Authoritative Literature:

AU Section 341

The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern
Source: SAS No. 59.

This section provides guidance to the auditor in conducting an audit of financial statements in accordance with generally accepted auditing standards with respect to evaluating whether there is substantial doubt about the entity's ability to continue as a going concern. Continuation of an entity as a going concern is assumed in financial reporting in the absence of significant information to the contrary. Ordinarily, information that significantly contradicts the going concern assumption relates to the entity's inability to continue to meet its obligations as they become due without substantial disposition of assets outside the ordinary course of business, restructuring of debt, externally forced revisions of its operations, or similar actions.

AU Section 722

Interim Financial Information
Source: SAS No. 100; SAS No. 116; SAS No. 121.

The purpose of this section is to establish standards and provide guidance on the nature, timing, and extent of the procedures to be performed by an independent accountant when conducting a review of interim financial information.

The term interim financial information means financial information or statements covering a period less than a full year or for a 12-month period ending on a date other than the entity's fiscal year end. Interim financial information may be condensed or in the form of a complete set of financial statements.

AU Section 508

Reports on Audited Financial Statements
Source: SAS No. 58; SAS No. 64; SAS No. 79; SAS No. 85; SAS No. 93;
SAS No. 98.

This section applies to auditors' reports issued in connection with audits of historical financial statements that are intended to present financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. It distinguishes the types of reports, describes the circumstances in which each is appropriate, and provides example reports.

Certain circumstances, while not affecting the auditor's unqualified opinion, may require that the auditor add an explanatory paragraph (or other explanatory language) to the standard report, such as, when there is substantial doubt about the entity's ability to continue as a going concern.

Background:

First Class Telecommunications Inc. (FCT) is a regional wireless telecommunications service provider in the U.S. that serves around 3 million customers in rural areas/small cities that covers seven states. FCT has two operating segments: retail (cell phone sales) & services (providing wireless service). There are some questions about the company’s ability to continue as a “going concern”. A going concern is the assumption that a company will continue to operate in the foreseeable future. Here are some brief facts about FCT’s questionable financial situation.

FCT has a debt totaling 200 million that includes financial covenants, along with a material adverse change clause. This could cause the company to be required to pay the full amount of all outstanding balances to its lender immediately. They also incurred a downturn in a joint venture recently. Before year-end assessment, goodwill was recorded as $230 million. There is presently a significant amount of risk related to the telecommunications industry, along with some individual risk/potential problems for FCT that could have an adverse effect on its ability to continue as a going concern.

Auditors are the ones responsible for evaluating and reporting whether or not there is substantial doubt about FCT’s ability to continue as a going concern during the ensuing fiscal year. There are guidelines and standards these auditors must go by to come to a conclusion.

Discussion of Solutions for Each Question:

1. There are quite a few conditions or events that may cause substantial doubt about FCT’s ability to continue as a going concern for a reasonable period of time. (Source: AU 341.07 Paragraph .06) a. Negative trends due to industry and capital structure risks could cause an adverse effect on the company looking forward: i. Recurring operating losses, working capital deficiencies, negative cash flows from operating activities, and adverse key financial ratios. b. Other indications of possible financial difficulties: ii. The potential occurrence of an event that triggers the material adverse change clause in FCT’s debt agreement. iii. Their substantial debt obligations, including restrictive covenants. iv. Many competitors are larger than FCT, limiting capital growth and maintaining the necessary capital to be successful. c. Internal matters: v. Their ability to attract and retain qualified personnel d. External matters that have occurred: vi. They rely heavily on two suppliers. Additionally, the contracts with these two suppliers expire in the following year-2013. vii. The results of litigation filed or which may be filed against FCT or its vendors, including relating wireless billing, using wireless telephones while operating an automobile, and litigation relating to infringement of patents. viii. The effects of governmental regulation of the telecommunications industry. ix. Market prices for the products and services they offer may decline in the future. 2. There are several steps the auditors must take in the belief that substantial doubt exists about FCT’s ability to continue as a going concern for a reasonable period of time. (Sources: AU 341.07, Paragraph .07; AU 341.12 Paragraph .10; AU 341.12 Paragraph .12; AU 341.13 Paragraph .17; AU 341.19 Paragraph .18) e. An auditor should consider management's plans for dealing with the adverse effects of the conditions and events. The auditor should obtain information about the plans and consider whether it is likely the adverse effects will be mitigated for a reasonable period of time and that such plans can be effectively implemented. (.07) f. The auditor should consider the possible effects on the financial statements and the adequacy of the related disclosure. (.10) g. The audit report should include an explanatory paragraph (following the opinion paragraph) to reflect that conclusion. The auditor's conclusion about the entity's ability to continue as a going concern should be expressed through the use of the phrase "substantial doubt about FCT’s ability to continue as a going concern". (.12) h. The auditor should communicate with those charged with governance: x. The nature of the events or conditions identified. xi. The possible effect on the financial statements and the adequacy of related disclosures in the financial statements. (.17) i. Documentation (.18) 3. The auditors may perform the following procedures to confirm or dispel whether there is substantial doubt about FCT’s ability to continue as a going concern for a reasonable time period: (Source: AU 341.07 Paragraph .05) j. Analytical procedures k. Review of subsequent events l. Review of compliance with the terms of debt and loan agreements m. Reading of minutes of meetings of stockholders, board of directors, and important committees of the board n. Inquiry of an entity's legal counsel about litigation, claims, and assessments o. Confirmation with related and third parties of the details of arrangements to provide or maintain financial support 4. The audit team’s responsibilities regarding its consideration of FCT’s ability to continue as a going concern during its review of the company’s interim financial information are as follows: (Sources: AU 722.10 Paragraph .09; AU 722.24 Paragraph .22; AU 722.12 Paragraph .12; AU 722.33 Paragraph .34; AU 722.03,.04 Paragraph .03; AU 722.06 Paragraph .08) p. The accountant is responsible for conducting the review in accordance with standards established by the AICPA. A review of interim financial information consists principally of performing analytical procedures and making inquiries of persons responsible for financial and accounting matters. (.09) q. If, in performing a review of interim financial information, the accountant becomes aware of information that leads him or her to believe that the interim financial information may not be in conformity with the applicable financial reporting framework in all material respects, the accountant should make additional inquiries or perform other procedures that the accountant considers appropriate to provide a basis for communicating whether he or she is aware of any material modifications that should be made to the interim financial information. (.22) r. The accountant performing an initial review of interim financial information makes inquiries of the predecessor accountant and reviews the predecessor accountant's documentation for the preceding annual audit and for any prior interim periods in the current year that have been reviewed by the predecessor accountant if the predecessor accountant permits access to such documentation. (.12) s. When conducting a review of interim financial information, the accountant also should determine whether any matters, as they relate to the interim financial information, have been identified. If such matters have been identified, the accountant should communicate them to those charged with governance. (.34) t. Although not required, the accountant may determine it appropriate to issue a written report to address the risk that a user of interim financial information may associate the accountant with the interim financial information and, in the absence of a review report, inappropriately assume a higher level of assurance than that obtained. (.03) u. The accountant should establish an understanding with the client regarding the services to be performed in an engagement to review interim financial information and should document the understanding through a written communication with the client. (.08)

Conclusion:

When comparing financial data year to year and financial forecasts, FCT’s financial ratios are sufficiently stable. For example, its total leverage ratio of 1.72 and projected ratios through 2013 are in compliance with the 4.50 quarter-end requirement. However, if the actual results are not in line with the forecast, management has plans to counteract these negative effects, therefore alleviating themselves from qualifying as a substantial doubt to continue as a going concern in the foreseeable future. With the exception of the forecasted current ratio of .99 in the 4th quarter-2013, the current period, as well as the 2013 forecasted current ratio analysis, show a ratio above 1.0. A current ratio of 1.0 is perceived to be the minimal ratio for being able to pay its current obligations and assumed to be in adequate financial health. However, management is in the process of implementing plans that involve negotiations with its lender(s). This should keep them from falling below the minimal ideal ratio of 1.0 in the foreseeable future. The likelihood of default on its loan covenants is minimal because the situations that may trigger the material adverse change clause has not happened historically. FCT’s debt ratio is in good standing with a ratio of .4. Also, FCT has a stable long term growth rate in both retail and service sectors of 3% and 4%, respectively. Lastly, FCT passed the goodwill impairment analysis summary using the step-1 test.

As previously stated, management is in the process of negotiating with its lender and establishing a relationship with a second lender. This will allow FCT to increase its capital, maintain stable financial leverage, and continue growth.

Even though FCT’s contracts with its suppliers end this following year, management’s responses in Appendix D state that it is currently negotiating with one of its existing suppliers and one replacement supplier. Although an agreement hasn’t been reached, management assures the negotiations are close to final and is confident it will take place before the other two existing contracts expire.

After reviewing and applying the steps and guidelines in determining what qualifies as a substantial doubt about FCT’s ability to continue as a going concern and assessing Appendixes A through D and the related financial data within, I conclude that there is not, in fact, a substantial doubt in FCT’s ability to continue as a going concern in the ensuing year.