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Forestcrest Woolen Mills is a closely held North Carolina company that has existed since 1920. The company manufactures high-quality woolen cloth for men’s and women’s outerwear. Your firm has audited Forestcrest for 15 years.

Five years ago, Forestcrest signed a consent decree with the North Carolina Environmental Protection Agency. The company had been convicted of dumping pollutants (such as bleaching and dyeing chemicals) into the local river. The consent decree provided that Forestcrest construct a water treatment facility within eight years.

You are conducting the current-year audit, and you notice that there has been virtually no activity in the water treatment facility construction account. Your discussion with the controller produces the following comment: “Because of increased competition and lower sales volume, our cash flow has decreased below normal levels. You had better talk to the president about the treatment facility.”

The president (and majority shareholder) tells you the following: “Given the current cash flow levels, we had two choices: lay off people or stop work on the facility. This is a poor rural area of North Carolina with few other job opportunities for our people. I decided to stop work on the water treatment facility. I don’t think that the state will fine us or close us down.” When you ask the president if the company will be able to comply with the consent decree, he informs you that he is uncertain.

Which of the following statement(s) is/are correct regarding the implications of this situation if these events occurred in the seventh year after the signing of the audit decree?

Multiple Choice

A. The auditor would not be concerned with this situation because it has no bearing on the financial statements.

B. If the facility cannot be completed, the auditor would most likely issue a standard unqualified report.

C. If the facility cannot be completed on time and the penalties under the consent decree are significant enough to raise doubts about the company's continued existence, the auditor would likely issue a modified report with an explanatory paragraph for going concern.

Answer 1

1.Since, Forestcrest is pertaining a lower sales volume and an excessively decreased cash flows, the more details for the same must be distinctly disclosed in the financial statement so as to ensure an intimation to the concerned stakeholders as well as a transparent overview of the Company. This would gain the Company an upper hand in relation to the North Carolina Environmental Protection consent decree constraint as the Company may exercise the principle of “Force Majeure” which is a legal term that provides a temporary amnesty to a party from performing its obligations under a consent decree or a contract when an extraordinary event or circumstances happen beyond the control of the parties involved.

2. A client’s assurance and the pledge of timely work is not the only appropriate parameter to issue a standard unqualified audit report. A standard unqualified audit report or in other parlance what we call as an independent auditor's “clean opinion” can only be issued when the auditor believes, verifies and establishes that the entity’s “financial statements” are fairly and properly presented in all material respects taking into account all relevant financial frameworks and the accounting standards.

3. Since, Forestcrest has signed a “consent decree” with the North Carolina Environmental Protection to construct a water treatment facility within eight years, it should continue working on the same. Failure to do so will be a strict violation of the relevant laws & regulations and may lead the Company to pay penalties. Also, it may lead the Company to halt its operations, liquidate its assets, et cetera in the foreseeable future, in case they infringe & overstep the going-concern principle which is a fundamental assumption of a healthy Company.

Therefore, If the facility cannot be completed on time and the penalties under the consent decree are significant enough to raise doubts about the company's continued existence, the auditor would likely issue a modified report with an explanatory paragraph for going concern.

Hence Option (C) is correct.

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