Question

You have been conducting an audit of the financial reports of Rainbow Forest Ltd (Rainbow Forest). Rainbow Forest Ltd is a publishing company, specialising in books and other promotional material for special industry sectors and professional bodies. Over the last three years Rainbow Forest has been experiencing difficult trading conditions resulting in operating losses and deferred dividends.

In particular, Rainbow Forest has had difficulty managing its cash flow. Book sales are down on the prior year and longstanding customers are no longer making bulk purchases, but instead they are producing e-books which are emailed to members on the mailing list.

Whilst Rainbow Forest can still provide online technical support services and web design advice, they have lost a major source of revenue and 20% of employees have been made redundant.

You have been told by different sources that Senior Management is under a lot of pressure to turn this difficult situation around and improve both sales and profitability. You note that some of the reports you have been provided are either incomplete or are not consistent with what you have been told. Based on your initial understanding of the entity and its environment, you have concluded that Rainbow Forest Ltd is a going concern risk.

Required:

1. Based on the concept of professional scepticism, what indicators are most relevant when evaluating Rainbow Forest’s ability to continue as a going concern?
2. Assume Rainbow Forest Ltd is a subsidiary of a parent company based in London, UK, what steps should be taken by the auditor to confirm the appropriateness of the going concern assumption when an entity is dependent on its parent entity for financial support?
3. Assuming that the financial statements of Rainbow Forest Ltd were prepared on a “going concern” basis, discuss the effect on the audit opinion, if this assumption was now in dispute?

Answer 1

Answer to Part A.

Based on the concept of professional skepticism, various indicators are relevant in determining an entity's going concern approach. In this case following indicators are most relevant in Rainbow Forest's ability to continue as a going concern:

1. Negative Financial Trend : This includes declining sales, increasing costs, recurring losses, adverse financial ratios, etc.

2. System Records: This includes inadequate accounting record keeping & inconsistent/improper information.

3. Employees: This includes loss of key managers or major portion of skilled employees, as well as labor difficulties of various types.

4. Market Risk: Reduce demands for the product or services.

5. Reducing Cashflows: Inability to recover dues from customers.

6. Business Structure : Entity loosing key vendors & unable to replace them.

Answer to Part B

Steps to be considered in analyzing the going concern assumption for a subsidiary company who is dependent on its parent company for financial support:

1. The Auditor should try to collect evidences on going concern of subsidiary company. Auditor should focus on going concern risks i.e it is based on market risk factor or financial risk factor. If going concern risk is due to decrease in demand of the product, going concern of subsidiary is at risk no matter parent company is providing financial support or not.

2. The Auditor should check the appropriateness of going concern assumption of the Parent Company also. If there is a risk of going concern assumption of Parent Company then the dependence of Subsidiary on its Parent Company for financial support will be in question.

3. The Auditor should assess the Financial stability of the Parent Company and a degree to which the Parent Company can support its Subsidiary Company in the adverse scenarios.

4. The ability and willingness of Parent Company to provide necessary financial support to the subsidiary on need basis

5. The degree of autonomy the subsidiary company has and fits in the group's activities and future plans for growth.

Answer to Part C

Going concern is a fundamental principle for preparation of financial statements. The Management of the company assess going concern of the entiry, the auditor's responsibility is to evaluate that assessement.

It is not the responsibility of the auditor to conclude whether the entity is a going concern – this responsibility rests with the Management. The auditor’s responsibility is to evaluate the Management's assessment of the company’s ability to continue as a going concern.

Where the auditor determines that a material uncertainty exists which may cast significant doubt over the entity’s ability to continue as a going concern, then the auditor will modify the report by the inclusion of an ‘emphasis of matter’ paragraph in the audit report after the opinion paragraph. This is, of course, subject to the disclosures in the financial statements concerning the material uncertainty being adequate.

Where the Financial statements are prepared on 'going concern basis' but in auditor's view the management's assessment on going concern is inappropriate, auditor would express an adverse opinion.

Therefore, in this case the financial statements of Rainbow Forest Ltd were prepared on a “going concern” basis, and according to the Auditor going concern of Rainbow Forest Ltd is at risk, the auditor should express an adverse opinion in its Report.