Question

Part 1. Going Concern

Facts:

• A Chicago area company (“Company”) has been manufacturing metal gas tanks for passenger automobiles since 1918.  The Company has always been a privately held family run business.
• The Company has been profitable for much of its history; retained earnings at the end of 20X1 was $20 million.
• Recently mandated EPA mpg requirements have caused automobile manufacturers to move to utilizing plastic gas tanks – which are much lighter than metal.  This change in materials helped automobile manufacturers reduce auto weights and meet the increased mpg requirements.
• The Company decided not to convert their operation to plastic gas tanks because their expertise was only in manufacturing metal products.
• A few years back, the owners were faced with two options:  Liquidate and distribute available assets or move into a different line of business.  The Company decided to do the latter.  The Company felt it could use its expertise to manufacture metal frames for televisions (like for Toshiba, Panasonic, etc.)
• The Company built a new manufacturing plant in Georgia for manufacturing these metal TV frames; the plant was financed with low interest rate IRBs (Industrial Revenue Bonds).
• The IRBs were for $25 million with a 20-year term.  The Company has no other debt.
• Unfortunately, in its first two years of operation of the new metal picture frame plant– 20X2 & 20X3 – the Company lost $11 million and $8 million, respectively.  The metal TV frame business is extremely competitive; sales prices of metal TV frames are quite low.  The Company was simply unable to produce large quantities of metal frames at a cost which would enable the Company to generate adequate gross profit.
• You are finishing your Audit of 20X3 & discussed the Going Concern issue with the Company’s management, including the family owners.  The owners / managers feel they have no choice but to continue producing metal TV frames – due to the 20-year IRB term.
• Management prepares financial projections for the next year which shows the Company breaking even; the projections reflect a significant increase in the gross profit – it is unclear how management will improve their gross profit margin so significantly.

Required: Part 1

1. State whether you believe there is or is not substantial doubt about the Company’s ability to continue as a Going Concern.  Provide your supporting arguments, specifically addressing:

• Conditions and Events
• Management’s Plans
• Stating that you believe there is substantial doubt means that your Audit Firm’s Independent Auditor’s Report for the year of 20X3 will include an emphasis of a matter paragraph with the supporting footnote.  (There is no need to formally draft the paragraph & supporting footnote.)

Stating that you believe there is not substantial doubt means that your Audit Firm’s Independent Auditor’s Report for the year of 20X3 will not include an emphasis of a matter paragraph but the Audited Financial Statements will include a footnote describing the conditions and events and how management’s plans alleviated the conditions and events.  (There is no need to formally draft the footnote.)

Part 2.  Subsequent Events

Facts:

You are performing an annual audit of a company with a December 31, 20X1 year-end.  Your firm is planning to complete the audit on March 1, 20X2 and release the report on March 31, 20X2.  On March 15, 20X2, two material subsequent events occur:

• A fire caused extensive damage to the company’s manufacturing plant in New Jersey.
• A large customer went bankrupt.  At December 31, 20X1, the Company had a receivable of $2,500,000 from this customer; at December 31, 20X1 the Company had established an allowance for doubtful accounts of $700,000 for this customer.

Required:

1. Explain whether each subsequent event is a Type 1 or Type 2 Subsequent Event.
2. What is the impact of each subsequent event on the company’s audited financial statements for the year ended December 31, 20X1?  Be specific as to whether (a) there will be an adjustment which will cause the company’s balance sheet and / or income statement to change plus footnote disclosure, (b) there will only be footnote disclosure, or (c) there will be no impact to either the financial statements or the footnote disclosures.

How should your Audit Firm date its audit report?

Item A.  Payments to Company’s Former President

Facts:

Joan Smith, CPA, receives a telephone call from her client, XYZ Company.  The company’s controller states that the board of directors of XYZ has entered into two contractual arrangements with Steve Green, the company’s former president, who has recently retired.  Under one agreement, XYZ Company will pay the ex-president $7,000 per month for five years if he does not compete with the company during that time in a rival business.  Under the other agreement, the company will pay the ex-president $5,000 per month for five years for such advisory services as the company may request from the ex-president.  

XYZ’s controller asks Smith whether the balance sheet as of the date the two agreements were signed should show $144,000 in current liabilities and $576,000 in long-term liabilities, or whether the two agreements should only be disclosed in a contingency note to the financial statements (i.e. no amounts should be accrued in the financial statements pursuant to these two agreements).

  

Required:

1. How should Joan Smith reply to the controller’s questions?  Note: your answer could be different than either of the alternatives suggested by the XYZ controller.

Item B. Contingent Liability

Facts:

• You are auditing a very successful and highly profitable manufacturing company as of December 31, 2020.
• The Company has always maintained adequate insurance in different areas.  The Company has decided, effective January 1, 2021, not to purchase insurance against risk of loss that may result from injury to others, damage to the property of others, or interruption of its business operations.
• The Company would like to record a $5,000,000 reserve as of December 31, 2020 for claims associated with future events which may occur.

Required:

1. Should the Company record this $5,000,000 Reserve for Claims (a contingent liability) in its 12/31/2020 Financial Statements?  Why or why not?

• A Chicago area manufacturing company (“JKL”) has 2 unrelated owners.  The CPA firm (“Flexible”) for the manufacturing company prepares annual compiled financial statements and corporate tax returns (1120S).  In addition, Flexible prepares the personal income tax returns for one of the owners – a different tax accountant prepares the personal income tax returns for the other owner.  The Company has a December 31^st year end.
• Toward the end of February each year, there is an annual meeting in the western suburbs, with the following in attendance:  the 2 owners of JKL, Flexible’s CPA Partner, the tax accountant for the other owner, and pension consultants.
• In anticipation of the meeting, Flexible prepares and distributes draft financial statements, and a year to date General Ledger; everything is complete except the amount of any pension accrual and the final amount of inventory.
• The purposes of the meeting are to determine:

1. the pension accrual
2. the desired taxable income for the year
3. the amount of inventory necessary to bring taxable income to the desired level (achieved through a debit or credit to inventory with an offsetting debit or credit to cost of goods sold).

Required:  For the situation described above, please answer the following two questions:

1. What are the business ethical issues?

What are the professional ethical issues for Flexible’s CPA Partner?

Answer 1

Part.1 Going Concern:

As per the information provided the company's expertise is to make metal frames and entered into manufacturing the metal frames for televisions with a loan of $25 million out of which the company lost $11 million in year 1 and $8 million in year 2. As the sales prices of metal TV frames are quite low they cannot make sufficient profits to get into break-even position.

Management prepares financial projections for the next year which shows the Company breaking even; the projections reflect a significant increase in the gross profit.  The company is only left with the amount of $6 million out of the borrowed amount and also in a situation of unable to produce enough stock to get profits. As per this situation, the company is unable to continue as a going concern.

Part.2 Subsequent Events:

The events which occur after the finalising the books of accounts and before getting approval from the board of directors are called as Subsequent Items. The financial statements are adjusted if an event is an adjusting event and for non-adjusting event disclosure in the board report is required.

As per the given information the Type 1 event is considered as an adjusting event as the damage caused by fire outbroke to the manufacturing plant is MATERIAL IN NATURE so the books should be adjusted for such damage and the Type -2 event is also an adjusting event and requires a change in the books of accounts as the company is in aware of the financial position of the customer and created a provision while closing the books of account. The book of accounts should be changed for the total loss incurred due to the bankruptcy of the customer.

Item.A Payment to Company's Former President:

A liability is defined as the future sacrifices of economic benefits that the entity is obliged to make to other entities as a result of past transactions or other past events. The company entered into an agreement with the former director to pay an amount to not to entered other rival company. The Expense can be treated as a Liability as it satisfies the above definition. Whereas, the payment to the former president fo the advisory services is neither liability nor a contingency. he is getting paid for the services provided by him so it should be treated as an expense.

Item.B Contingent Liability:

Contingent liability:

• a possible obligation depending on whether some uncertain future event occurs, or
• a present obligation but payment is not probable or the amount cannot be measured reliably.

As there is no possible or present obligation for the company it cannot be considered as a contingent liability as there is no suit or any obligation on the company. It can maintain the amount as the reserve but not to disclose it as a contingent liability.