The Going Concern Case

To investigate the process used by auditors to assess continuity of a firm, a case study was developed in which the going-concern decision was not clear. A description of an audit client was given along with financial statements and past history of the client/auditor relationship. Both contrary and mitigating evidence was included to insure consideration of whether substantial doubt existed as to the client's ability to continue as a going concern.

The cues provided as evidence were developed from the examples set forth in SAS No. 59. The cues were then divided into basic, favorable, and unfavorable information. Introductory information about the client is described in Table 1 as "baseline cues." Facts that tend to support continuance are labeled "positive cues," factors that would likely cast doubt on the client's ability to remain in operation are designated "negative cues."

The case was sent to 344 professional auditors. Two hundred and two usable responses were received for a 59% response rate. Fifty-eight percent of the participants were audit managers, and forty-two percent were audit partners. The average age was about 36 years, and the average experience exceeded 12 years. The respondents were employed by both national and regional CPA firms. Thus, the participants appeared to possess the background needed to address the going concern issue being raised in the case materials.

The participants were asked to read the case and to make a categorical decision on whether the audit report should be modified due to the existence of substantial doubt about the client firm's ability to continue as a going concern. Participants were subsequently asked to rate each case cue (listed in Table 1) as to its impact upon their decision-making processes. The cues were evaluated on an eleven point scale. A strongly negative rating (-5) would support a decision to include an explanatory paragraph about continuity in the audit report, a rating of "0" would indicate neutrality, and a strongly positive rating (+5) would imply that an explanatory paragraph is unnecessary.

Information Considered in Making the Going-Concern Decision

Table 2 shows the overall importance of the various factors presented in the case regardless of whether the auditor decided to modify the audit report by including the explanatory paragraph. On an individual basis, the cues with the highest mean scores were a significant loss from operations in the current year (LOSS), the continued availability of trade credit (TRADE CREDIT), a potential liability from litigation (LITIGATION), the possibility of losing a major customer (MAJOR CUSTOMER), the potential sale of a patent (SALE OF PATENT), and a current ratio that is approaching the limit set in a loan agreement (CURRENT RATIO). It is interesting to note that four of the top six cues are negative in nature and, therefore, could indicate auditor conservatism due to legal-liability implications. The auditor might logically be cautious and more sensitive to factors pointing toward a going concern problem in the future.

To investigate whether the participants rated negative factors higher on average than positive ones, the absolute mean values of the negative (1.66) and positive (1.55) cues were compared. Results indicate a high probability that, on the average, the positive and negative cue values are not different. This result suggests that when considered independently, the direction of the cue does not affect its perceived importance.

The ranking of the cues in Table 2 also indicates the prospective nature of the factors most pertinent to the issue of continuity. Of the top six cues, only one (LOSS) is related to the past performance of the firm. Judging from the data, auditors tend to place more emphasis on prospective circumstances than on historical information when making the going-concern decision. The going-concern issue automatically necessitates consideration of the firm's future and requires the auditor to expand the evaluation procedure.

TABULAR DATA OMITTED

TABLE2

RELATIVEIMPORTANCEOFEVIDENCECUES

CueNameMeanValue

Loss-2.44

TradeCredit+2.38

Litigation-2.17

MajorCustomer-1.99

SaleofPatent+1.86

CurrentRatio-1.81

EconomicOutlook+1.65

SalesExecutive-1.56

Technology+1.51

High-QualityProducts+1.51

GrossProfit-1.36

UncertainProduct-1.29

Debt-EquityRatio-1.21

MajorSupplier+1.13

WorkingCapital-1.11

AccountsReceivable+0.80

Projection-0.80

CashFlow-0.50

Note:Theaboveamountswerecomputedonascalewherezero

equalsneutralandfiveequalsstronglypositiveornegative.

TABLE3

HIGHESTTENRATINGSOFCUESBYGOING-CONCERNDECISION

DecisiontoIncludeGoingConcernExplanatoryParagraph

CuesMeans

Litigation-2.91

Loss-2.78

CurrentRatio-2.74

MajorCustomer-2.40

SalesExecutive-1.95

TradeCredit-1.85

Projection-1.80

UncertainProduct-1.74

GrossProduct-1.74

SaleofPatent+1.56

DecisionnottoIncludeGoing-ConcernExplanatoryParagraph

CuesMeans

TradeCredit+2.78

Loss-2.18

SaleofPatent+2.10

EconomicOutlook+1.93

Technology+1.79

High-QualityProduct+1.68

MajorCustomer-1.67

Litigation-1.61

MajorSupplier+1.31

SalesExecutive-1.25

Different Auditors--Different Decisions

Additional analysis of the participant's responses was undertaken to determine a) whether auditors advocating the inclusion in the audit report of a going concern explanatory paragraph tended to consider different cues than those who felt such an explanation to be unnecessary and b) if the same cues are considered by auditors but with different weights (levels of importance) assigned to them. The data set was divided into two groups: 88 auditors who analyzed the case materials and decided to include going concern explanatory comments, and 114 auditors who analyzed the same case materials and decided that no explanatory paragraph was required. The mean cue ratings were then computed separately for each group of auditors. The results are shown in Table 3.

The current period's operating loss (LOSS) turned out to be an important cue regardless of whether the decision was to include an explanatory paragraph dealing with continuity or to exclude such an explanation. The cue was ranked second in importance by both groups of respondent auditors. LOSS tended to influence to the same extent both the positive and negative viewpoints. Because the cue was of equal importance to the participating auditors, it would not be the decisive factor in determining whether to include an explanatory paragraph on going concern. LOSS may be more of an attention-directing factor.

Those other cues which were viewed differently in terms of importance by the two groups would be more relevant to the selection of a position on the issue.

Except for LOSS, the five highest ranking cues differed significantly depending upon the auditor's decision. Auditors whose decision was to add an explanatory paragraph tended to rate negative cues higher than positive cues. These individuals were greatly influenced by the possibility of litigation (LITIGATION), a long-term debt restriction that was approaching its limit (CURRENT RATIO), the potential loss of a major customer (MAJOR CUSTOMER), and the possible departure of a key sales executive (SALES EXECUTIVE). On the other hand, the cues rated highest by auditors who decided to exclude the explanatory paragraph were the continued availability of trade credit (TRADE CREDIT), the potential sale of a patent (SALE OF PATENT), a favorable economic outlook for the industry (ECONOMIC OUTLOOK), and the presence of competitive technology (TECHNOLOGY).

Auditors who decided to include an explanatory paragraph on the firm's ability to continue in business focused on a material liability from litigation and the potential violation of the loan agreement. Auditors who saw no need for the explanation focused on the ability of the firm to pay its obligations and the possible sale of a patent and prototype of a new high-tech product. The indication is, therefore, that auditors who reached different judgments relied on different cues in making their decisions. The assignment of different degrees of importance to the same cues was apparently not a significant part of the decision making process. The respondents rated the cues presented to them in a manner consistent with the way they used them in the decision-making process.

The study provides empirical evidence that different auditors, when presented with the same information relative to the firm's ability to continue in existence, concentrate on different aspects of the data and arrive at different judgments. From this preliminary research, it is not possible to conclude whether the same "real world situation" would result in the same disparity in reporting decisions.

The results of this study, for example, suggest a significant loss from operations in the current year may be a significant factor used by auditors to identify potential going concern problems. However, because of its historical rather than prospective nature, the current year's loss may not be important in the actual decision whether an explanatory paragraph on continuity is needed. The going concern decision tends to be based on prospective information--credit, economic outlook, litigation, etc., not on factors related to past performance.

This result suggests that auditors should recognize an important distinction between factors that identify a going concern problem and the factors that should be evaluated to decide whether there is substantial doubt about the ability to continue as a going concern.

Vicky Arnold, PhD, CPA, Arizona State University, and Donald E. Edwards, PhD, CPA, University of Arkansas at Little Rock