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Considering the Going-Concern Assumption: Surfer Dude Duds

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

*This case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. The case was inspired by discussions with Craig Isom, a former audit partner, and we gratefully acknowledge his contribution to its development. Surfer Dude Duds is a fictitious company. All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental.

Mark S. Beasley, Frank A. Buckless, Steven M. Glover, Douglas F. Prawitt

Learning Objectives
After completing and discussing this case, you should be able to
• Understand the difficulty of assessing the client's going-concern assumption
• Describe the "self-fulfilling prophecy" aspect of a going-concern modified auditor's report
• Identify factors that encourage objective auditor judgments despite the presence of friendly client-auditor relationships

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 year's 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 George's 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 Dude's 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 Dude's direction. As a result, Mark was beginning to doubt Surfer Dude's 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 Baldwin's office, a secretary greeted him and told Mr. Baldwin of Mark's arrival. When Mark heard George say, "Send him in," he took a deep breath and headed into George's 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, what's up? You know I don't like meetings on Friday afternoons," George yawned.

"Well George, I'll get right to the point. As you well know, the retail clothing market has really gone south the past few months. I know I don't need to tell you that Surfer Dude is struggling right now."

"I know, but we'll pull out of it," George insisted. "When you fall off, you've 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 we've 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 we're 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 can't 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 account—all our inventory purchases and everything else will be C.O.D. It'll be cash-and-carry only. And what about our customers? Will they buy if they're not sure we'll be there to stand behind our return policy? It'll be your report that puts us under, not the ripples we're hitting now. I've got a feeling things are going to get better soon. We just need a little more time."

"George, you've got to consider the consequences if...."

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

Mark was silent for what seemed like an eternity. "Okay George, let's both think about it over the weekend. I'll 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.

1. What are Mark's 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?

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Solution Summary

The expert examines the going-concern assumption for Surfer Dude Duds.

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1. Mark has the responsibility to bring George face-to-face with financial position of Surfer Dude. The economy was in mild recession and Surfer Dude was struggling to meet all its financial obligations. Retail analysts predicted hard times for clothing retailers and as such latest clothing trends were not favorable for Surfer Dude. As a result Mark had doubts regarding Surfer Dude's ability to stay in business through the next year. He sought to include going-concern explanatory paragraph to the audit report. However George has his own apprehensions which prevent him from giving in to Mark. Hence only option available to Mark is to convince George for inclusion of going-concern in the audit report. He could explain George effects of not including this note as opposed to being fixated to including it at any cost.

2. A going-concern explanatory paragraph would become a self-fulfilling prophecy to Surfer Dude as all stakeholders of ...

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