Capstone Research Project
- 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.
The concept of inventory write down involves charging a certain amount of inventory to
the expenses account in a given accounting period. There are various reasons that necessitate
inventory write down and they include lose of inventory, theft, loss of value etc. Write down of
inventory should be done once the need is noted to ensure financial statements reflect the correct
inventory value (Larson, Turcic, & Zhang, 2011). If inventory write-down is not done on time a
Running head: Accounting 2
company’s financial statements will reflect the wrong inventory value which will be misleading
to a company’s stakeholders. Inventory value is normally equal to the difference between current
market replacement value (fair value) of inventory held and the original inventory cost or the
historical cost of inventory. If a small inventory loss is noted by accountants, it can be included
in that year’s cost of goods sold but if a the inventory loss is huge it is reported in a company’s
income statement on its own as a write-down expense according to IAS 1(Larson, Turcic, &
Zhang, 2011). Some of the latest accounting frauds have been associated with inventory write-
down anomalies. Some of the latest inventory write-down violations were perpetrated by such
corporations such as Enron and WorldCom. Presentation of financial statements in covered in
IAS 1 which further directs that inventory write-down be disclosed separately in the financial
statements. Events and information that demand inventory write-down should also be disclosed
in the financial statements for the year. If inventory write-down is not captured in financial
statements even though it is required by investors, management will have deliberately misled
investors. Such an omission can raise serious ethical concerns such as lose of shareholders
confidence if discovered later and lose of goodwill of the company among others. The CEO and
CFO of the company should assess the negative impact of Internal Revenue Service (IRS} as
write downs reduce the amount of revenue that is taxable. In this case, inventory was written n
down to reduce the amount of tax payable to Internal Revenue Service (IRS) (Derrick, 2015).
Inventory that was written down was not factual and the write down was just to evade paying the
right amount of taxes. The amount written down was also not included in the company’s
income statement. The company would therefore mislead the public on the earning potential of
the company while hiding the truth about the company, inventory value (Askew, 2012).
Running head: Accounting 3
In the event that the IRS audit determines that a civil fraud was perpetrated by the company, the
IRS will slap the corporation with a hefty penalty of 75 percent on the tax underpaid. The
impact of such a penalty is that the company will end up paying more to IRS than it would have
actually paid had it omitted the write down (Derrick, 2015). The company will also be subjected
into more thorough scrutiny than was practiced before the civil fraud. Once the civil fraud case
leaks out to the public, the company will start losing customers as they will start doubting the
quality of its products or services. Competitors will start using that case as a way to increase their
market share (Askew, 2012). The company will have to spend more funds to reverse negative
opinion on it from its stakeholders which will increase its expenses and reduce the net profit. The
other consequence is that the board of directors of the company is likely to dismiss those
involved in the case. The CEO and CFO should ensure that the fair value of all assets in the
company books is determined before preparing annual reports. Any adjustments should be done
prior to releasing annual reports to the public. Revaluation reports should be forwarded to the
CEO and CFO for approval before they are filed. This internal control will ensure such cases do
not recur in future. Accountants who did not handle the inventory write down according to IAS
1 should be trained on how to treat inventory write down in future(Askew, 2012).
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.
An Internal Revenue Service audit that generates additional tax and penalties or subsequent
audits has several negative results on stakeholders and the financial statements of a company.
Firstly, if an audit generates additional tax and penalties the company will have to pay more
Running head: Accounting 4
taxes than before. Such payments impact on the cash flows which reduce the amount of
dividends that is payable to shareholders. The additional inventory write downs will be expensed
in the income statement which would reduce the bottom line. A reduction on the bottom line
affects a company’s return on equity which means that shareholders will receive lesser dividends
than before (Robinson, 2014). This also implies that employees will have to either be retrenched
or salary increments frozen for a while to allow the company to recover. The company may have
to start cutting costs which could include retrenching workers. Additional tax and penalties
could affect a company’s ability to meet its short term obligations which includes paying trade
payables and making interest and principle payments to banks for loans taken (Askew, 2012).
The company might default on some payments which could lead to legal suits. Subsequent
audits and law suits due to default on payments normally leads to contingent liabilities which
could scare potential investors and lead to a fall in the company’s share on the stock exchange in
the case of a company listed on a national stock market. The company’s market share could fall
as it could lose many customers to competitors as news of IRS audit leaks to the mainstream
media (Askew, 2012). The financial statements of an affected company will have to be restated
for the period the company started using the inventory reserve account. The market
capitalization would reduce and this would affect the share price and increase the beta of the
company to more than one. This would signal to investors that the company is a risk investment.
Many stakeholders could feel deceived and start pushing for removal of the top management
personnel of the company (Askew, 2012).
- 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.
Running head: Accounting 5
According to Internal Revenue Service, inventories include all goods purchased and which are
held for resale to customers by traders or merchants. Inventories include property, land or
merchandise which a trader holds for sale to customers. Finished goods and work in progress in
a manufacturing entity are classified as inventory. Inventories also include materials and supplies
awaiting use in a manufacturing entity to produce goods for resale (Feuer, 2015). According to
Inventories (IAS 2), inventories are supposed to be measured a lower of cost and net realizable
value; net realizable cost is the price that inventory could be sold at in the ordinary course of a
company’s business. Writing down involves determining the net realizable value of the said
inventory. The net realizable cost is the actual price that could be realized by selling inventory
in normal business transactions (Feuer, 2015). In the case of Mountain State Ford Truck Sales,
Inc., 112 T.C. No. 7, March 2, 1999, the ruling was that tax payers must use the actual cost
of inventory and not the replacement cost for last in first out (LIFO) inventory purposes
since income is not clearly reflected when a company uses replacement cost. In the case low of
Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979), 1979-1 C.B. 167, the court held
that the excess inventory could not be written down to the replacement cost since it was not
scrapped, written off or sold at a price lower than the market price (replacement cost) but the
taxpayer sold them at the market price. The write down was disallowed. The applicable rule
according to Revenue Procedure 2002-17, IAS 2 and the two case laws repealed is that inventory
is only written down to the net realizable cost or lower of cost in the case (replacement cost) if it
is to be scrapped or written off (Walker,2014.
- 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
Running head: Accounting 6
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.
According to generally accepted accounting principles (GAAP) a stock option confers an
employee the right to purchase the stock of a company after a certain specified period of time at
a certain set price(Ouyang & Sallehu, 2015). Generally accepted accounting principles (GAAP)
requires a company to treat stock option to an employee as expense to the company and income
to the concerned employee. This is partly because stock options are sold to an employee at below
fair market value. The expense to be recognized is the difference between the fair market value
and the purchase price of the stock option (Ouyang & Sallehu, 2015). The US GAAP gives
companies two options to account for stock options. The two options are either to treat the stock
option as employee compensation and hence expense it in the income statement which reduces
the net profit or increases the net loss or disclose the stock option in the notes to financial
statements. Most companies chose the second option since it does not affect the bottom line. A
stock option given by a company confers the employee of the company the right but not the
obligation to sell or buy a stock within a set time period at a specified price. On the other hand,
stock-appreciation rights plan (SARS) is a right given to an employee to receive a bonus equal to
the appreciation in the stock of the company within a certain period of time(Ouyang & Sallehu,
2015). The difference between stock appreciation rights plan and stock option plan is that in
stock appreciation rights plan the employee is not be required to pay the exercise price but just
receives the increase in price or bonus in either cash or shares. Stock option requires an
employee to pay the exercise price to access the stock option. The main difference is that stock
appreciation rights plan motivates the employee unlike the stock option which may be in
Running head: Accounting 7
accessible to employees if they are not empowered adequately to buy those (Ouyang & Sallehu,
2015). The most ideal option plan is stock appreciation rights plan since it motivates employees
more to give their best in their work. The correct accounting treatment is to treat the stock
appreciation rights plan as credit in the expenses account and include it in the expenses in the
income statement and then debit share capital in the balance sheet. This would reduce the
company’s shareholder’s equity accordingly (Ouyang & Sallehu, 2015).
- 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.
International Financial Reporting Standards (IFRS) covers leases under IAS17 which requires
leases to be classifies as finance leases or operating leases. Under IAS17 leasing is more
principle based and requires professional judgment to a greater extend. International Financial
Reporting Standards (IFRS) in IAS17 a lease, irrespective of whether a lease is a finance lease or
an operating lease does not depend on the form of the transaction but on the substance of the
transaction. International Financial Reporting Standards (IFRS) requires more professional
judgment as it does not provide specified percentages for determining the economic value of the
assets leased or the fair value of the specific assets leased(Feuer, 2015). Generally accepted
accounting principles (GAAP) on the other hand classifies leases into capital and operating
leases. In capitalized leases the risks and rewards are born by the lessee whereas in operating
leases the risks and rewards are born by the lessor. The GAAP is provides precise guidelines as
it is rule based (McAnally, McGuire & Weaver, 2010). The GAAP in FAS13 specifies the
Running head: Accounting 8
economic life of a leased asset to be 75% or more of the asset’s life and substantially all of the
leased assets fair value to be 90% of the fair value of the leased asset which contrasts IFRS
guidelines(Feuer, 2015).
Off balance sheet financing involves setting up special purpose entities (SPEs) which provide
operating lease to a company. The benefits of such an arrangement are that the company
manages to keep debt out of its books and only discloses the leases as a foot note. It is perfectly
legal to do that. The company is able to maintain financial ratios that it targets (Santosh, 2012;
King, 2010). The disadvantage of this arrangement is that the company can easily become
technically insolvent without shareholders and other stakeholders knowing. Enron is one such
example which had off balance financing which eventually led to its collapse. A company can
use off balance financing to get more debt and inflate its revenues while hiding expenses (King,
2010).
- 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.
According to International Financial Reporting Standards (IFRS) a company records in its books
a lease as either an operating lease or a finance lease. The best international accounting standard
that I would recommend to the CFO is international financial reporting standards (IFRS) (King,
2010). International Financial Reporting Standards will benefit the company in the long run.
International Financial Reporting Standards (IFRS) allows an entity to revalue property, plant
and equipment assets including leased assets and record them at a value above historical cost.
Most accounting entities however carry out revaluation of buildings, land and forest products
mainly. According to IFRS if an entity revalues its leased property, plant and equipment and
Running head: Accounting 9
either records a gain or a loss then it must be committed to subsequent periodic revaluations in
future (King, 2010). That is to mean than an entity cannot benefit from a onetime gain and not
revalue to determine any loss or gain on the assets value in future. It has been noted that many
companies operating in IFRS environments actually carry out frequent leased assets revaluations
which enables them to present a fair value of their leased assets. During revaluation, the price of
the leased asset is mainly determined using the fair value approach which is permitted under
International Financial Reporting Standards (IFRS) (King, 2010). Fair value practice of asset
valuation involves determining the value of assets based on the principle of willing seller willing
buyer. Once the price is obtained it is then used to value the leased assets of land, buildings and
agricultural assets. It would be difficult to determine the fair value of leased assets if the lease
accounting used by the leasing and lessor is different. By adopting IFRS, the company will be
able to carry out cross border leases faster and easily (King, 2010).
Adoption of International Financial Reporting Standards (IFRS) brings with it a lot of
benefits. Some of these benefits include; that they offer accountants useful working rules and
ensure quality is upheld in preparation of financial statements among other benefits. Application
of IFRS worldwide standardizes accounting treatments and goes a long way in ensuring financial
statements represent a true and fair view of companies (King, 2010). The world wide application
of IFRS arguably reduces the cost of obtaining equity and debt financing from capital markets
for leasing assets or in cross border leasing since it reduces the need for supplementary
information. Other notable benefits include reduction in the cost of carrying out cross border
business and also that financial statements prepared under IFRS guidelines enable comparability,
evaluation and analysis (Madawaki, 2012)
Running head: Accounting 10
- Examine the major implications of SAS 99 based on the factors you discovered during the
initial evaluation of the company. Provide support for your rationale.
According to SAS 99 auditors are required to look for fraud as they carry out an audit ofa
company. Fraud is defined as being an act that is intentional and which stems from material
misstatement of a part or section of a company’s financial statements. According to SAS 99
fraud could arise from misappropriation of assets which could then lead to misstatement or
fraudulent financial reporting which could cause misstatement (Buchholz, 2012). In this case the
treatment of inventory write down can be classified as fraud since it was fraudulent financial
reporting that led to the misstatement. The three conditions that need to be met for fraud to
occur are incentives or pressures in which case the pressure was that the managed wanted to
report favorable financial position to maybe get bonuses, have their contracts or forestall a
planned retrenchment (Clark & Ryerson, 2010). The next condition is attitudes/rationalization
which in this case could be that the management thought no one would know. The other
condition under SAS99 is opportunities which in this case was filing returns to Internal Revenue
Service (IRS) unsupervised by IRS staff. In the absence of IRS staff the managed were able to
write down the inventory without much interference or anyone raising an objection (Clark &
Ryerson, 2010). - Analyze the potential for a material misstatement in the financial statements based on the
issues identified in your initial evaluation. Make a recommendation to the CFO for the
issuance of restated financial statement restatement. Identify at least three (3) significant
issues that can result from the failure to issue restated financial statements.
There is reason to restate the financial statements of the company. There is a potential for
misstatement as the accountant who filed the IRS returns was left unsupervised and again wanted
Running head: Accounting 11
to cut taxes payable. The incentive could have been to get an increment or to get a salary
increment for cutting costs. Failure to restate the financial statements could potentially mislead
shareholders who would demand for higher dividend payout based on the income statement and
cash flow statement (Clark & Ryerson, 2010). Failure to restate the financial statements could
lead to penalties from IRS which would have a huge impact on the cash flows of the company.
The last reason is that failure to restate the statements would lead to wrong stock planning. Stock
planners will plan for activities based on wrong opening stock records which could lead to under
stocking or stock outs which would lead to customer dissatisfaction and loss of revenues (Clark
& Ryerson, 2010).
- Examine the economic effect of restatement of the financial statements on investors,
employees, customers, and creditors.
Restatement of financial statements would affect various stakeholders differently. To investors
restatement would enable them to make good investment decisions. Investors would estimate
expected dividends payable correctly which would enable them to make good investment
decisions. Employees would be able to determine the future ability of the company to pay them
and determine their career paths correctly (Feuer, 2015). To customers, restatement would enable
them to determine whether the company is able to continue meeting its obligations. Customers
are interested in knowing whether they will be able to get the products or services that they get
from the company. To creditors, restatement will enable them to determine whether to offer more
credit facilities to the company or not. They will be able to know whether their debts will be paid
on time or not and hence make good investment decisions(King, 2010).
Running head: Accounting 12
References
Askew, K. (2012, Mar 13). CANADA: Write-downs hit SunOpta FY earnings. Just – Food
Global News Retrieved
