Auditing and assurance revision question and answer

Auditing and Assurance Revision Questions and Answers

You are carrying out the audit of ACB Computers limited for the year ended 31 December 2003. The company assembles microcomputers purchased from the Far East and sells them to retailers, and to individuals and other businesses. In the current year, there has been a recession and strong competition, which has resulted in a fall in sales and the profits. This has led to a trading loss and the company is experiencing going concern problems.

Required
a) Describe the factors, which indicate that a company may not be a going concern. Your list should include all factors and not just those, which relate to ACB Computers Limited. (10 Marks)
b) Consider the form of audit report (i.e. qualified or unqualified) you would issue of ACB Computers limited if you conclude that the company is experiencing serious going concern problems, in the following two situations:
I) You conclude that the financial statements give sufficient disclosure of the going concern problems.
II) There is no disclosure of the going concern problems in the financial statements and you believe there is a serious risk that the company will fail in the foreseeable future (6 marks)
c) State the parties who may successfully sue you as auditor for negligence, and consider the arguments you could include in your defense when:

I) The financial statements of ACB Computers Limited for the year ended 31 December 2003 do not mention any going concern problems and your audit report on these financial statements was unqualified and
II) The company fails on 15 February 2004 (4 marks)
ANSWER
a) The indications or risk that continuance as a going concern may be questionable could come from financial statements or from other sources

Financial indicators
 Liabilities are more than the assets of the company;
 Borrowings with fixed repayment dates approaching maturity without realistic prospects of renewal or repayment, or excessive reliance on short-term borrowings to finance long-term projects undertaken the company.
 Adverse key financial ratios e.g. current ratio below one;
 Substantial operating losses.
 Inability to pay creditors on due dates.
 Difficulty in complying with terms of loan agreements e.g. failure to pay interest and principal on due dates.
 Change from credit to cash on delivery transactions with suppliers.

Operating Indicators
 Loss of key management without replacement.
 Loss of major market or customer.
 Labour difficulties or shortage.

Other Indicators
 Non-compliance with capital or other statutory requirements. This could lead to the company being wound up under the law.
 Pending legal cases against the entity that may, if successful result in judgments that could not be met.
 Changes in legislation or government policy that adversely affects the client‘s business.
b) Where there is adequate disclosure in the financial statements

I) According to ISA 700 the auditors report on financial statements, the going concern problem is a fundamental uncertainty i.e. it is uncertain whether the company will continue to trade to 31 December 2004, and if the company failed, the consequences of the failure would have a fundamental effect on the financial statements. Since the financial statements have given adequate disclosures about the uncertainty created the going concern problem the auditor should issue an unqualified opinion with an emphasis of matters paragraph. The emphasis of matters paragraph will disclose the going concern problems and refer to the relevant notes in the financial statements. Normally, the paragraph will say that the continuation of the business will depend on the company becoming profitable and the bank and creditors
continuing support to ACB Computers Limited.

II) If there is no disclosure of the going concern problem in the financial statements then the financial statements are misleading since the effect of the disagreement is so material and pervasive. The auditor should issue an adverse opinion. The opinion paragraph should give details that have led to the qualification i.e. the need for the company to become profitable and obtain support from the creditors and the bank and also because of the failure to include details of the going concern problems, the financial statements do not show a true and fair view of the company‘s affairs as at 31 December 2003 and of its loss for the year then ended.

c) Since ACB Computers Limited has failed within a year and the auditor had given an unqualified report, certain parties may be able to successfully sue him for negligence. The decision in the Caparo case is that only the company and the shareholders as a body can bring a claim for negligence against the auditor. It is possible that the court will refer to the ISA that indicates that the audit report should have mentioned the going concern problems. As the auditor did not mention them, the claim for negligence could be successful. In the situation, the going concern problems were apparent during the audit and this reduces the strength of the auditor‘s defense. There are a variety of arguments the auditor could make in defense against a negligence claim, but these depend on the circumstances. If ACB failure was caused a sudden event or one that occurred after the audit report was signed and was not expected to occur at the time the audit report was signed, then the auditor may have a good defense against the negligence claim. These could include a legal claim against ACB, a substantial loss on a contract entered into after 31 December 2003. If the failure was not foreseen as at 31 December 2003 then the auditor can avoid a claim for damages.



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