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Research Project

Accounting Capstone

06/05/2015

Being an auditor of a Fortune 1000 company, it is the duty of the firm to conduct the audit procedures after taking all the relevant measures for statutory compliances. The firm found out some issues in respect of the audited company. The major questions related to the evaluation of the effects of the company were resolved.

Evaluation of Repercussions of Failure to Include Inventory Write-Downs

The first point is associated with the disclosures of IAS 1. As per the guidelines, proper information should be provided and recorded while writing down the inventory. The standard also suggests that appropriate disclosures have to be made in the Income Statement, as well as in the overall financial statements. Besides following the accounting standards, it is also the professional and moral responsibility of the accountants to abide by the regulations imposed by IAS 1.

Since I am the partner of the firm, it is my duty to let the management understand the prospects of not disclosing the item in the financial statements. The IRS could easily find out that the inventory levels were manipulated which has lead to computation of taxes at lower rates. The IRS after consultation with their Fraud Technical Advisor could impose a penalty up to 75% of the fee owed. There shall also be other interest related penalties. The CEO and CFO of the organization should follow certain internal control processes that are as follows:

1. Establishment of an internal whistleblower program

2. Promoting transparent culture

3. Having two different lines of accounting staff and transaction staff

4. Proper analysis and reconciliation of any fluctuations in the assets and liabilities.

In case the CEO and CFO keep on ignoring the internal control systems, similar frauds would keep on arising which will eventually tarnish the image of the organization.

Negative Results on Stakeholders

As it was pointed out in the previous paragraph, the IRS could easily find out about the fraud that the company has been sitting over during the past couple of years. Knowing about the misappropriations in the inventory levels, the IRS did find out the inventory standards of the company were drastically reduced by 10% over a period of three years. Now, the IRS will consult its front line managers about the imposition of 75% penalty. The Fund Technical Advisor will also be consulted while fixing the magnitude of penalty. The amount of penalty cannot go beyond this level; however the IRS has the right to reduce this amount.

One of the main issues before the company now is the fact that they could be charged with criminal wrongdoing. Tax evasion is a serious crime in the United States, and the IRS could file a criminal case against the decision-makers if they deem fit. It could result in serving of jail term and heavy fines. Write-offs of the closing inventory values could be considered as a significant tax fraud in the eyes of the law (Taxation.lawyers.com, 2015). The CEO and CFO would be held responsible for any inadvertent discrepancies in the books of accounts. Besides this, the IRS could order subsequent audits that will target to get more information about any other frauds that the company might have done over the years. The share prices of the company will fall if any such news is released in the market. It will have a negative impact on the goodwill of the business.

Applicable Federal Tax Laws and Regulations

Writing down the value of the inventory is not an accounting fraud if legitimate reasons for it were provided by the accounting staff. The Federal Laws allow some write downs in the value of the stock. For example, if the stock has been stolen or becomes useless due to any natural causes, then the value could be written off. However, while writing down the value of the inventory, the accounting staff should strictly follow any of the valuation methods as prescribed by the IRS.

The first method is the cost method. As per this method, all the costs related to the inventory being transportation and other allied costs are added. Besides this, lower of the historical cost and present fair market value of the stock could be taken as the value in the financial statements. Any natural disasters that have made the inventory useless could also be provided as reasons for writing off the value of inventory.

The courts have also allowed such write downs. In the example of "WEST COVINA MOTORS, INC. TC MEMO 2008-237", similar situations were faced by the court in the past. The IRS alleged that the taxpayer had violated IRC 471 since they have used the Inventory Reserve, and they have also failed to substantiate the stock value. Since the taxpayer was using the historical cost or present market value, whichever is low, criteria, they had decided to write down the value of the inventory even when it was not sold. Another reference could be provided for CITING BEST AUTO SALES, INC, TC MEMO 2002-297.

Current GAAP Related to Stock Options and Share-Based Appreciation Rights

The fourth point is related with the employees' stock option plan. For this, US GAAP shall be considered. As per FAS 123R, the definition of ESOP should be understood. Any expenses incurred between the grant date and the date of exercise should be properly recognized and recorded in the financial statements. For measurement of the expenses, any of the two methods, namely Intrinsic Value Method or Fair Value Measurement Method could be considered by the organization.

As per the Intrinsic Value Method, any expense on the option date (grant date) or any subsequent date is the excess of the quoted market price over the exercise price that the employee has to pay. Under Fair Value based method, the expense is measured at the grant date based on of the value of the reward, and it must be computed by the service period of the employee. As per Opinion No. 25 of ASB, entities are allowed to use Intrinsic Value Based method for accounting that is in contrast with IFRS 2. I.

US GAAP FAS 123R has been violated in this particular case since no disclosures have been made in the financial statements of the organization in respect of expenses made in respect of employee stock option plan (Shamrock, 2012). The three primary key impacts of the decision have been discussed as under:

1. If the organization has decent cash flows, it could go further for stock appreciation rights.

2. If the numbers of shares issued by the organization are significant, the ownership could be diluted.

3. It could result in administration costs and complexity in management

4. Proposal for Future Lease Transactions

The fifth point is related to an accounting of lease transactions. Let us discuss implications of US GAAP here as well. FAS 13 talks about the least transactions. As per the IFRS, IAS 17 takes account of it (IFRS, 2015). There were some open issues in the US GAAP, which have been addressed by IFRS (Fasb.org, 1976). There are significant differences between GAAP and IAS more relating to Discount Rates used by Lessee, Recognition of Gain or Losses under Sale and Leaseback Transactions both under Operating Leases and Capital Leases, Leveraged Assets, etc. (Shamrock, 2012).

The CEO should be advised that given the market conditions, the organization has no other option but to go for elaborative lease policy. Since a large portion of the organizational assets shall be leased out, the impact of such policy should be analyzed on the overall portfolio of the organization. If the organization continues to keep risk weighted lease receivables in the books, the overall risk position of the company shall be severely affected. In this case, the securitization of the assets should also be considered. Some of the most significant benefits that the organization could get by getting off the assets from the balance sheet have been listed as follows:

1. The funding costs could be reduced consistently due to securitization. If the credit rating of the organization improves, it will also have a positive impact on the intrinsic cost of debt.

2. It transfers all the risks associated with the debt including the counter party default risk to the special purpose vehicle.

3. The liquidity position of the organization could be improved due to securitization.

4. The asset-liability mismatch, if any, could be reduced.

Therefore, the CEO should contemplate this process for long-term sustainable future of the organization.

Arguments Related to International Financial Reporting Standards for Leases

The sixth point talks about the country-wise accounting policies and disclosure requirements. The organizations that have branches in some nations face this issue while integrating their financial statements. Revenue recognition related problems often creep up while preparing the group-wise financial statements. Accounting practices are followed differently in every country as per the accepted accounting principles of the place that makes it difficult when it comes to a cross border lease transaction as the lesser and lessee would be following a different set of accounting practices. I am definitely for making the accounting practices identical cross border i.e. internationally. It can be done by adopting the International Financial Reporting Standards by each nation. The benefits and risks that would entail could be analyzed in the discussion made as under:

1. The first benefit is a comparison. Switching to IFRS would allow entities to watch various companies from different parts of the world on the same plane.

2. Under IFRS, the discount rate used by a lessee to present value the minimum lease payments is the rate implicit in the lease that is more practical. Under US GAAP, incremental borrowing rate is being used.

3. Gain or Loss on a Sale leaseback of a capital leaseback is deferred and amortized over the lease term under IFRS. Under GAAP, the same is treated as Gain or Loss on an Operating Lease Sale Leaseback transaction only.

4. Leveraged Assets are also treated at par under IFRS. No special accounting rules have been provided for the same as are provided in the US GAAP.

Implications of SAS 99

The seventh point talks about the functions of the auditor in an organization. SAS 99 directs the auditors to function is a particular manner so that any issues that are caught during the financial statements examination could be reported to the management, especially if they make up any fraud (Hsu & Zhu, 2005).

In this particular case, the initial evaluation of the partner had brought down some issues involving inventory write down and not recording the ESOP. This made sure that the auditors turned a bit more suspicious of the intentions of the organization. Despite the fact that the firm had been carrying out the audit process for the company for over five years, SAS 99 directs that every auditor must follow professional skepticism. Irrespective of good internal control systems, if two such accounting blunders are being made by the organization, then a proper examination of all the financial statements become necessary.

The auditor has the right to access the minutes of meetings, along with other financial statements of the organization. Since the initial evaluation has pointed out towards any suspicious activity, the auditor should consider an in-depth independent analysis of the affairs of the organization. It is not only his professional duty but also moral responsibility towards some stakeholders that are directly or indirectly related to the organization.

The auditor must communicate all the findings of frauds and misrepresentations to the management of the company. However, if the auditor thinks that the management is not interested in taking any corrective actions, he could disengage himself from the assignment, and proper disclosures should be given to any new auditor who joins in his place.

Evaluation of Potential for Material Misstatement

The eighth point talks about the restatement of the financial statements. It is in pretty extreme cases when the organization has to restate the financials since material frauds or misrepresentations are found by the auditor in the initially submitted financial statements.

The restatement of the financial statements is required when the previous statements contain material inaccuracy. It could be due to accounting errors, misrepresentation, fraud, or non-compliance with generally accepted accounting principles.

In our case, I would recommend CFO to look upon for the restatement of the financial statements to the extent the observations have been found. Non-inclusion of inventory write downs in the financial statements and non-disclosure and non-expensing of Compensation cost on employee stock options provide sufficient cause to recall a restatement of the financial statements. Current financial statements do not depict a true and fair picture of the company.

Not restating the financials could cause significant issues like:

• Legal effects under Sarbanes-Oxley Act.

• Corporate Governance non-compliance.

• Restriction on Trading of Company Stock on Stock Exchange.

• Delisting of Company share. Etc.

Therefore, it is advised to the company that the financials should be restated to the above effect and should be re-submitted. Since many issues have been already found in the financials of the company, it will only be wise for the management to take proper steps in the current year, and go for disclosures. We have discussed the violation of GAAP, IAS, and IRS regulations by the company in the past few points. The organization must try to save its grace and goodwill now, and must try to restate the financials after incorporating all the issues that were ignored earlier.

Economic Effects of Restatement on Stakeholders

The last point here will discuss the implications of restating the financial statements on some stakeholders. Some of the most relevant points have been discussed as under:

1. Investors: The investors will not like the restatement of financial statements. The investors, not only invest their money but, also their trust in a business organization. When they realize that the trust has been broken through manipulation in the books of accounts, the goodwill of the organization is affected. Proper disclosures should be given that the restatement of financial statements is being made solely because the organization wants to provide the best possible picture of the financial health of the business. It should also be noticed that the investors no longer pay heed to every announcement made by the business.

2. Employees: The labor union, as well as the employees, could allege shortcomings in the ethical conduct of the organization. There could be huge dissatisfaction among the employees since the organization had to restate the financial statements, which puts the future of the business as well as the workers in serious jeopardy. There could be sharp criticism from various parts of the employee union.

3. Customers: The customers could easily lose confidence if they feel that the organization with which they have been dealing is unethical. No customer wants to buy product or services of a company that has been accused of ethical misbehavior.

4. Creditors: In the case of unsecured loans, the creditors could expectedly ask for securities for their loans, and rightly so since they are concerned about the repayment of their loans.

References

Hsu, K., & Zhu, Z. (2005). SAS 99 consideration of fraud in a financial statement audit: a new auditing standard. IJSS, 1(4), 414. http://dx.doi.org/10.1504/ijss.2005.007469

IFRS. (2015). IAS 17 Leases. Retrieved 11 December 2015, from http://www.ifrs.org/Documents/IAS17.pdf

Fasb.org, (1976). Statement of Financial Accounting Standards No. 13. Retrieved 11 December 2015, from http://www.fasb.org/cs/BlobServer?blobkey=id&blobwhere=1175820908834&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

Shamrock, S. (2012). IFRS and US GAAP. Hoboken, New Jersey: Wiley.

Taxation.lawyers.com, (2015). Business Casualty and Theft Loss Tax Deductions. Retrieved 11 December 2015, from http://taxation.lawyers.com/income-tax/business-casualty-and-theft-loss-tax-deductions.html