Case 12.4: Surfer Dude Duds, Inc.: Considering the Going-Concern Assumption ^*

Learning Objectives

After completing and discussing this case, you should be able to

Understand the difficulty of assessing the clients going-concern assumption

Describe the self-fulfilling prophecy aspect of a going-concern modified auditors report

Identify factors that encourage objective auditor judgments despite the presence of friendly client-auditor relationships

Background

Mark glanced up at the clock on his office wall. It read 2:30 P.M. He had scheduled a 3:00 P.M. meeting with George Hang-ten Baldwin, chief executive officer of Surfer Dude Duds, Inc. Surfer Dude specialized in selling clothing and accessories popularized by the California surfer culture. Mark had served as audit partner on the Surfer Dude Duds audit for the past six years and was about ready to wrap up this years engagement.

He enjoyed a strong client relationship with George Baldwin, who was ordinarily a relaxed and easygoing man, now going on 50 years of age. For several years, Mark had received a personal invitation from George to attend a special Christmas party held only for Georges employees and close associates. Mark considered George a good friend.

In his six years on the audit, Mark had never had any reason to give anything but a clean audit opinion for Surfer Dude Duds, Inc. But this year was different. The economy was in a mild recession, and given the faddishness of clothing trends, Surfer Dudes retail chain was hurting. As sales decreased, Surfer Dude was struggling to meet all its financial obligations. Retail analysts foresaw continuing hard times for clothing retailers in general, and current fashion trends did not seem to be moving in Surfer Dudes direction. As a result, Mark was beginning to doubt Surfer Dudes ability to stay in business through the next year. In fact, after conferring with the concurring partner on the audit, Mark was reluctantly considering the addition of a going-concern explanatory paragraph to the audit report. When Mark broached this possibility with George several weeks ago, George brushed him off.

The purpose of the scheduled 3:00 meeting was to inform George of the decision to issue a going-concern report and to discuss the footnote disclosure of the issue. Mark rehearsed what he was going to say several times, but he remained uneasy about the task before him.

When Mark arrived at George Baldwins office, a secretary greeted him and told Mr. Baldwin of Marks arrival. When Mark heard George say, Send him in, he took a deep breath and headed into Georges office with a smile on his face. George was sprawled out in a large executive chair, with his ever-present smile. Mark always marveled at how a person could invariably seem so relaxed and happy. Hey Mark, whats up? You know I dont like meetings on Friday afternoons, George yawned.

Well George, Ill get right to the point. As you well know, the retail clothing market has really gone south the past few months. I know I dont need to tell you that Surfer Dude is struggling right now.

I know, but well pull out of it, George insisted. When you fall off, youve got to climb right back on to ride the next monster, right? We always manage to come out on top. We just need to ride this one out, just like the other times weve struggled.

George, I know you have high hopes that things will get better soon, but this time things are a little different, Mark sighed. I know that you might just be able to pull the company out of this. But given the circumstances, I think were going to have to look at including a going-concern explanatory paragraph in the audit report. I substantially doubt that Surfer Dude will be able to continue as a going concern for the next year. I also recommend that you include a footnote in your financial statements to the same effect.

What? Mark, you cant go slapping a going-concern report on me! Surfer Dude will go belly-up for sure. No one will be willing to loan us any money. Shoot, nobody will even be willing to sell us anything on accountall our inventory purchases and everything else will be C.O.D. Itll be cash-and-carry only. And what about our customers? Will they buy if theyre not sure well be there to stand behind our return policy? Itll be your report that puts us under, not the ripples were hitting now. Ive got a feeling things are going to get better soon. We just need a little more time.

George, youve got to consider the consequences if....

Mark, if you slap me with a going-concern report, there is no way well be able to pull out of this. Think of all the people who will lose their jobs if Surfer Dude shuts down. Please, Im asking you to at least think about it. Georges ever-present smile was gone.

Mark was silent for what seemed like an eternity. Okay George, lets both think about it over the weekend. Ill drop by on Monday morning so we can work this out. Thanks for your time.

Mark walked slowly out of the building and to his car. This was not going to be a relaxing weekend.

Please answer the questions below.

Requirements

1. What are Marks options?

2. How might a going-concern explanatory paragraph become a self-fulfilling prophecy for Surfer Dude?

3. What potential implications arise for the accounting firm if they issue an unqualified report without the going-concern explanatory paragraph?

4. Discuss the importance of full and accurate auditor reporting to the public, and describe possible consequences for both parties if the going-concern explanatory paragraph and footnote are excluded. How might Mark convince George that a going-concern report is in the best interests of all parties involved?

5. How appropriate is it for an audit partner to have a friendly personal relationship with a client?

6. What factors should motivate Mark to be objective in his decision, despite his personal concern for his friend?

7. In your opinion, what should Mark do?

Thank You,