Legal Issues
Going concern is a fundamental principle in preparing financial reports and a vital assumption applied by the reporting entity. When going concern is claimed, the business necessarily means to continue operations for the foreseeable future with no indication to cease trade, liquidate, or seek protection from creditors to pay obligations. It also indicates the strength of financial statements and components that are being reported such as realizing assets and discharging liabilities. Going concern assumption undergoes auditing procedures to test if the assumption is appropriate and subsequently protect the decision-making implications of investors, creditor, suppliers, regulators and other users of financial statements.
When the business has shown historically profitable activities and business stakes as well as provides evidence for easy access of financial resources, detailed analysis on going concert test need not be imposed. Otherwise, the business will be applied with sequential audit trail set forth by pertinent auditing standards. Going concern assumption is significantly injected with judgment of future outcomes for certain events/ conditions. The soundness of these judgments is inclined on three notions. As they are pushed further into the future, outcomes become more uncertain. They are based on the contemporary facts relevant to the business. Lastly, judgments are affected by size and complexity of the business, nature and condition of operations and degree of impact of external factors.
Some events/ conditions that may cause business risks and contribution to doubt on going concern assumption are the following: financial (net current liability position, excessive reliance on short-term loans, signs of withdrawal of support from creditors, negative operating cash flows, substantial degradation of valued assets, inability to pay on due dates, inability to comply with loan agreements, inability to obtain financing for new product, adverse financial ratios, etc.), operating (loss of key management yet to be replaced, loose of major market and business partners, shortages on factors of production, etc.) and other factors outside company’s control. However, the business can mitigate the doubt by disclosing plans and strategies to solve the adversaries.
Two main tasks of auditors are assessing the validity of going concern assumption claimed by the business in preparing financial statements and evidence supporting such assessment. Procedures of evaluation include identification of events/ conditions leading doubt to going concern, evidence and risks of misstatements. In most cases, the management of the business executed preliminary evaluation that is required to be at least a going concern assumption for 12-month period. However, the review of auditor can involve consideration of periods exceeding this required period if the effort significantly affect going concern assumption for the original time frame. As judgment further in the future is more uncertain, evaluations exceeding the original period must have determined impact to going concern assumption.
The mitigation that management offers in the case the doubts to going concern validity is also audited to evidence feasibility and effectiveness. One useful tool and basis is cash flow analysis where consideration is applied to reliability of inputs that generate the information, adequacy of supporting variables in reaching the forecasts, historical accounts and current performance. When material uncertainty is proven, the financial statements of the business can gain an assessment that its contents have significant potential to mislead users. However, if material uncertainty is proven but going concern is assumed, financial statements must show events/ conditions that can increase significant doubt to going concern validity or simply directly state doubt to such validity. Regarding material uncertainty conclusions, the auditor can apply unqualified position where financial statements reflect them and sketch the important parts of the report that signal going concern issues. If they are not reflected, qualified or adverse position can explicitly explain material uncertainty.
Ethical Issues
The governance structure and structural relationships of Gamesoft compromises several ethical issues. The company is dominated by one family, there are several litigation against its patenting, members of the family have close ties with the prospective auditing firm, a former auditor of Gamesoft’s competitior is working on the prospective auditing company and the like. These facts can easily situate Gamesoft into a position where unethical auditing practices will be put on the prospective auditing firm’s reputation. There are audit standards that protect the impartiality of every audit services. Auditors are expected to do their jobs objectively as one mistake can have substantial impact on an economy and the public at large.
The limitation aims to provide investors with financial information from a publicly-listed firm that has reliability and integrity which has undergone scrutiny from auditors. Thus, auditor’s independence from the audited firms are crucial for investors to place their money on such firms and prevent adverse speculations (like collusion or bribery) that can discourage/ delay investments. Such investments have micro- as well as macro-benefits in the economy. Almost half of American households have money in the stock market. Considering this and the reliance of investors to technological advances like Internet, intensifies the need for impartial auditors and strict assurance that the only basis of engaging into risks (FS) is really “impartial” and objective.
As a result, providing non-audit services by auditing firms to their respective initially auditing clients was a long concern to auditor’s objectivity. There could be manipulation and insider’s under-the-table agreement due to dualism of services that may hinder the interests of investors with regards to reliable FS. Because of this, US-SEC firstly considered historical relevance of non-audit regulation as far as 1970s when Congress was unease on independence issue. This is followed by 1994 and 1996 reports from AICPA, US-SEC Staff and GAO relating to same apprehension due to increasing number of services offered by auditing firms. In general, US-SEC had released and adapted non-absolute ban on non-audit services of auditing firms.
The US-SEC took into consideration in analysis before setting the policies the fact that there are two divergent/ opposing issues in the “statement that non-audit services create economic incentives that may inappropriately affect audit.” One side said that when Congress allowed direct transaction and payment between auditing firms and clients, the body also accepted economic benefits that may arise therein. In contrast, the other side characterized non-audit services as the platform for “self-serving bias” by auditors and will affect behavior away from independence. In addition, one reputable public policy adviser, Earnscliffe, was also acknowledged by the office in its report that increased non-audit services adversely affected investor’s confidence on FS. The office also refused to accept the argument that there should be no restriction to non-audit services due to absence of evidences that prove its departure to audit independence (theory of prophylactic rules).
In general, the restriction of non-audit services applies in condition when: (1) it creates conflicting interest, (2) places accountant in the position of auditing its own work, (3) results in accountant acting as management or employee and (4) places accountant’s advocacy on the client. These restrictions, however, are considered relative to the stance of either the accountant of the audit firm or client. Bookkeeping is one non-audit service that is prohibited by the office. The function is considered a managerial function, thus, passing directly condition number 3. However, the prohibition is relaxed at instances where bookkeeping is done to a foreign subsidiary or local division of the client. With this as initial consideration, there is a need to prove other things such as absence of competent employee of the client and impracticality for the client to seek the service other than the audit-accountant.
The assessment, design and implementation of financial information systems of the client should also be limited to its employees and management. This prohibition, however, views the audit quality theory and is willing to limit the restraint to issues wherein the client is performing at the advisee level not the decision-maker on matters pertaining to information systems. Since it is beneficial for audit firms and clients to have the same hardware and software even local area network connections, the office is less restrictive to this respect as long as there is independence to final decision-making.
Appraisal and valuation services are prohibited since this will trigger number 2 condition wherein the auditor evaluates its own valuation criteria despite of the fact the inadequacy of involvement of accountant in the transaction. However, there are several exceptions like when valuation is done to aid clients to forecast future cash flows. This is enforced by the general exception that such specific service is done with fairness opinion (adequacy of consideration) and the results would be a minimal part of clients’ FS and such part of FS will not be reviewed by the same accountant.
Actuarial services that were previously and generally considered as prohibited with regards to insurance firms was relaxed and specified towards such firms’ basic operation and management particularly the determination of company policy reserves and related accounts. This is supported by crucial instances to quote the service a departure to audit independence such as the primary role of management or third party about actuarial strategies and the non-continuous nature of such service. Internal audit services are deemed restrictive when the client has at least 0 million of assets and outsource more than 40% of internal audit to its audit accountants. The exception is given to small businesses with less than 0 million of assets despite outsourcing internal audit in excess of 40%. The client, however, should have competent internal manager who is responsible in final execution of financial findings although most are outsourced.
Commercial Issues
Average collection period is increasing since 2007. As a general rule, lower average collection period is optimal because the business need not wait long to receive cash payments from their credit sales. The performance of the business for this ratio indicates that it has difficult time in converting account receivables into more liquid assets (i.e. cash). It can also mean that the business is more exposed in acquiring bad debts and defaults. Cash conversion cycle is adversely affected because of the pressure imposed by longer collection periods. The time of outlaying cash and cash recovery is widened which signifies more time capital is tied-up to business processes (i.e. conversion of inputs to outputs). Due to this, the business is required to source out additional capital to maintain daily operations because most of its current capital is tied-up. This additional requirement is necessary to pay production expenditures, wages and overheads. Failure to address these costs can lead to interruption and stoppage of work or even disposal of value-creating assets that suggest bigger problems. High average collection period is aggravated/ mitigated by low/ high inventory turnover and high/ low average payment period.
Current ratio is decreasing since 2007. From stronger liquidity in 2006, the business dropped to a ratio less than 1 suggesting that it cannot pay its obligations as they fall due. These obligations are accounted to short-term liabilities such as debt and other payables while short-term assets that are used to pay them include cash, inventory and receivables. With reduced current ratio, the business has more obligations than potential payments and signals the need to source financing to various channels. The risk, however, is that the strain of overdue obligation which can force the business to enter credit agreements and other contracts that are obviously detrimental compared to options available if the strain is not too urgent or if it only has assets to pay them. Lower current ratio is related to higher average collection period which implicated likelihood of bad debts. With a more conservative analysis (i.e. getting the quick ratio), the exclusion of inventories, pre-paid expenses, and as proved, account receivables, can only aggravate the liquidity of the business.
Debt-equity ratio is rising since 2007. This indicates that the business is becoming more dependent on interest-bearing debt financing than less risky internal or equity financing. As a result, its earnings are also more volatile due to reductions by payment of the interest. It can also put the business into greater agreement risks mentioned in current ratio such as collateral of value-creating assets and disposal when debts are long overdue. In the case of dissolution, shareholders are in greater risks to recover investments because outside creditors are preferred in distribution of assets and may even demand the former to contribute to the losses. In 2007, the business is sourcing debt that is two-times larger than proceeds from equity which can trigger the preceding consequences. However, there is a need to investigate where the debt proceeds are invested. This is important because debt-financed projects with significantly high returns compared to debt interest (i.e. debt coverage) can alternatively increase earnings.
Gross profit ratio is decreasing since 2007. This can either mean that the business is generating fewer revenues or experiencing price increases on cost of goods sold than previous periods. As a result, it decreases its opportunity to create savings for engagements in the future and payment of unexpected expenses. Problems are likely rooted in ineffective production and marketing of products, inefficient relationship with suppliers and expensive logistics design. On the other hand, the negative figures pertaining to profit after tax ratio show that the business has no earnings (i.e. at loss) from 2006 to 2007. It is a difficult time for the business which various aggravations such as low collection period, current ratio and high debt-equity ratio. This can also indicates that the projects the business is entering and financing are not contributing to profitability. However, the ratio on profit after tax can be applied with tax holidays or incentives that can transform profit to positive figures.
Net asset per share is declining since 2007. Assuming that shares outstanding are constant, this indicates that the assets of the business have lower values and new value-creating assets are yet to be included in its operations. As a result, the interest and wealth of shareholders is not protected leading to their divestment. The preceding possibility can aggravate the problem of the business on sourcing out safer funds to pay current obligations, prevent stoppage/ litigation and finally to report its financial statements as a going concern. However, there is a need to investigate whether this ratio includes intangible assets which is eminent to the innovative products that the business is creating and planning to distribute.
Conclusion
With going concern questions, substantial compromise of ethical auditing and adverse financial ratios, it is advised that WA LLP should not accept the client position of Gamesoft. There are numerous risks involved in the process by which the monetary gains in the engagement are outweighed by not only monetary costs but also implicit risks. Reputation of the WA LLP will also be safeguarded by avoiding business with Gamesoft. If any, WA LLP would advise Gamesoft to pursue the following tasks to strengthen the latter’s future auditing pursuits over the general public and investors:
1. Explain risks in considering investing activities of the firm; mention laws such as requirements from the Bureau of Economic Analysis that can support the lacking of the firm; and efforts done by auditors to minimize the data difficulties such as research.
2. Emphasize the importance of browsing over the “notes to financial statements” for the safety of disclosure users; and explain how a change in accounting method does not violate any disclosure requirements
3. Supporting facts that can validate the observation of auditors; the date of verdict; and maximum settlement amount that the firm would pay if it loses.
4. Explain the degree of impact of inventory methods to financial statements (e.g. substantial, non-critical) especially when the firm is in service industry.
5. Mention the regulation that the firm omitted including its financial effects.
6. Describe the why auditors lack confidence on previous audits; and the period where these audit took place.
7. Explain the comparison deficiencies; and the period of transition.
8. Mention the request of creditors for waivers including important dates.
Bibliography
AICPA, viewed on 9 April 2008, http://www.aicpa.org/about/code/et_203.html#et_203.01
Auditor Independence and Other Services; 2003; Auditing & Assurance Standards Board; viewed on 9 April 2008; http://www.aarf.asn.au/docs/NewGuidanceNoteMarch2003.pdf
Leung, P, Coram, P & Cooper, B 2007, Modern auditing and assurance services, 3rd edn, John Wiley & Sons, Milton, Queensland.
US Securities and Exchange Commission; 2001; Washington DC; viewed on 9 April 2008; http://www.sec.gov/rules/final/33-7919.htm
Credit:ivythesis.typepad.com
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