Going-Concern Evaluation: Factors Affecting Decisions
Arnold, Vicky, Edwards, Donald E., The CPA Journal
SAS No. 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, requires the evaluation of the business entity's going concern status in every audit. Conditions and events that may, in the aggregate, indicate substantial doubt as to an entity's continuance may be grouped into four categories: negative trends, other indications of possible financial difficulties, internal matters, and external matters. e auditor must examine the magnitude of these pertinent factors and, where substantial doubt exists as to the ability of the firm to continue as a going concern, modify the audit report to include an explanatory paragraph to reflect such uncertainty. The characteristics of companies with going concern problems must be recognized by the auditor and evaluated as to severity, and a decision must be made regarding whether an explanatory paragraph is necessary.
THE GOING CONCERN CASE
To investigate the process used by auditors to assess continuity of a firm, a case study was developed in which the going-concern decision was not clear. A description of an audit client was given along with financial statements and past history of the client/auditor relationship. Both contrary and mitigating evidence was included to insure consideration of whether substantial doubt existed as to the client's ability to continue as a going concern.
The cues provided as evidence were developed from the examples set forth in SAS No. 59. The cues were then divided into basic, favorable, and unfavorable information. Introductory information about the client is described in Table 1 as "baseline cues." Facts that tend to support continuance are labeled "positive cues," factors that would likely cast doubt on the client's ability to remain in operation are designated "negative cues." (Table 1 omitted)
The case was sent to 344 professional auditors. Two hundred and two usable responses were received for a 59% response rate. Fifty-eight percent of the participants were audit managers, and forty-two percent were audit partners. The average age was about 36 years, and the average experience exceeded 12 years. The respondents were employed by both national and regional CPA firms. Thus, the participants appeared to possess the background needed to address the going concern issue being raised in the case materials.
The participants were asked to read the case and to make a categorical decision on whether the audit report should be modified due to the existence of substantial doubt about the client firm's ability to continue as a going concern. Participants were subsequently asked to rate each case cue (listed in Table 1) as to its impact upon their decision-making processes. The cues were evaluated on an eleven point scale. A strongly negative rating (-5) would support a decision to include an explanatory paragraph about continuity in the audit report, a rating of "0" would indicate neutrality, and a strongly positive rating (+5) would imply that an explanatory paragraph is unnecessary.
INFORMATION CONSIDERED IN MAKING THE GOING-CONCERN DECISION
Table 2 shows the overall importance of the various factors presented in the case regardless of whether the auditor decided to modify the audit report by including the explanatory paragraph. On an individual basis, the cues with the highest mean scores were a significant loss from operations in the current year (LOSS), the continued availability of tade credit (TRADE CREDIT), a potential liability from litigation (LITIGATION), the possibility of losing a major customer (MAJOR CUSTOMER), the potential sale of a patent (SALE OF PATIENT), and a current ratio that is approaching the limit set in a loan agreement (CURRENT RATIO). It is interesting to note that four of the top six cues are negative in nature and, therefore, could indicate auditor conservatism due to legal-liability implications. The auditor might logically be cautious and more sensitive to factors pointing toward a going concern problem in the future. …