Accounting Concepts

Going Concern, Consistency and Materiality

Going Concern

Financial statements are prepared on the assumption that the business will continue to trade for the foreseeable future — it is not about to be liquidated or cease operations.

Consequences of the going concern assumption:

• Non-current assets are valued at cost less accumulated depreciation (net book value), not at break-up/resale value
• Long-term liabilities are shown as such rather than as immediately due
• Depreciation is spread over the asset's useful life

When it does not apply:

• If there is evidence the business will cease to trade (e.g. it cannot pay debts, the owner is retiring and closing down), assets must be revalued at their net realisable value (what they would sell for immediately)
• The notes to the financial statements must disclose any material uncertainty about going concern

Important: A business making a loss does not automatically fail the going concern test. Many businesses make short-term losses but continue to trade.

Consistency

The same accounting policies and methods must be used from one accounting period to the next, so that financial statements are comparable over time.

Examples:

• If straight-line depreciation is used in Year 1, the same method must be used in Year 2
• If the provision for doubtful debts (PDD) is set at 5% of receivables, the same percentage should be used each year

Changing a method: Allowed only if the new method gives a truer and fairer view. If a method is changed, the reason must be disclosed in the notes, and comparative figures must be restated.

Materiality

An item is material if its omission or misstatement would influence the decisions of a user of the financial statements. Material items must be disclosed separately.

Examples of materiality in practice:

• A £5 box of paperclips is not material — it can be treated as an expense even if it lasts several years (rather than capitalised as an asset)
• A £50,000 machine is material — it must be capitalised and depreciated
• A £200 error in a large company's accounts may be immaterial; the same error in a small sole trader's accounts may be material

Link to capital vs revenue: The materiality concept is one reason small items of expenditure are treated as revenue expenditure even if they technically provide benefit beyond one year.