Assume you are the partner in an accounting firm hired to perform the audit on a fortune 1000 company. Assume also that the initial public offering (IPO) of the company was approximately five (5) years ago and the company is concerned that, in less than five (5) years after the IPO, a restatement may be necessary. During your initial evaluation of the client, you discover the following information:

The client is currently undergoing a three (3) year income tax examination by the Internal Revenue Service (IRS). A significant issue involved in the IRS audit encompasses inventory write-downs on the tax returns that are not included in the financial statements. Because of the concealment of the transaction, the IRS is labeling the treatment of the write-down as fraud.

The company has a share-based compensation plan for top-level executives consisting of stock options. The value of the options exercised during the year was not expensed or disclosed in the financial statements.

The company has several operating and capital leases in place, and the CFO is considering leasing a substantial portion of the assets for future use. The current leases in place are arranged using special purpose entities (SPEs) and operating leases.

The company seeks to acquire a global partner, which will require IFRS reporting.

The company received correspondence from the Securities and Exchange Commission (SEC) requesting additional supplemental information regarding the financial statements submitted with the IPO.

(1) Evaluate any damaging financial and ethical repercussions of failure to include the inventory write-downs in the financial statements. Prepare a recommendation to the CFO, evaluating the negative impact of a civil fraud penalty on the corporation as a result of the IRS audit. In the recommendation, include essential internal control procedures to prevent fraudulent financial reporting from occurring, as well as the major obligation of the CEO and CFO to ensure compliance.

(2) Examine the negative results on stakeholders and the financial statements of an IRS audit which generates additional tax and penalties or subsequent audits. Assume that the subsequent audit and / or additional tax and penalties result from the taxpayer’s use of an inventory reserve account, applying a 10 percent reduction to inventory over three (3) years.

Answer:

Part 1)

The inventory write-downs are required to be seperately disclosed in the financial statements as per the relevant accounting standard. Any information that may have an effect on the significant events and are required to understand the financial position of the company should be appropriately reported. Non-reporting of inventory write-downs may result in the financial statements indicating higher earnings for the company, thus misleading investors and other stakeholders. It may also give rise to various legal and ethical concerns which may affect the overall reputation of the company.

A negative assessement by IRS may result in civil fraud penalty of 75% (together with the applicable rate of interest) of the tax amount that was due on the amount of the fraud.

Some of the internal controls that could have been implemented are as follows:

1) Segregation of duties: It is one of the most important controls as it involves performance of different function by different employees of the organization, thus, reducing the possibility of frauds.

2) Implementation of Whistleblower Program: Employees should be encouraged to report any deviation from established accounting procedures and practices required be followed throughout the organziation. Employees should be ensured that they can report fraudulent activities/conduct observed by them without any fear of negative consequences/action against them.

3) Job Rotation: Employees should be rotated from one job to another to ensure that same activities/processes are not performed by same employees over extended periods of time. This will not only improve the job skills of employees, but would also provide an opportunity of the frauds getting detected by the new employee.

4) Periodic Reconciliation: A reconcilation of all assets and liabilties, with proper matching of revenues should be done to ensure that the financial statements are prepared in adherence to the relevant accounting standards/principles. Inventory reconciliation, supplier balance confirmation, etc, are some of the controls that can help in detecting and preventing frauds at an early stage.

5) Approvals and Authorizations: All changes in business processes, business expenditures, write-offs, etc. should be done after obtaining proper approvals/authorizations from the management or from the employees (managers) designated with the authority to give approvals.

To ensure that the internal controls function as intended, it is the responsibility of the CEO and CFO to set the right tone at the top. It should be clearly communicated to the employees that any kind of fraudulent activity will not be tolerated and strict action will be taken against the perpetrators. Employees should be continously trained and informed on their job responsibilties and how their behaviour and performance contribute to the growth of the organization.

Part 2)

It can be interpreted from the information provided in the question that the company might have to pay a civil fraud penalty of 75% (together with the applicable rate of interest) of the tax amount that was due on the amount of the fraud. Further, the case can also be subjected to criminal prosecution which may result in jail imprisonment for the company's officials.

Besides, providing incorrect and incomplete information in the financial statements can result in loss of investor trust in the company's operations. Market reputation can be severly affected resulting in loss of goodwill and established brand image. Further audits and evaluation of different business processes may be conducted/performed by government authorities which may affect the continuity of business operations.