Inventory Write-Downs in Financial Statements – ACC 499

ACC 499 – Undergraduate Accounting Capstone Instructions

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.

Write an eight to ten (8-10) page paper in which you:

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.
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.
Discuss the applicable federal tax laws, regulations, rulings, and court cases related to the inventory write-downs, and explain the specific relevance of each to the write-down.
Research the current generally accepted accounting principles (GAAP) regarding stock option accounting. Evaluate the current treatment of the company’s share-based compensation plan based on GAAP reporting.
Contrast the financial benefits and risks of the share-based compensation stock option plan with the financial benefits and risks of a share-based stock-appreciation rights plan (SARS). Recommend to the CFO which plan the company should use, and provide the correct accounting treatment for each.
Research the reporting requirements for lease reporting under GAAP and International Financial Reporting Standards (IFRS). Based on your research, create a proposal for future lease transactions to the CFO. Within the proposal, discuss the use of off-the-balance sheet financing arrangements, capital leases, and operating leases, and indicate the related business and financial risks of each.
Create an argument for or against a single set of international accounting standards related to lease accounting based on the global market and cross border leases of assets. Examine the benefits and risks of your chosen position.

Sample Answers

Repercussions of Failure to Include Inventory Write-Downs in Financial Statements

The Sarbanes-Oxley Act and GAAP (generally accepted accounting principles) rules provides for the restatement of the financial statements (Powers, & Needles, 2012). In addition, the IAS does not demand separate disclosures on write downs in the income statement being a low persistence item. However, it (IAS) requires that sufficient information that affects significant events and warrants a better understanding, to be provided.

The exclusion of inventory write downs pose a financial threat as there is likelihood of overestimation of earnings persistence, which poses a great ethical concern. Moreover, it is a source of ethical and financial concerns such as excessive compensation of top executives; it can derail belief of shareholders in the management, loss of goodwill, loss of brand values and concealment of fraud penalties. The company accountants, who promote less than full financial reporting, violate the accounting standards, ethics of the profession and the trust accorded to the accounting professional behavior.

As a partner in the audit firm, it would be recommended that strong internal controls be implemented and monitored by the company CEO and CFO. The IRS poses negative repercussions on the company owing to likelihood of financial misrepresentations that arise from write downs. The internal controls that the company should implement under the guidance of the CFO and CEO include creation of culture of integrity, total intolerance on frauds, separation of accounting from transaction operations, analysis of asset and liability swings, matching cash flows with revenues and implementation of educative and training programs to train company employees on standard accounting principles, general ethics that involve accounting and the negative effects of improper accounting procedures.

The Negative Results on Stakeholders and the Financial Statements of an IRS Audit

The evidence by the Internal Revenue Service shows that the inventory has been written down by about 10% in a span of three years. According to (Jones, & Spalding, 2012), an IRS Civil Fraud Penalty of about 75% could be imposed due to the fraud. The Internal Revenue Service fraud team would consult with the Fraud Technical Advisor and Front Line Manager to determine and impose the fraud penalty.

Moreover, the IRS audit that generates additional tax and penalties or subsequent audits can result of prosecution. The criminal tax fraud for which the company is responsible would result in prosecution costs and jail time. This could have significant impact on the company image, and the entire organization bottom line owing to bad image that is generated due to the fraud. Also, the share-based stock option would be at risk, impacting on the confidence and trust of the company shareholders.

The Applicable Federal Tax Laws, Regulations, Rulings, and Court Cases Related to the Inventory Write-Downs

The United States taxpayers which include individuals, businesses, and other entities, rely on tax accounting principles when deriving their taxable income. The clear reflections of income standards in the United States have existed since the inception of the Internal Revenue Code (IRC) (Jones, & Spalding, 2012). According to the authors, the IRC stipulates in statutory language, the methods of accounting that the taxpayers must use in making financial reporting. In addition, there are other regulations and court precedence that provides the methods and framework from which companies must follow in making their financial reporting.

Generally, the regulations that govern the inventory write-downs are provided in the Internal Revenue Code. According to (Avdeev, 2012) section 471 of the IRC and the regulations therein outlines two basic methods of inventory valuation- lower of cost and cost. In addition, different rules have been outlined, which govern subnormal and normal goods. Other regulations include the rules that govern the determination of the market value of inventory, change in accounting methods and the maintenance of records.

The federal tax laws that govern inventory write-downs are important in the sense that writing off inventory that has been stolen, damaged or unsellable could reduce the tax bills. In accordance with the federal tax laws, in order to claim an inventory write off, a company must determine the value of its inventory using the methods that have been determined by the IRS. With the cost method, all direct and direct costs of the inventory, which includes transportation and allied costs, should be summed up.

There are a number of court cases and rulings, which have been determined that are related to the inventory write downs. According to (Jones, & Spalding, 2012) Artnell Company (400 F. 2d 981, 1968) and Cincinnati, New Orleans & Texas Pacific Railroad (191 Ct. Cl. 572, 1970), are some of the cases that have been determined and which are relevant to the inventory write downs. In the case of Cincinnati, New Orleans & Texas Pacific Railroad (191 Ct. Cl. 572, 1970), the court in determining if income was clearly reflected, held that GAAP “is entitled to some probative value”. A more recent landmark court ruling is the Thor Power Tool Co. vs. Commissioner (439 U.S. 522, 1979). The company had used lower of cost in valuing its inventory and owing to its management change, it was determined that the company’s inventory was overvalued. However, the court determined that the Thor Power violated the treasury regulations that demand the actual offer of inventory at reduced price to determine the lower market value of the inventory.

The Current Generally Accepted Accounting Principles (GAAP) Regarding Stock Option Accounting

The accounting for the employee stock options are defined in the US GAAP, “FAS 123R” (Powers, & Needles, 2012). Under these provisions, it is required that the expenses on stock options that are offered to the employees in the vesting period to be recognized. The recognition can be done through fair value or intrinsic value measurements. In the intrinsic value measurement, the expense at grant date refers to the excess of the quoted market price over the exercise price that the employee has to pay. On the other hand, in the fair value measurement the expense is recognized over the service period and is measured at grant date on basis of the value of the award. The Opinion No. 25 of ASB allows business entities to employ the Intrinsic Value Based in accounting, unlike in IFRS 2. In the case a given entity chooses to use ASB Opinion 25, then they must provide a pro forma disclosure of net income and earnings per share as if the Fair Value Method of accounting was used.

In the case provided, the company management exercised the options during the year and the expense for the same was not provided by the company in the company financials. The company in doing so went against the provisions in the US GAAP FAS 123R. The company in the case should provide for the compensation cost in its financials that is incurred through the provision of the stock options to the employees. If the Intrinsic Value Method is applied, then the excesses of the current market price over the exercise prices (less already provided for in the earlier years) needs to be expensed in the current year. There is also the need for the company to disclose in the financials the effects on net income and EPS if the Fair Value method is applied. In addition, the number of the stock options applied should be disclosed in the financial statements.

The Financial Benefits and Risks of the Share-Based Compensation Stock Option Plan and a Share-Based Stock-Appreciation Rights Plan (SARS)

Cash flow- For stock appreciation rights, an increase in stock price is paid by the entity in cash to the employee. This has the potential of negatively affecting the company’s cash flows. In stock option, the company issues only stock, which poses no risk to companies with poor cash flows.
Ownership- When stock options represent a higher percentage, per share earnings can increase significantly. This is a source of major threat and can dilute ownership, making it not suitable for closely held business entities. However, the stock appreciation rights have got no significant ownership interest, making it good for large businesses.
Complexity and costs- The use of option pricing models is often costly and complex, whereas stock appreciation rights makes it simple to account for expense without necessarily making external consultations as in the use of stock options.

In the case above, the company is undergoing IPO, which will create significant amount of cash flows. The paper recommends that owing to presence of good cash flows and the relative ease in accounting, the CFO should opt for stock appreciation rights. The company must then record a compensation charge in the income statement when there is an increase in the employee interest. The company must record the value of the promised shares or increase in shares. The shares must be pro-rated during the award, and records kept from the time the grant is made to the time the awards are paid out. Adjustment of value must be done every year so as to give a reflection of the additional pro-rata share of the awards.

The Reporting Requirements for Lease Reporting under GAAP and International Financial Reporting Standards (IFRS)

In view of the US GAAP FAS 13 and IFRS, IAS 17, which governs accounting leases, it is proposed that an elaborate lease policy be developed by the CFO. In addition, the IAS and GAAP have significant differences, especially as it relates to discount rates by lessee, recognition of gain or loss in sales, and the lease back transactions that are under leveraged assets, capital leases or operating leases.

Read also Amazon (GAPP) Vs Rakuten (IFRS)

Since the company plans to lease a substantial amount of its assets, it should be assessed to determine the overall impact it may have on the overall company performance. Carrying the Risk Weighted Lease Receivables in the company books has a potential of affecting the company’s risk position. It is also important for the company to carry out the securitization of its assets. This involves the process of taking the company assets off the balance sheet by pooling them through contractual debt receivables such as commercial and residential mortgages and auto loans, then consolidating and passing them through securities. They are then passed by the owner (originator) to a special purpose vehicle (SPV).

The potential benefits of securitization include reduction in funding cost since it helps in improving the company’s credit ratings. It also helps in transferring all the risks related to the debt assets, increases liquidity by making funds available for immediate use and helps in reducing the assets liability mismatch. While keeping in mind these benefits, the company CFO should consider employing securitization as a form of lease hedge.

Argument for or against International Accounting Standards Related to Lease Accounting

The accounting standards differ from country to country depending on the generally accepted accounting principles of specific country (Trewavas, Botica Redmayne, & Laswad, 2012). The lessor and lessee will be forced to adopt different accounting standards when they do internal cross-border assets lease arrangements. It is of the position that the generally accepted accounting principles that govern cross-border assets leases be made to be identical across all the countries. This can be done if individual countries agree to adopt the International Financial Reporting Standards.

However, the adoption of the International Financial Reporting Standards offers benefits and risks (Tovsultanova, 2015). A switch to IFRS makes comparison of companies across the globe much easier, the leveraged assets are treated as at par under the IFRS. In addition, under the IFRS, the discount rate used by a lessee to present value the minimum lease payments, is the rate implicit in the lease which is more practical unlike in United States GAAP where the incremental borrowing rate is used.

The Major Implications of SAS 99 Discovered after the Company Evaluation

The SAS 99 “consideration of fraud in a financial statement audit” shapes the behavior of independent auditor such that any underlying frauds can be discovered and appropriate reporting and treatment can be employed (Mustapha, n.d.). In the company evaluation, some inappropriate instances such as voluntary inventory write downs and inappropriate use of employee stock options were discovered. In accordance with the SAS 99, there are likelihoods of inherent and controls risks, which necessitates the independent auditor to be very skeptical, and exercise proper examination and evaluation of the records for any material misstatement.

The Potential for a Material Misstatement in the Financial Statements

According to (Powers, & Needles, 2012) a company is required to make restatements if the previous financial statements had material inaccuracies. This can be caused by non-compliance with the GAAP, fraud, accounting errors or even misrepresentations. In the case under consideration, it would be recommended that the company CFO issue restated financial statements to the extent of the errors that the evaluation process has outlined. The restated financial statements must address the following errors identified; the non-inclusion of inventory write downs, non-expensing and lack of disclosure of compensation costs of the stock options awarded to the employees. Failure to issue restated statements can in litigation under the Sarbanes-Oxley Act, delisting of company shares, corporate governance non-compliance and restriction of trading of the company on the stock exchange market.

The Economic Effect of Restatement of the Financial Statements on Investors, Employees, Customers, and Creditors

The restatement of the financial statements has potential economic impacts to the investors, employees, customers and creditors. It can have negative impact on the investor confidence and it may affect the morale of employees who would often express skepticism on whatever financial statements company releases in future. Moreover, customer confidence will reduce, which can lead to revisiting of contracts. On the other hand, the company creditors can start to ask for securities for their debts.

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