Introduction
Listed companies are required to prepare accurate financial reports, which investors could use to assess their performance. However, the process is often undermined by the risk of material misstatement, which could arise from different quarters. One of them is a company’s external environment, which includes industry factors and the relationship between the company and its shareholders. The risk of material misstatement may also affect a company’s internal environment and company-specific factors. The potential for material misstatements in this space could arise from the temptation by some errant officers to manipulate financial records to achieve certain monetary targets.
At the same time, the potential for this type of fraud occurring may arise from the incompetence of some accounting officers to comply with accounting standards. This report is a response to a preliminary investigation, which has detected instances of accounting anomalies in your organization. It covers relevant laws, accounting procedures, and consequences associated with failing to account for inventory write-downs. Such problems pose different ethical and financial implications on the business, as highlighted below.
Financial and Ethical Repercussions of not Including Inventory Write-downs in the Financial Statements
The initial evaluation of the company highlighted the failure to include inventory write-downs in the financial records. One implication of SAS on this issue is that it may change what may be considered a “fraudulent process.” This implication suffices because SAS rules are often updated. Therefore, what may be considered a breach of accounting rules today may not be so tomorrow (Petrucelli, 2013). However, since the write-down has been established as an omission on the company’s accounts, it has different implications. One of them is the possible overstatement of net income. In other words, the missing inventory write-down could lead to an exaggeration of the company’s net income (Wahlen, Baginski, & Bradshaw, 2017).
Another financial implication is a reduction in the owner’s equity of the business. Ethically, the financial omission would have an impact on the business by eroding investor confidence. These outcomes could negatively affect the relationship between shareholders and the business. If such an outcome suffices, typically a civil fraud penalty could be imposed. Similarly, a negative internal revenue service (IRS) statement could significantly hamper the operations of the company.
One way this could happen is through the imposition of a civil fraud penalty, which is equal to 75% of all the total tax owed by the business to the government (Petrucelli, 2013). In the current case where there has been an inventory write-down by 10% in the last three years, the IRS could impose the penalty highlighted above or institute criminal proceedings on the organization. It is essential to note that the latter action could lead to the imprisonment of the concerned officers and the possible imposition of hefty fines on the business (Skalak, Golden, Clayton, & Pill, 2015).
The involvement of the IRS in the company’s financial process attracts several negative effects on Shareholders. This problem could be more profound if the IRS audit generates additional tax and penalties. For example, some shareholders could lose trust in the financial documents prepared by the organization. At the same time, the shareholders could suffer financial losses because when the write-downs are corrected, they will lead to a decline in earnings, and by extension, the earnings per share paid out to the shareholders (Skalak et al., 2015).
Applicable Federal Tax Laws, Regulations, and Rulings
Federal tax laws allow companies to write-down inventory if they are lost or damaged. However, such data need to be computed using IRS-stipulated procedures. The cost and market value methods are the most common techniques proposed by the IRS. SAS 99 is a tax law/regulation that relates to the inventory write-down. It is applicable in cases where auditors identify or suspect fraud in financial reporting. Some rulings and court cases that led to its formulation include the 1999 Mountain State Ford Truck Sales case and the 1979 case of Thor Power Tool Co. v. Commissioner (Petrucelli, 2013).
The relevance of these cases to the write-down is understandable through the provisions they created which required auditors to integrate their considerations for fraud or inventory write-downs in the audit process until it is complete. The goal of doing so is to prevent the overreliance on the information provided by the clients during the audit process (Petrucelli, 2013). Nonetheless, the company needs to adhere to specific accounting rules regarding how it reports its finances
The United States Securities and Exchange Commission has adopted the generally accepted accounting principles (GAAP) as the main set of accounting principles governing accounting processes in the country. This body of rules has been adopted to make sure that different companies use the same set of rules of reporting for easy computation and comparison. Accounting for inventory is subject to two sets of accounting rules: cost and lower cost (Wahlen et al., 2017). The lower-cost method dictates that the inventory write-down should be recorded in the specific year they occurred. The cost method requires companies to record inventory write-downs at their fair or intrinsic values.
Evaluation of Current Treatment of Share-Based Compensation Plan
The current case shows that management has exercised some options, but the write-down expenses are not in the company’s financial records. This issue appeals to the GAAP, which stipulates that the affected companies should account for the compensation costs associated with the stock options. The intrinsic method requires the company to exercise the difference between the intrinsic and market values of the stock within the specified year (Wahlen et al., 2017). Another issue that needs to be analyzed is the financial benefits and risks of share-based compensation and stock option as well as the financial benefits and risks of a share-based stock-appreciation rights plan (SARS).
Relative to the above need, Wahlen et al. (2017) say share-based compensation is often issued to motivate employees to work harder. Furthermore, it is commonly associated with the minimization of the principal-agent problem in corporate ownership. The GAAP rules provide that stock options could assume two forms: incentive or qualified. Incentive options are usually tax-free until they are sold. Comparatively, the non-qualified options assume no tax benefits to their owners.
Share-based stock-appreciation plans hurt earnings per share because they increase the number of share denominations. The issuance of stock options is priced lower than the market value, thereby causing a decline in the valuation of the business. Therefore, the issuance of a stock option has deemed a dilution of earnings per share under GAAP rules. In this regard, it is highlighted in the income statement as an expense (Petrucelli, 2013).
The SARS plan should be used because it has a profound impact on employee motivation. After all, workers get shares freely. They should be accounted for in the same way as deferred cash is done. Since the liability amount changes annually, a decline in value should create a negative entry, while a positive value should create a positive entry (Bagshaw, 2013).
Reporting Requirements for Lease Accounting Under GAAP and International Financial Reporting Standards (IFRS)
The company could use two accounting procedures for documenting leases: operational and capital leasing procedures. The operating lease method requires the ownership transfer to happen at the time of using the leased item. Comparatively, the capital-leasing model assumes outright ownership from the start of the leasing agreement (AICPA, 2017a). Under the GAAP, only capital leases should be documented on the balance sheet. Comparatively, the IFRS stipulates that all leases should be recognized on the balance sheet unless they are less than 12 months (AICPA, 2017a).
Based on the above differences, it is prudent to use the operating lease because it attracts both tax and non-tax incentives. One of the tax incentives is the depreciation expense, which is deductible on the balance sheet, while a common non-tax incentive covers liabilities and assets under the operating lease. Both items are usually excluded from the balance sheet. The outcome is a high return on capital, but the inverse scenario would involve the computation of the same expense as a liability on the balance sheet statement (AICPA, 2017b).
Comparatively, operating leases should be classified as a rental expense. The accounting procedure that follows should see the rental expense debited and the lease payable account credited. Off-the-balance sheet arrangements, capital leases, and operating leases should not have their ownership transferred to the business because they would attract capital gains tax. Additionally, the lease life of the assets should not exceed 75% of the economic life of the asset because it would be considered a capital gain on the business.
Therefore, undertaking these procedures should minimize the business and financial risks of the business. Another risk associated with off-the-balance-sheet arrangements and capital leases is depreciation or the imposition of an interest expense, which will typically be declining over the life of the asset. Broadly, these risks should be minimized by adopting the above recommendations.
A single set of international accounting standards should be adopted to account for leases because companies have more to gain than lose by doing so. The benefits and risks of doing so are varied. However, several analysts have pointed out that having a single set of accounting standards would ease the process of financial reporting across different jurisdictional boundaries (Wahlen et al., 2017; AICPA, 2017b; AICPA, 2017a). Adopting global accounting standards would also aid in the expansion of the business (internationally) and support the creation of a central accounting body that would minimize the number of disputes between different countries regarding the right accounting procedures to follow (Wahlen et al., 2017).
The main disadvantage associated with the process of using a single accounting standard is the imposition of “transfer costs” associated with the adoption of global accounting standards. Lastly, although the new international standards would standardize accounting procedures across different jurisdictions, some countries will find that the same accounting principles conflict with their policies because laws do not change even with the adoption of the global standards (Wahlen et al., 2017).
Recommendations for the Issuance of Restated Financial Statement Restatement
Because initial investigations detected the omission of inventory write-downs in the company’s report, the CFO and CEO should authorize a thorough review of the company’s financial records and correct the anomalies. The failure to do so could lead to several issues. One of them is a confirmation that the company has failed to comply with existing corporate governance principles (Petrucelli, 2013).
This problem has widespread implications on the company’s financial performance because it would generate negative publicity for the company. Secondly, another issue that could emerge from the failure to issue restated financial statements is the suspension of the company’s shares in the stock exchange. This outcome could affect its operations because it would affect its capital structure as people would be unable to trade its shares. Thirdly, the failure to issue restated financial statements could lead to a downgrade of the company’s credit rating position because it would be difficult to ascertain the accuracy of the company’s financial health.
Lastly, the failure to issue restated financial reports could lead to the authorization of a full audit process of all its financial statements because authorities may want to further verify that all information presented in them is accurate (Wahlen et al., 2017).
The economic effects of restating the company’s financial statements could apply to different groups of shareholders, including employees, customers, and creditors. First, as mentioned in this report, investors could lose confidence in the business and its management whenever a restatement has to occur. This outcome could hurt the public’s perception of the business, thereby leading to a decline in the company’s share price. This phenomenon may occur through an increase in the number of offloaded shares and a decrease in the demand for the same. Consequently, there is likely to be a significant decline in the volume of shares traded, thereby affecting the economy negatively.
Creditors are also likely to change their mode of doing business with the company if it has to restate its financial records. Notably, their perception of risk is likely to increase and consequently, they may start to demand collateral to guarantee any loans given to the company. Similarly, they may start to charge high-interest rates, because of the heightened risk profile. Lastly, a restatement of financial records could lead to job losses because of a decline in market share and sales. Nonetheless, these issues could be prevented by formulating affecting internal control procedures.
Some internal control procedures to prevent fraudulent financial reporting in the current organization should involve screening accounting officers thoroughly before hiring them, implementing internal control procedures to minimize the risk of fraud, allowing employees to report “misdeeds” anonymously, and encouraging managers to lead by example. Generally, fraudulent financial reporting could be avoided if the chief financial officer (CFO) and the chief executive officer (CEO) instill a progressive corporate governance culture to match cash flow with revenues.
The CFO and CEO also have a responsibility to oversee the accounting processes in the organization and compare the company’s actual performance with the information presented in the financial reports. Their main goal is to make sure the two areas match. They are also supposed to discipline errant officers by reporting them to authorities. Lastly, they need to undertake regular inspections of accounting processes to make sure everything is done well.
Summary
The potential for material misstatements that could arise from improper accounting procedures or fraud is high in an environment where officers are not accountable for their mistakes. The responsibility of making sure the organization fully complies with existing accounting principles rests with the CFO and CEO. They should make sure all officers are effective because the implications of failing to do their job well come with serious legal, financial, and ethical costs to the business.
References
AICPA. (2017a). Auditing and accounting guide: Not-for-profit entities, 2017. London, UK: John Wiley & Sons.
AICPA. (2017b). Practice aid: Audit and accounting manual, 2017. London, UK: John Wiley & Sons.
Bagshaw, K. (2013). Audit and assurance essentials: For professional accountancy exams. London, UK: John Wiley & Sons.
Petrucelli, J. (2013). Detecting fraud in organizations: Techniques, tools, and resources. New York, NY: John Wiley & Sons.
Skalak, S., Golden, T., Clayton, M., & Pill, J. (2015). A guide to forensic accounting investigation. New York, NY: John Wiley & Sons.
Wahlen, J., Baginski, S., & Bradshaw, M. (2017). Financial reporting, financial statement analysis, and valuation (9th ed.). New York, NY: Cengage Learning.