Question

Surfer Dude Duds, Inc.

Mark glanced up at the clock on his office wall. It read 2:30 P.M. He had scheduled a 3:00 P.M. meeting 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 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 running, Mark had received a personal invitation from George to attend a special Christmas party held only for George's employees and close associates. Mark considered George a good friend.

In his six years on the audit, Mark had never had any reason to give everything 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 reaction. 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 P.M. meeting was to inform George of the decision to issue a going-concern report and to discuss the footnote disclosure of the issue. Mark went over in his mind several times what he was going to say, but 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'' 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 said. "When you wipe out, you've got to climb right back on to ride the next bomb, right? We always, manage4 to come out on top. We just need to ride this one out, just like the other tough times we've been through."

"George, I know you're optimistic that things will get better soon, but his time things are a little different," Mark sighed. "I know you well enough to 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. There is a non-trivial possibility that Surfer Dude will not 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 out inventory purchases and everything else will be C.O.D. It'll be cash-and-carry only. And what about your customers? It'll be your report that puts us under, not the ripples we're hitting now. I've got a feeling thins are going to be better soon. We just need a little more time."

"George, you've got to consider the consequence 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 think hard about this." George's ever-present smile was gone.

Mark was silent for what seemed even to him like an eternity. "Okay George, let's both think about it over the weekend. I'll drop by on Monday morning so we can figure out where to go from here. Thanks for your time."

Mark walked slowly out of the building and to his car. This was not going to be a relaxing weekend.

Question:

a. What are Mark's option? b. How might a going-concern explanatory paragraph becomes a "self-fulfilling prophecy" for Surfer Dude? c. What potential implications arise for the accounting firm if they issue an unqualified report without the going-concern explanatory paragraph? d. 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. e. Is it appropriate for an audit partner to have a friendly personal relationship with a client? At what point could be a personal relationship become an independence issue? f. What factors might motivate Mark to be objective in his decision, despite his personal concern for his friend? e. In your opinion, what should Mark do? Briefly justify your position and explain how you would approach George on Monday.

Answer 1

In the case in question, Mark is stuck between fulfilling his professional duties and personal relationship. As the profession demands, Mark must mention the “going concern” footnote. However:

Ans. A. There are four types of audit report: unqualified, qualified, adverse and disclaimer of opinion. An unqualified report signifies that the financials provided are true and fair position of the firm (it is considered clean report), while qualified report comes with a qualification that financials are not prepared in accordance with Generally Accepted Accounting Principles (GAAP) but there is no false representation or fraud. Adverse report states that the firm has resorted to misrepresentation of facts,etc. The fourth kind, disclaimer of opinion, is where the auditor declines to present any opinion on the business due to various reasons such as inadequacy of time to complete audit or when there is lack of independence or conflict of interest between auditor and auditee, or when there is concern over auditee’s ability to continue as going concern.

So, here the second best option available to Mark is to issue disclaimer of opinion in case he is not able to convince George to add the “going concern” footnote.

Ans. B. The “going-concern” paragraph will act as a self-fulfilling prophecy since it is likely to create fear and panic amongst various stakeholders of the Company, which will make them adverse and withdraw all support to the Company, thereby affecting the Company’s entire cycle from procurement of resources to its’ ability to generate sales. Lower sales, lower capital availability will all ultimately lead the Company towards liquidation.

Ans. C. If the auditor gives unqualified report despite knowledge of the fact that the Company is having difficulty running as a going concern and eventually the business faces problem, the accounting firm whom the auditor represents will suffer reputation risk and moreover, may suffer lawsuit against it by various stakeholders of the audit report for issuing false audit report.

Ans. D. Full and accurate auditor reporting is of utmost importance since audit report is the document based on which various stakeholders including shareholders, creditors, vendors, employees decide on the extent of their relationship with the Company. Audit report provides them a glimpse of how the Company is performing and whether the financials compiled by the Company are true and fair, whether they should trust on them for their decision-making.

If the footnote is deliberately excluded, both the Company and the accounting firm including the auditor face the risk of legal action against them for hiding material facts. In addition to that, they face the risk of huge reputation loss which might permanently disable them of doing business in the market. The auditor submitting the report faces career risk.

Mark must convince George to include the paragraph by detailing all of the above risks to George, most importantly, making him realize that George’s Company too would suffer legal action and reputation loss if material facts are misreported.

Ans. E. Since the start point of the engagement between the two – auditor and client - is a professional task, i.e., audit of the Company, the underlying professionalism and required independence must be maintained at all times. Cordial relations with the client can be maintained but to the extent they do not interfere in the independence of the auditor in doing his work.

Ans.F. First and most important reason for Mark to be objective in his decision is his career. He is likely to lose his job and career forever if any case of false reporting comes up against him. The accompanying reputation loss would end his career as an auditor for good.

Therefore, Mark should try his best to convince George to include the “going concern” paragraph. If still George does not agree, he should give ‘disclaimer of opinion’ to safeguard his position as well as help his friend. The disclaimer ensures that the message is sent to various stakeholders that the auditor is not willing to comment on the financials. Any doubting stakeholder upon reading disclaimer, such as a creditor, may probe further before taking any decision. This way, he fulfills his professional duty and helps his friend.