CPA Exam — AUDAssessing Risk and Developing a Planned ResponseEasy
A client, a publicly traded retail company, has recently experienced significant negative publicity due to a product recall, leading to a sharp decline in sales and stock price. Management has indicated that they are exploring options to secure additional financing. When developing the overall audit strategy, the auditor should consider this situation primarily as an indicator of an increased risk related to:
- AValuation of inventory.
- BGoing concern.
- CRevenue recognition.
- DRelated party transactions.
Show answer & explanationAnswer & explanation
Correct answer: B. Going concern.
Significant negative publicity, declining sales, and the need for additional financing are strong indicators of potential financial difficulties that could raise substantial doubt about the entity's ability to continue as a going concern. The auditor must specifically evaluate this risk.
Why the other options are wrong
- A. While a product recall could impact inventory valuation (e.g., obsolescence), the broader context of declining sales, stock price, and need for financing points to a more fundamental going concern issue.
- C. Declining sales affect revenue, but the core issue described, especially the need for financing, transcends just revenue recognition to the entity's overall viability.
- D. There is no information in the scenario to suggest an increased risk of related party transactions.
Going Concern
The assumption that an entity will continue to operate indefinitely, without the intention or necessity to liquidate or cease operations in the foreseeable future (typically 12 months from the financial statement date).
- Auditor must evaluate if substantial doubt exists.
- Indicators include financial, operating, and other matters.
- Requires specific audit procedures and disclosures if doubt exists.
Memory trick: Going Concern: 'Financial, Operating, Other' signs of trouble.