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Key Topics
Requirement
Answer the following questions:
(a) Explain SIX potential indicators that Clarinet Co is not a going concern.
(b) Describe the audit procedures which you should perform in assessing whether or not Clarinet Co is a going concern.
(c) The auditors have been informed that Clarinet’s bankers will not make a decision on the overdraft facility until after the audit report is completed. The directors have now agreed to include some going concern disclosures.
(d) Describe the impact on the audit report of Clarinet Co if the auditor believes the company is a going concern but that this is subject to a material uncertainty.
Solution
Clarinet Co Case
Six Potential Indicators
Below are the potential indicators for the Clarinet co:
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1. Drums Design co has outplayed Clarinet by offering a competitive price in the market. It has helped Drums Design capture a significant market share. Hene, a potential impact on the clarinet cash flows is expected in the near future. It will be driven the further loss in the market share by Clarinet Co. Moreover, the competitive pricing offered by Drums Design Co will force Clarinet to drop their prices, hence a worsening of cash flows.
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2. The customer's preference has changed and they have moved to Drums Design Co. Hence, a discontinuity in the trading will result in a fall in the revenue and a rise in the loss. It can only be stopped by making new customers.
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3. Clarinet has also been going through skilled employee crisis. Due to the change in the market scenario, most of the Clarinet’s developers have moved to Drums and Clarinet hasn’t been able to find the replacement. The company is planning to invest in the development of new products, but the lack of skilled professionals is a potential hurdle for the company movement with the product development. Hence, a decreasing revenue.
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4. Adding the company problems is the supply problem. It is given in the case that the main supplier of specialized equipments has stopped trading with Clarinet. If the equipments are niche to the functioning of Clarinet’s business, then it will be hard for the company to find another supplier for these products. There is a direct impact on the company’s ability to trade. There might be a replacement for the current supplier, but the cash outflow might increase due to the higher price offered by the new supplier.
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5. Stakeholders are not interested in any further investment in the company business for the development of new product. Company failure to find an investment from the investors shows that company is considered risky for the investment. Investors are concerned that company might not be able to produce beneficial returns, hence a potential cash flow problem.
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6. Significant growth in the company’ overdraft during the financial year is another concern for the company. If the bank doesn’t agree to the draft renewal of overdraft, the option for alternative finance will be closed for the company. Adding to the problems of the company is the worsening of the cash flow positions for the next 12 months. The forecast on the cash flows shows that company overdraft will increase further and non-availability of cash.
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7. The last problem is a problem with one of the client’s who is planning to file a case against the company for the poor hardware installed at client’s online ordering system. It has lead to the loss for the client’s due to malfunctioning. If the customer successfully sues the company and win the case, it implies a penalty on the company and pressure on the cash flows. The company will go through a potential loss on both image and money. That will add to the existing problems for the company.
Audit Procedure for the Clarinet’s Assessment
There should be a thorough process to audit the company balance sheets and cash flows. The first step is to get the cash flow forecast of the company and reviewing it for both the cash inflows and outflows. The findings from the assessment of the cash flows should be discussed with the management.
Below is the procedure for the assessment of Clarinet’s co.
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1. The first step is to evaluate the potential margin of safety the company has in terms of net cash flows. It can be done using the sensitivity analysis of the net cash flows of the company.
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2. Address the company concern about the customer loss. It should be discussed with the management, whether the company has found any replacement or not.
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3. Order books and year end sales review to assess the impact on the trade levels of the company. It is mentioned that company has been facing a tough competition from Drum Design Co that has impacted the company’s cash flows. Moreover, forecast done for the next 12 months should also be assessed.
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4. Address the issue of lost developers to Drums Design and their replacement. A thorough discussion with the management should provide a further information about the issue and its resolution.
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5. Checking with the bank about overdraft of the company. It is to ensure that funds have not been used for any personal gains. Moreover, it should also ensure that any covenant (Smallbusiness.chron.com, 2016) has not been breached by the Clarinet Co.
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6. Discussion with the stakeholders about their decision and likelihood to invest in the Clarinet Co.
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7. Discussion with the management and directors about their plan to find an alternative investment from any other bank that can help company to develop a new product.
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8. Conducting an audit test to check whether the going concerns are appropriate or not. It will also check the potential mitigation techniques for the identified risks.
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9. Consult the lawyer of the company to check that how much amount is company going to pay if it losses against the client.
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10. Review year end account of the management to check whether it is inline with the projected cash flows forecast.
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11. Evaluate the appropriateness of financial statements preparation on the basis of the going concerns.
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12. Take a written representation from the Clarinet Co director that the problems are going concern for the company.
Impact on the Audit Report of the Company
From the given case it is evident that there is an agreement among directors of Clarinet Co about the going concerns disclosure. Audit report is dependent on the disclosure adequacy, hence the disclosures will set a course of action on the audit report. If the disclosures turns out to be adequate, then there must be some modification in the audit report because a matter paragraph will be included.
The content of the matter paragraph will be based on the cross reference to the disclosure made by the company directors and management. Paragraph will state that the opinion towards audit has not been modified. The paragraph will be placed after the opinion paragraph.
In case the management disclosures turned out not-adequate, then the audit opinion (Kfknowledgebank.kaplan.co.uk, 2016). will change due to the inappropriate material statef tments. Another paragraph relating to the lack of disclosures about the uncertainty in the going concerns will be included before the opinion paragraph. It will point out the matters responsible for the modification. There will be a change in the opinion paragraph that will state ‘except for’ or the financial statements presentation in unfair (AccountingWEB, 2015).
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'Clarified Auditing Standards: Modifications Of Audit Reports And Emphasis-Of-Matter Paragraphs' (AccountingWEB, 2015) accessed 23 April 2016
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(Kfknowledgebank.kaplan.co.uk, 2016) accessed 23 April 2016
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'What Are Covenants In Accounting?' (Smallbusiness.chron.com, 2016) accessed 23 April 2016
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