Question

A new client has been paying its suppliers late consistently; well in excess of the suppliers’ agreed credit terms. As a result, some suppliers have begun demanding cash on delivery from the client. You are also aware that a review of correspondence between the new client and its bank reveals that the new client has been experiencing cash flow problems for two years.
Required
Discuss THREE events or conditions described in the case that may cast significant doubt on the new client’s ability to continue as a going concern, and briefly explain why these vents or conditions could indicate going concern issues.

Answer 1

THE GOING CONCERN CONCEPT OR GOING CONCERN ASSUMPTION STATES THAT BUSINESSES SHOULD BE TREATED AS IF THEY WILL CONTINUE TO OPERATE INDEFINITELY OR AT LEAST LONG ENOUGH TO ACCOMPLISH THEIR OBJECTIVES. IN OTHER WORDS, THE GOING CONCERN CONCEPT ASSUMES THAT BUSINESSES WILL HAVE A LONG LIFE AND NOT CLOSE OR BE SOLD IN THE IMMEDIATE FUTURE. COMPANIES THAT ARE EXPECTED TO CONTINUE ARE SAID TO BE A GOING CONCERN. COMPANIES THAT ARE EXPECTED TO CLOSE IN THE NEAR FUTURE ARE NOT A GOING CONCERN.

• IN THE EARLY 2000S, GENERAL MOTORS WAS EXPERIENCING GREAT FINANCIAL DIFFICULTIES AND WAS READY TO DECLARE BANKRUPTCY AND CLOSE OPERATIONS ALL OVER THE WORLD. THE FEDERAL GOVERNMENT STEPPED IN AND GAVE GM A BAILOUT AS WELL AS A GUARANTEE. IN NORMAL CIRCUMSTANCES, GM WOULD NOT BE CONSIDERED A GOING CONCERN, BUT SINCE THE FEDERAL GOVERNMENT STEPPED IN, WE HAVE NO REASON TO BELIEVE THAT GM WILL CEASE TO OPERATE.
• ASSUME MICROSOFT IS CURRENTLY SUING A SMALL TECH COMPANY FOR COPYRIGHT VIOLATION OVER ITS SOFTWARE PACKAGE. SINCE THIS SOFTWARE PACKAGE IS THE ONLY OPERATION THE SMALL TECH COMPANY DOES, LOSING THIS LAWSUIT WOULD BE DETRIMENTAL. THERE IS A 95 PERCENT EXPECTATION THAT MICROSOFT WILL WIN THE LAWSUIT. THE SMALL TECH COMPANY IS NOT A GOING CONCERN BECAUSE IT IS PROBABLE THEY WILL BE OUT OF BUSINESS AFTER THE LAWSUIT IS SETTLED.
• IN 2011, GIBSON GUITAR FACTORY WAS RAIDED BY THE FEDERAL GOVERNMENT FOR ILLEGALLY SMUGGLING ENDANGERED WOOD INTO THE COUNTRY. THE FEDERAL GOVERNMENT TOOK MORE THAN $250,000 WORTH OR GIBSON’S INVENTORY AND SLAPPED THEM WITH LARGE FINES FOR VIOLATING INTERNATIONAL LAWS. GIBSON IS STILL CONSIDERED A GOING CONCERN, BECAUSE IT IS NOT LIKELY THE FINES AND PUNISHMENT WILL STOP ITS OPERATIONS.

THE CONCEPT OF GOING CONCERN IS PARTICULARLY RELEVANT IN TIMES OF ECONOMIC DIFFICULTIES AND IN SOME SITUATIONS MANAGEMENT MAY DETERMINE THAT A PROFITABLE COMPANY MAY NOT BE A GOING CONCERN, FOR EXAMPLE BECAUSE OF SIGNIFICANT CASH FLOW DIFFICULTIES.

THE CONCEPT OF GOING CONCERN IS PARTICULARLY RELEVANT IN TIMES OF ECONOMIC DIFFICULTIES AND IN SOME SITUATIONS MANAGEMENT MAY DETERMINE THAT A PROFITABLE COMPANY MAY NOT BE A GOING CONCERN, FOR EXAMPLE BECAUSE OF SIGNIFICANT CASH FLOW DIFFICULTIES. IT IS IMPORTANT THAT CANDIDATES UNDERSTAND THAT IT IS THE RESPONSIBILITY OF MANAGEMENT TO MAKE AN ASSESSMENT OF WHETHER THE USE OF THE GOING CONCERN BASIS OF ACCOUNTING IS APPROPRIATE, OR NOT, WHEN THEY ARE PREPARING THE FINANCIAL STATEMENTS.