Background Information

You are an audit senior on the Trading Styles, Inc. engagement, which is a private retail company. You work for the audit firm Elliott & Roan, LLP in the Denver, Colorado office. This is your first year on the engagement; however, the company has been your firms audit client for the past six years and represents approximately 15 percent of your audit offices revenue. Your audit firm issued a standard unqualified opinion for the audits of Trading Styles, Inc. in each of the last six years. You are currently working with your team to complete the 2018 audit (year ending 12/31/2018). This morning, the engagement partner (Tom) approached you and asked you to help him with his assessment of the companys ability to continue as a going concern. As part of this request, Tom provided you with some background and financial information related to Trading Styles, Inc.

Company Background

Trading Styles, Inc. was founded in 1991 and is headquartered in Ohio. The company operates in the highly competitive business of apparel-based specialty retailer and personal care and beauty categories. Trading Styles defines itself as a place that provides a luxury shopping experience and focus on fashion and is a trend-setter in the industry. The company targets its products toward the high-end segment of the market, appealing to women of all ages who are concerned with fashion as well as value. Trading Styles sells merchandise through specialty retail stores in the United States and Canada, which are primarily mall-based, as well as through websites and catalogues. The majority (approximately 75 percent) of company sales come from the stores and the remaining 25 percent are generated online and through catalogs. Based on the competitive nature of the industry, your client strives to maintain brand image through marketing, design, price, service, assortment, and quality. The company also engages in aggressive advertising campaigns during major television events to promote its products.

As in any other retail business, the operations are seasonal in nature and consist of two principal selling seasons: October through March (Q4 & Q1) and April through September (Q2 & Q3). The fourth quarter, including the holiday season, accounted for approximately one-third of net sales during 2018, 2017, and 2016 and is typically the companys most profitable quarter. Accordingly, cash requirements are highest in the latter part of the first quarter and the second quarter as inventories are built up in advance of the holiday season.

During 2014 and 2015, the company was mismanaged, with actual growth severely lagging expected growth. During this time, management overinvested in inventory from overseas vendors, and the expected increase in sales from these vendors did not materialize. In 2015, the company was required to write down a significant portion of its inventory due to obsolescence and also recorded a goodwill impairment charge. As a result of the poor financial performance, the board of directors decided to restructure the management team in hopes of returning to more successful operations as experienced in the late 1990s and early 2000s. The board of directors was able to recruit the prior CFO, Jonathan Smith, from several years ago, to rejoin the company as the new CEO. Jonathan has prior experience in public accounting as well as extensive knowledge of the client and the retail industry. The remainder of the management team is new to Trading Styles, Inc. and began employment at the beginning of 2016.

Company Financial Performance

Trading Styles, Inc. experienced improvements in operations over the past three years, including continuous growth in sales as reflected in the financial statements. This increase was consistent with managements expectations of annual sales growth between 10 and 11 percent. Since continued growth of this magnitude cannot be supported by domestic sales only, management plans to support future sales growth by expanding the companys core products into the European market. The companys growth strategy also includes targeting more customers through online channels. Management recently enacted tighter expense policies; however, the company has yet to generate a significant amount of operating income. One of their primary cost-cutting strategies includes implementation of more efficient printing, mailing, delivery, and order-fulfillment systems for online and catalogue sales. As reflected in the financial statements, the company experienced a small net loss during 2018 related primarily to a goodwill impairment charge recorded in the fourth quarter. However, the statement of cash flows shows net inflows of cash provided by operations in each of the past three years.

The current periods goodwill impairment charge relates to the discontinuation of one older product within the companys personal care line. The impairment loss removes the entire goodwill balance related to this product from the balance sheet. As a result of this impairment, management re-evaluated the remaining goodwill and is confident that this balance will not require additional impairments in the near future. Management expects to focus on more profitable products and views this discontinuation as a positive step forward. With this increased focus, management estimates that the company will continue to experience double-digit sales growth over the next three years, which is expected to generate net income in excess of $7.5 million in each of those years.

Firm Background

Tom has been the partner on this engagement since the firm took Trading Styles on as a client six years ago. Tom was one of the partners who was instrumental in winning the company as a client. He is known for creating close relationships with his clients and has never lost a client due to complaints about audit service. Tom takes great pride in his ability to balance the needs of his clients with his requirements as an auditor and is respected for his integrity and client service.

Tom mentioned to you that he has a strong client relationship with both the Chairman of the Board of Directors for Trading Styles, Inc. and Jonathan Smith (CEO). Tom was one reason why Jonathan agreed to come back to Trading Styles as CEO three years ago; at the Boards request, Tom had spoken candidly with Jonathan about the company and improvements taken to change the management of the company. Jonathan respected Toms opinions about the company and agreed to take on the job. For the past three years, Tom has been invited to Jonathans special Christmas party, which is open only to Jonathans employees close associates. Tom considers Jonathan to be a good friend.

Issues Noted By The Partner

Tom mentioned to you that the company has two outstanding loans with regional banks. The company does not have a line of credit and uses the funds from these loans to finance most of its ongoing operations. One of these two loans requires a balloon payment of $50 million on the maturity date, which is December 15, 2019. Therefore, this balance has been reclassified as the current portion of long-term debt for purposes of the 2018 financial statements. The debt is secured by substantially all of the companys assets; therefore, the bank could call the debt and sell the assets to re-coup its investment if the companys cash flows are not sufficient. Since this balloon payment requires a significant cash outflow within the next 12 months, Tom discussed this issue with Jonathan Smith (CFO) to determine managements plan for repaying or refinancing the debt.

Discussions With Management

Jonathan told Tom that the balloon payment is not an issue. He is confident that they will be able to secure a lender to buy out their current loan and avoid the payment due at the end of 2019. He said that management has a great relationship with their lenders, which is why the company was able to obtain a waiver on the current years debt covenant that requires positive net income. Additionally, Jonathan stated that he has such confidence in the future performance of the company that he would even consider personally guaranteeing the loan with the bank.

Jonathan reiterated that he does not see any reason for a going concern audit opinion and explained how critical a standard unqualified opinion is for continuation of Trading Styles, Inc.s recent success. To illustrate, he pointed out that the companys sales and gross profit margins have steadily increased over the last three years, which signals the companys revival. Finally, Jonathan emphasized that negative news like a going concern opinion could result in a self-fulfilling prophecy, wiping out all of managements recent efforts.

Next Steps:

Tom has informed you that he is struggling over this going concern assessment and he wants you to put together some research and thoughts about this decision for him to consider while making this decision. Tom has some specific areas that he wants you to address in your research, which are listed below.

Questions:

What three steps must the auditor perform when assessing the entitys ability to continue as a going concern?

Examine AU-C Section 570, The Auditors Consideration of an Entitys Ability to Continue as a Going Concern, to understand the auditors responsibilities when testing the going concern assumption. The AICPAs Clarified Statements on Auditing Standards can be found on the AICPAs website:

https://www.aicpa.org/research/standards/auditattest/clarifiedsas.html

Based on AU-C 570, what period of time is required for this assessment? In your response, provide both the time period as well as the reference for where in the standard you obtained this information (refer to Chapter 2 for the reference guide). If management expected to issue the financial statements on May 10, 2019, what specific period of time would be required for your assessment?

Describe what is meant by a self-fulfilling prophesy and how it might play a role in this scenario. Should the auditor be concerned with the self-fulfilling prophesy?

List three things noted in the discussion above that lead you to think Elliott & Roan, LLP could consider issuing an unqualified opinion without a going concern explanatory paragraph.

Describe the possible consequences to both Trading Styles, Inc. and Elliott & Roan, LLP if the going concern explanatory paragraph and footnote disclosure are excluded. What are the possible consequences to both if the going concern explanatory paragraph and footnote disclosure are included?

What possible issues arise for the accounting firm if they issue an unqualified report without the going concern explanatory paragraph?