Case 12.4



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Case 12. 4: Surfer Dude Duds, Inc. : Considering the Going-Concern Assumption* *This case was prepared by Mark S. Beasley, Ph. D. and Frank A. Buckless, Ph. D. of North Carolina State University and Steven M. Glover, Ph. D. and Douglas F. Prawitt, Ph. D. of Brigham Young University, as a basis for class discussion. The case was inspired by discussions with Craig Isom, a former audit partner, and we gratefully acknowledge his contribution to its development. Surfer Dude Duds is a fictitious company. All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental.

Mark S. Beasley, Frank A. Buckless, Steven M. Glover, Douglas F. Prawitt Learning Objectives After completing and discussing this case, you should be able to • Understand the difficulty of assessing the client’s going-concern assumption • Describe the “self-fulfilling prophecy” aspect of a going-concern modified auditor’s report • Identify factors that encourage objective auditor judgments despite the presence of friendly client-auditor relationships Background Mark glanced up at the clock on his office wall. It read 2:30 P. M. He had scheduled a 3:00 P. M. eeting with George “Hang-ten” Baldwin, chief executive officer of Surfer Dude Duds, Inc. Surfer Dude specialized in selling clothing and accessories popularized by the California “surfer” culture. Mark had served as audit partner on the Surfer Dude Duds audit for the past six years and was about ready to wrap up this year’s engagement. He enjoyed a strong client relationship with George Baldwin, who was ordinarily a relaxed and easygoing man, now going on 50 years of age. For several years, Mark had received a personal invitation from George to attend a special Christmas party held only for George’s employees and close associates.

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Mark considered George a good friend. In his six years on the audit, Mark had never had any reason to give anything but a clean audit opinion for Surfer Dude Duds, Inc. But this year was different. The economy was in a mild recession, and given the faddishness of clothing trends, Surfer Dude’s retail chain was hurting. As sales decreased, Surfer Dude was struggling to meet all its financial obligations. Retail analysts foresaw continuing hard times for clothing retailers in general, and current fashion trends did not seem to be moving in Surfer Dude’s direction.

As a result, Mark was beginning to doubt Surfer Dude’s ability to stay in business through the next year. In fact, after conferring with the concurring partner on the audit, Mark was reluctantly considering the addition of a going-concern explanatory paragraph to the audit report. When Mark broached this possibility with George several weeks ago, George brushed him off. The purpose of the scheduled 3:00 meeting was to inform George of the decision to issue a going-concern report and to discuss the footnote disclosure of the issue.

Mark rehearsed what he was going to say several times, but he remained uneasy about the task before him. When Mark arrived at George Baldwin’s office, a secretary greeted him and told Mr. Baldwin of Mark’s arrival. When Mark heard George say, “Send him in,” he took a deep breath and headed into George’s office with a smile on his face. George was sprawled out in a large executive chair, with his ever-present smile. Mark always marveled at how a person could invariably seem so relaxed and happy. “Hey Mark, what’s up? You know I don’t like meetings on Friday afternoons,” George yawned. Well George, I’ll get right to the point. As you well know, the retail clothing market has really gone south the past few months. I know I don’t need to tell you that Surfer Dude is struggling right now. ” “I know, but we’ll pull out of it,” George insisted. “When you fall off, you’ve got to climb right back on to ride the next monster, right? We always manage to come out on top. We just need to ride this one out, just like the other times we’ve struggled. ” “George, I know you have high hopes that things will get better soon, but this time things are a little different,” Mark sighed. I know that you might just be able to pull the company out of this. But given the circumstances, I think we’re going to have to look at including a going-concern explanatory paragraph in the audit report. I substantially doubt that Surfer Dude will be able to continue as a going concern for the next year. I also recommend that you include a footnote in your financial statements to the same effect. ” “What? Mark, you can’t go slapping a going-concern report on me! Surfer Dude will go belly-up for sure. No one will be willing to loan us any money.

Shoot, nobody will even be willing to sell us anything on account—all our inventory purchases and everything else will be C. O. D. It’ll be cash-and-carry only. And what about our customers? Will they buy if they’re not sure we’ll be there to stand behind our return policy? It’ll be your report that puts us under, not the ripples we’re hitting now. I’ve got a feeling things are going to get better soon. We just need a little more time. ” “George, you’ve got to consider the consequences if…. ” “Mark, if you slap me with a going-concern report, there is no way we’ll be able to pull out of this.

Think of all the people who will lose their jobs if Surfer Dude shuts down. Please, I’m asking you to at least think about it. ” George’s ever-present smile was gone. Mark was silent for what seemed like an eternity. “Okay George, let’s both think about it over the weekend. I’ll drop by on Monday morning so we can work this out. Thanks for your time. ” Mark walked slowly out of the building and to his car. This was not going to be a relaxing weekend. Requirements 1. What are Mark’s options? The option available to Mark was only to convince George about the financial position of the concern.

Although George knows the lacunae involved in his retail business he is not willing to accept the fact that the business is so much at a loss that it needs no going concern explanatory paragraph. Therefore it is the duty of Mark to explain to George the consequences of not including the explanatory paragraph in the report. He should also probably predict the future position of Surfer Dude given the present economic conditions and try to explain George the reasons why the company may not be able to recover in the consequent year for which the going concern explanatory report becomes necessary. . How might a going-concern explanatory paragraph become a “self-fulfilling prophecy” for Surfer Dude? By giving the going concern explanatory paragraph in the audit report it becomes a self fulfilling prophecy to Surfer dude as the various classes of people involved with the company that is the creditors, customers, investors etc. , all their hopes and plans will be shattered and the company will lose its business for eternity. There will be no one willing to lend money, no one willing to sell stock to the company and just about no one will be willing to trust the company. . What potential implications arise for the accounting firm if they issue an unqualified report without the going-concern explanatory paragraph? It would be unethical to issue an unqualified report without the going concern report. This is because every audit report must consist of the reasons for the unqualified report. An unqualified report is a clean bill of health of the organization and an auditor must not exclude any information or insert any irrelevant information in this report.

Every unqualified report has a structure which consists of three parts that is introductory paragraph, scope paragraph and opinion paragraph therefore it is necessary that the auditor fills in all the necessary information. 4. Discuss the importance of full and accurate auditor reporting to the public, and describe possible consequences for both parties if the going-concern explanatory paragraph and footnote are excluded. How might Mark convince George that a going-concern report is in the best interests of all parties involved? It is necessary that the auditor and the company reports full and perfect information in the audit report.

This is because the audit report acts as an ideal way of getting to know the health of the business. It is the responsibility of the organization to provide full and correct information to the auditor which in turn helps the auditor to prepare correct report. If the company does not provide the correct accounts, it will be held liable. If the auditor despite knowing the fact that the financial information is not correct and he prepared a report in favor of the company he will be held liable by the court of law. Therefore it is essential that the parties involved in auditing provide a true report.

Mark might convince George by telling him the consequences of not including the going concern report. He may also encourage him by telling him that the well wishers of the organization who would not like the company to liquidate may come forward to help the company or he may suggest the company to merge with its competitors to avoid the current financial position. 5. How appropriate is it for an audit partner to have a friendly personal relationship with a client? It is appropriate for the audit partner to have a friendly personal relationship with the client so long as it does not disturb their professional values and standards.

Just as in this case, Mark was so hesitant to tell George about his wanting to include the going concern explanatory paragraph in the audit report. Mark was actually in a awkward position to reveal this to George but then he did it. This condition arouse because Mark and George were friends. So long as the friendship of audit partner and client does not affect their professional motives it is good to maintain a healthy relationship. 6. What factors should motivate Mark to be objective in his decision, despite his personal concern for his friend? The factors that should motivate Mark to be objective are ? The legal consequences The values and standards of auditor ? The ethical considerations 7. In your opinion, what should Mark do? In my opinion it is essential that Mark should include the going concern explanatory paragraph in his report. This is because he will be doing justice to his profession. This will in a great way be of help to both the company and the various parties involved with the company. This will help the company to take this as a challenge to recover from its loss position provided it has the required finances and this report will provide a clear picture of the company to the parties and help them to secure their capital.

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