AUDITING
By Bruce K. Behn, Kurt Pany, and Richard Riley
Statement on Auditing Standards No. 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, requires auditors to evaluate whether substantial doubt exists about an audit client's ability to continue as a going concern. The first stage in making this going concern evaluation requires consideration of whether the results of audit procedures performed related to the various audit objectives identify existing conditions and events that indicate substantial doubt about the client's ability to continue as a going concern. Those conditions and events are divided into four categories: 1) negative trends, 2) other indications of possible financial difficulties, 3) internal matters, and 4) external matters. The sidebar gives examples from SAS No. 59.
When, after considering conditions and events in the aggregate, the auditors believe that substantial doubt may exist, they should consider management's plans for dealing with the effects of those conditions and events. If, after considering the conditions and events and management's plans, the auditors conclude that substantial doubt remains, the audit report should include an explanatory paragraph to reflect this uncertainty. Alternatively, the auditors may choose to issue a disclaimer of opinion upon the financial statements.
The purposes of this paper are to 1) present a summary of the conditions and events present when auditors have issued reports modified as to a client's going concern status and 2) consider the manner in which the going concern uncertainty was subsequently resolved. To learn of the conditions and events that are leading to disclosure of going concern uncertainties, we used the CD Disclosure database to examine data from 135 companies receiving first-time going concern explanatory paragraphs between 1989 and 1992. For these companies we also analyzed the subsequent resolution using the following three categories:
37 Successful resolutions within one year
62 Continuing going concern explanatory paragraphs
36 Bankrupt companies
135 Total
With the exception of bankrupt companies, the sample of 135 companies was categorized by the going concern modification status in the year subsequent to the initial going concern. Bankrupt companies include those that filed for bankruptcy up to four years after the initial going concern modification (13 of the 36 bankrupt companies filed within one year and 13 more petitioned for bankruptcy in the second year).
The Exhibit is structured using the existing conditions and events discussed in SAS No. 59 and the resolution outcome. For the total sample of 135 companies, 348 existing conditions and events (an average of 2.6 per company) were mentioned in either the audit report or financial statement notes referenced in the audit report in the year of the initial going concern modification. The lowest average, 2.4 existing conditions or events per company, was found among successful resolution companies, compared with averages of 2.7 and 2.6 found among continuing going concern modification and bankrupt companies, respectively.
Recurring operating losses (under negative trends) and default (under other indications) are by far the most frequently occurring conditions identified in the audit reports, occurring 54.1% and 58.5%, respectively. Conditions and events within the negative trends and other indications categories were disclosed more frequently than were internal or external matters.
When comparing the three groups--successful resolution, continuing going concern, and bankruptcy--recurring operating losses occurred approximately 58.3% of the time for companies that subsequently filed for bankruptcy, while that condition existed much less frequently for the successful resolution companies (43.2%). Also, negative retained earnings were associated with 38.9% of companies that filed for bankruptcy as contrasted with the 10.8% of companies that successfully resolved the going concern uncertainty.
While we identified few systematic differences between companies that successfully resolved their going concern status and those that did not, we did find--perhaps not unexpectedly--that recurring operating losses and negative retained earnings most frequently led to bankruptcy. *
Bruce K. Behn, PhD, CPA, is an assistant professor at the University of Tennessee, Kurt Pany, PhD, CPA, a professor at Arizona State University, and Richard Riley, PhD, CPA, an assistant professor at West Virginia University.
By Timothy B. Bell, Frank O. Marrs, Ira Solomon, and Howard Thomas
Reviewed by Hema Rao, DBA, CPA, assistant professor, SUNY Utica/Rome
This research monograph focuses on KPMG's new risk-based strategic-systems audit approach. The firm believes that its new holistic approach to evaluating client business risk is needed in today's more complex business environment. The new business measurement process (BMP) shifts the auditor's focus from an "accounting lens," or transaction-based approach, to a "strategic-systems lens" approach.
The Lincoln Savings and Loan (LSL) audit is cited in the monograph as an example of the failure of a transaction-based approach to an audit. In contrast, a BMP audit would consider macro information relevant to the savings and loan industry in assessing audit risk. This would include the weak economic environment, regulatory changes, disputes with a regulator, changes in strategic business practices that allowed the bank to invest in high risk securities, auditor changes, and business risks peculiar to LSL. If she had used this new approach, the LSL auditor might have been more skeptical about the 400500% overvalued reported land sales.
The stated purposes of the monograph are to present--
* "an overview of the theories and trends that create a need for a risk-based strategic-systems audit;
* a discussion of the systems theory and strategy concepts that underlie the risk-based strategic-systems audit;
* an overview of some of the business measurement principles, analytical procedures, and tools comprising KPMG's risk-based strategic-systems audit--BMP; and
* examples that illustrate how BMP might be applied to a retail client."
The Strategic-Systems Lens. KPMG applies concepts from systems theory and views the client's accounting transactions as an outcome of a complex web of economic and business interrelationships. The auditor's "lens" (mental orientation) to assess audit risk is influenced by the nature of these complex relationships. A broader and more comprehensive focus heightens skepticism in evaluating the economic reasonableness of reported management assertions.
Knowledge Acquisition Framework
To gain a comprehensive understanding of the client's business and industry, the auditor should understand the client's systems dynamics. Such a process includes the following:
* Gaining an understanding of the client's strategic advantage. How does the client create value?
* Assessing the threats that put the client's attainment of its business objectives at risk.
* Developing a client business model that will serve as a lens to perceive and judge client assertions. This model is called the "comprehensive decision frame guide."
* Developing expectations about key assertions embodied in the overall financial statements
* Comparing reported financial results to expectations and designing additional audit work to address gaps between the two.
The comprehensive decision frame guides the auditor to apply professional judgment to evaluate the appropriateness of--
* recorded transactions and
* assumptions made about the underlying accounting principles in executing nonroutine transactions, making accounting estimates, and valuing recorded assets.
In the absence of this framework, the professional judgment developed by the auditor to predict the client's ability to continue as a going concern and detect management fraud may be misguided. The differences in the new BMP audit and the traditional audit are explained in the Exhibit.
The KPMG Business Measurement Process (BMP)
The audit risk model components--inherent, control, and detection risk--continue to be relevant to the BMP audit process. Under this approach, audit risk assessment is made from the broader perspective of the client rather than from the transaction level alone. The BMP framework analysis is done at five different levels.
Strategic Analysis. This is intended to provide the auditor with a deep understanding of the industry and global environment in which the client organization operates. The analysis includes assessing business risks that affect financial statement assertions due to threats to the client from competition within its industry and the adequacy of the client's response to these risks.
Business Process Analysis. At the second level, the auditor uses a "value chain" approach to study the client's core business processes and total quality management used for creating value in the eyes of customers and resulting in profitable sales. The auditor evaluates methods and systems used by the organization in conducting its business using eight dimensions: process objectives, inputs, activities, outputs, systems, classes of transactions, risks that threaten objectives, and other symptoms of poor performance. The auditor develops an understanding of the client's financial and nonfinancial performance measures and determines the gaps that exist between the client's processes and those of its direct competitors. Such measures may be used as corroborative evidence in assisting the auditor support expectations about financial statement assertions.
Risk Assessment. At the third level, the auditor gains an understanding of the client's risk monitoring and management processes, both internal and external. With this understanding, the auditor can decide if the client has identified all aspects of business risk, prioritized them appropriately, established controls to reduce the risk to acceptable levels, and made accounting choices and disclosures in the financial statements that address any uncontrolled risks.
Business Measurement. At the fourth level, the auditor measures business processes and variables that have the greatest impact on the client's business. The auditor analyzes the client's financial and nonfinancial performance and measures both over time and against the competition. Additional audit work is done on financial statement assertions inconsistent with the auditor's understanding of the client's strategic systems analysis.
Continuous Improvement. The final phase allows the auditor to provide the client with valuable feedback for continuous improvement. The auditor reports on client gaps in process and financial performance measures based on standardized targets and competitor measures. Client reaction to these types of diagnostic business assurance is valuable information in assessing audit risk.
Improved Analytical Procedures
In external auditing, any significant deviations found in comparisons of auditor expectations of client business performance and financial position with financial statement assertions are evaluated in assessing audit risk. In traditional audits, these expectations are tested based on details of client accounting transaction samples. This reductionist process may lead to a potential bias in auditor judgment in favor of judging management assertions as being appropriate.
KPMG's complex business processoriented analytical procedures (which develop financial and nonfinancial expectations regarding every business activity of the audit client) may explain any uncontrolled business risks that resulted in these deviations by looking beyond the client's accounting system. This new comprehensive approach also allows the BMP auditor to comply more effectively with the requirements of SAS No. 82, Consideration of Fraud in a Financial Statement Audit, since diagnosing the problem improves under this holistic approach to the audit.
Conventional Auditing Still in Use
The BMP audit model retains much of existing conventional auditing. The strategic systems auditor will continue to use the audit risk model, allocate audit work on the basis of risk assessment, and for the most part use conventional audit procedures. However, the BMP auditor will use a higher level of knowledge base that combines traditional auditing with systems theory and business strategy to come up with audit expectations. The auditor understands the unexpected deviations from expectations from a more comprehensive analysis of the client's external and internal business environments and views the client's business and other processes as part of a larger system. Audit risk evaluation becomes more appropriate from this judgment plane.
In the opinion of this reviewer, current and future audit practitioners will benefit from the BMP enhancements explained in this monograph. Classroom use of this technical, yet easy to understand and well illustrated, audit approach will provide good training for future generations of auditors. *
GOING CONCERN CONDITIONS AND EVENTS
Negative trends: recurring operating losses, working capital deficiencies, negative cash flows from operating activities, adverse key financial ratios
Other indications of possible financial difficulties: default on loan or similar agreements, arrearages in dividends, denial of usual trade credit from suppliers, restructuring of debt, noncompliance with statutory capital requirements, need to seek new sources or methods of financing or to dispose of substantial assets
Internal matters: work stoppages or other labor difficulties, substantial dependence on the success of a particular project, uneconomical long-term commitments, need to significantly revise operations
External matters: legal proceedings, legislation, or similar matters that might jeopardize an entity's ability to operate; loss of a key franchise, license, or patent; loss of a principal customer or supplier; uninsured or underinsured catastrophe such as drought, earthquake, or flood
Editors:
Douglas R. Carmichael, PhD, CPA
Stan Ross Department of Accountancy,
Zicklin School of Business,
Baruch College
John F. Burke, CPA
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
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