You are the manager responsible for performing hot reviews on audit files where there is a potential disagreement between your firm and the client regarding a material issue. You are reviewing the going concern section of the audit file of Racific Co, a client with considerable cash flow difficulties, and other, less significant operational indicators of going concern problems. The working papers indicate that Racific Co is currently trying to raise finance to fund operating cash flows, and state that if the finance is not received, there is significant doubt over the going concern status of the company. The working papers concluded that the going concern assumption is appropriate, but it is recommended that the financial statements should contain a note to explain the cash flow problems faced by the company, along with a description of the finance being sought, and an evaluation of the going concern status of the company. The directors do not wish to include the note in the financial statements.
Required:
i) Consider and comment on the possible reasons why the directors of Racific Co. are reluctant to provide the note to the financial statements. (5 marks)
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The main possible reasons why the directors are reluctant to provide the note to the financial statements are that they fear that:
The note will send a wrong signal to the stakeholders as follows;
- The prospective loan creditor may refuse to provide the needed funds on the basis that the company is not a going concern.
- Trade Creditors may refuse further credit and resort to cash on delivery transactions with the company.
- If the company is a listed entity, its share prices may fall.
- The existing shareholders may think that management is not running the affairs of the company properly.
- Potential investors may be scared away from investing in the company.
- Predators may pick it as signal to make take-over bid for the company. (Any 5 points)
ii) Discuss the implications for the auditors if the directors refuse to include the disclosure note. (5 marks)
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- If the directors refuse to provide the note, the auditors may consider that the financial statements are materially misstated in account of the non-disclosure of the going concern uncertainty.
- In the height of this, the auditors would consider this disagreement on the type of opinion to issue which might be other than unmodified.
- This failure to disclose the going concern problem will result in an adverse opinion. The auditors could also assess the implication of management refusal on their continued association with the client.
- If they consider that it amounted to serious non-co-operation with them by management, they may consider terminating the client relationship.
- However, they have to seek legal counsel and also draw the attention of the shareholders of the problem.