apply.

How can we assess the risk of continuity?

Let's say your business is doing well, with good profits and positive cash flow. And you don't even dream of turning it off. So there is no need for you to worry. Nobody is going to force you to do a continuity evaluation.

But if any of these indicators fail, there is a risk of continuity for yourfinancial statements. Then it's time for you to do a continuity assessment. Your auditors will insist that you do this.

What factors would you consider when conducting the going concern assessment?

You would take into account factors such as:

  • future plans and prospects for the business; Is
  • promise of some parties (for example, shareholders, creditors) to sustain and support the business if necessary.

Be prepared to back up your supporting factors with evidence. You must be able to adequately and reliably demonstrate that the entity will not have to go out of business for at least one year from the date of issuance of thefinancial statements. A key piece of evidence for this will be a projected business cash flow. If we rely on third party promises, those promises must be in writing.

Impact of the going concern assessment on thefinancial statements

So you have concluded, after your detailed evaluation, that the going concern assumption remains valid. You can then proceed to apply the going concern assumption to that particular set offinancial statements. (Next year is another year).

However, the fact that there is a going concern will have been revealed inNotes to the financial statements. This note will also disclose key details of the going concern assessment and the basis for the conclusion.

On the other hand, let's say you failed to convince your auditors that business will be a constant concern. Then you will have to prepare thefinancial statementson sale.

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