Damaging financial and ethical repercussions of failure to include the inventory write-downs in the financial statements
Failureto include write-downs in financial statements leads to fraudulentfinancial reporting that give rise to materially misleading financialstatements. Failing to include write-downs in financial statementsfurther hinder the reflection of the market replacement cost of aninventory. As a result, companies may put their inventory balance ata higher price this is unethical as it goes against professionalcodes of ethics of businesspersons. Again, failing to includewrite-downs may increase an owner’s equity hence, having anegative impact on the overall financial statement (Draz, 2012).
The negative impact of a civil fraud penalty on the corporation as a result of the IRS audit
Negativeimpact of civil fraud penalty: This penalty is imposed in case ofunderpayment of tax on a company return due to fraud. It is equal toseventy five percent (75 %) of the portion of the underpayment thatis attributed to the fraud (Boskin, 2012).
Controlprocedures: Fraud can be prevented by applying strong internalcontrols as well as following an ethical organizational culture.According to Draz (2011), internal control refers to a process thataims at giving reasonable assurance towards the achievement ofefficiency and effectiveness of operations financial reporting’sreliability, and compliance with applicable regulations and laws. Acomprehensive review of the existing internal controls and risksfaced play a key role in strengthening internal controls. Segregationof duties that incorporate control, authorization, and custody ofrecords and documents can help companies and corporations tostrengthen their internal controls. Many corporations that fail tosegregate duties are often faced with cases of fraud and theft. CFOshould always segregate financial duties amongst multiple employeesin order to oversee any financial process at several places and atany time. This, in turn, ensures that one employee is not tempted tomanipulating the entire financial process which can result to casesof fraud. Again, corporations ensure that all employees haveindividual financial transactional levels, which vary depending onposition of authority, capacity to obligate business to a financialcommitment, and business unit needs. Additionally, segregation ofduties prevent employees from creating false invoices, vendoraccounts, as well as making payments against various invoices withoutfollowing necessary verifications (Draz, 2011). Companies andcorporations should also improve their communication process betweenvarious departments in order to strengthen their internal controls.They should have defined communication and processes protocols inorder to notify the key management employees who need certaininformation. Evaluation of communication protocols, which are used topromote ethics hotline and creation of awareness amongst employees onhow access and use it in an effective manner, is also necessary instrengthening internal controls in a company. Likewise, employeesshould change some attitudes that they have toward auditors in orderto have strong internal controls.
CEOand CFO should certify the appropriateness of their disclosures andfinancial statements. They should also present financial conditionand operations of their company in a fair manner. They should alsotake up the responsibility of signing off on quarterly financialreports in order to prevent any discrepancies and fraud in thefinancial statements.
Negative results on stakeholders and the financial statements of an IRS audit which generates additional tax and penalties or subsequent audits
Shareholdersmay be forced to purchase a share at a higher price than the previousone in order to cater for the additional tax and penalties. Likewise,financial statements will incur additional debts that will requireadditional of asset in order to offset it.
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.
Taxfederal law allow a person to write off items that he or she lose todisaster or theft the law also highlight some steps that a personcan follow to claim a tax write-off for inventory that h or shecannot seem to sell. A person who lose inventory to theft or due to acertain disaster can claim his or her loss as a tax deduction. Theperson can either include the amount of his or her loss as a separateadjustment to inventory or as part of the cost of goods sold (Agrawal& Sahiba, 2005). In either case, the person is supposed to reducethe claimed loss for the amount paid by the insurer if he or shereceives any insurance reimbursement for his or her inventory.
Ifa person has overstocked his or her shelves and then finds it hard toget rid of the inventory, then it is possible to dispose theoverstock and claim a tax loss. The person for instance can decide tosell the excess stock to a company that specializes in handlingoverstocked or obsolete merchandise. Again, the person may decide todonate the inventory to a charity and thereafter claim a write-off.However, a person must be careful to keep records in order to helpprove his or her case since there is a high likelihood of IRSscrutinizing the stated claims (Agrawal et al., 2005). Any company orcorporation that needs to determine its write-off must determine thevalue of its inventory employing one of the IRS methods that arealready approved. Lower of cost or market method make a comparison ofthe market value of the inventory while the cost method incorporatesall indirect and direct costs that are associated with the inventory.Federal law allows a company to make some adjustments on itsinventory for shrinkage. As a result, a company does not need to theactual shrinkage on an annual basis. IRS allows a company to claimits shrinkage amount in the current tax on a yearly basis if itsphysical inventory for previous years indicates a historical patternof shrinkage.
Boskin(2012) findings, tax write-downs depend on whether inventorycomponents are viewed as abnormal or normal goods. Normal goods limitavailable write-downs to market write downs in case a taxpayer decideto use the lower cost or market as his or her inventory accounting.Write-downs present under certain circumstances as described in theregulations are required for abnormal goods. UNICAP rules requiremost taxpayers to maximize into inventory additional costs, which areexpensed for the purpose of financial accounting in a direct manner(Pratt & Kulsrud, 2006). Abnormal goods that are already finishedgoods can be sold at a selling price equal to bona fide sellingprices, which do not constitute the direct cost of disposition. Thisapplies regardless of the type of method used be it cost, market, orlower of cost. Goods should be offered for sale less than 30 daysafter upon the expiry of the inventory valuation date for abnormalgoods (for the bona fide selling price). The burden of proof is uponthe taxpayer to strengthen or support the value. It is possible for ataxpayer to write off the whole cost if no market exists this isbecause such goods become obsolete in a complete manner as timeelapses. Abnormal goods can be valued using some reasonable basis ifthey are of raw materials or partly finished goods. In this case,there is no 30 day rule but taxpayers have the burden of proof tosupport the value. The value can never be less that the stipulatedscrap value. A change in accounting method can be caused by change inhow a company inventory is valued from its current practice. IRS mustgive taxpayers the go ahead to change a form of accounting method.Therefore, taxpayers must fill a certain form on a tax yearly basisin order for a change to be effected in a method of accounting.Nevertheless, some changes methods of accounting are made by IRS inan automatic manner. Pratt et al (2006) argues that timing of taxdeduction is influenced by whether the inventory goods are normal orabnormal.
Courtcase: Thor Power Tool Company v. Commissioner
Thiscase was held in a United States Supreme Court in 1979. The courtupheld regulations by IRS that limited how taxpayers could write downinventory. The application of the market or lower cost method waslimited to the two conditions in the regulations (Agrawal et al.,2005). The taxpayer as indulged in the reduction of its inventory toan amount that had a fair market value as asserted by the management.The taxpayer argued that its deduction for los should be applied andallowed for tax purposes since it was allowed for accountingpurposes. However, the court argued that it was not possible topresume that an inventory practice that was conformable to GAAP is aswell valid for tax purposes. He court further argued that thetaxpayer failed to present evidence to support its loss. Thor madeuse of multiple parts to manufacture equipment and capitalized thecost of the parts when they were produced. It wrote down inventoriesof parts that were in excess of production needs and took a lossbased on management judgment. The write down matched with theaccounting practice of the company. IRS provided a regulation thatargued that gods could only be written if either the goods weredefective or taxpayer could demonstrate a market price (Agoglia,Doupnik, & Tsakumis, 2011). The court denied the write-downbecause of various reasons that included failure of Thor to presentenough evidence that demonstrated a market price that was less thanits cost as well as due to the fact that there was no evidence toshow the parts were defective. The decision made by the courtprevents other companies from writing down goods simply because theyhave no intention of selling them.
Generally accepted accounting principles (GAAP) regarding stock option accounting
Stockoptions’ design help employees access the right to buy a particularnumber of shares of the stock of a company at a specified price andperiod (approximately 10 years). It has become an increasinglycontroversial method of compensation. This is attributed to the wayoptions are accounted for in various financial statements of thecorporations or companies that issue them. According to Agoglia(2011), currently, under GAAP, it is not a must for companies andcorporations to expense stock options on the income statementhowever, stock options are viewed as form of compensation just likewages. A significant distortion occurs in reported earnings due tofailure to expense stock options. This, in turn, leads to failure offinancial statements to represent corporate performance in anaccurate manner. Currently, companies can use the alternativeintrinsic value method instead of the earlier on fair value method.This method allow for the measurement of compensation cost as theexcess of stock priced in the market over the exercise price of thestock options on the particular date the options are granted. In mostcases, the exercise price is set at a price that is equal or greaterthan the price of the stock in the market on the date the option aregranted because stock options are generally used to create a platformfor incentives in order for the executives to grow the value of thecompany. Therefore, intrinsic value mostly does not assign any costto stock options hence, no there is no compensation expense that isrecognized on the income statement. However, any company that adoptthe use of this method is required to disclose, in form of afootnote, it net income had the fair value of employee stock optionsbeen expensed on the income statement.
Current treatment of the company’s share-based compensation plan based on GAAP reporting
Share-basedcompensation is a form of compensation in which the amount ofcompensation for employees get is tied or linked to the market priceof the company stock. . Stock awards, stock appreciation rights, andstock options are some of the share-based compensation plans.Stock-based compensation plans play a key role in motivating andrewarding managers. Non-transferrable Stock Appreciation Rights(SARs) and non-transferrable Employee Stock Option Plans (ESOPs) arethe two chief common types of stock based plans (Colvin, 2007).Currently, these plans allow for disclosures that are made in notesaccompanying financial statements. It is the aim of the accounting torecord the fair value of compensation expense over the time whenrelated services are carried out. This, in turn, entails thedetermination of the fair value of the compensation, expensing thecompensation over the durations in which participants carry outcertain services.
Contrast the financial benefits and risks of the share-based compensation stock option plan versus the financial benefits and risks of a share-based stock-appreciation rights plan (SARS)
Stockoptions: in this option a company can grant an employee the optionsto buy a certain number of shares at a specific grant price. Oncecorporate, group, or individual goals are met the option is vested.An employee can exercise the option at the grant price at any timeover the term of the option until the expiry date is met as soon ashe or she is vested. Stock appreciation rights plans on the otherhand refer to bonus plan that grant an employee the right to receivean award based on the value of the company’s stock instead ofgranting the employee the stock (Colvin, 2007). They give employeeswith stock or cash payment depending on the increase in the statednumber of shares’ value of a stipulated period of time.
Best plan for the company to adopt
Iwould recommend the company to adopt the stock options since they arenot subject to liability accounting as stock appreciation right plansare accounting costs in SARs are associated with accounting coststhat are never settled until they pay out or expire.
Lease reporting under GAAP and IFSR
UnderIFRS and GAAP, lessees and lesser are required to categorize a leaseas capital lease (for GAAP)/ finance (for IFRS) or operating lease(Agoglia et al., 2011). Operating leases are recorded as operatingexpenses over time and no asset or liability is recorded on thebalance sheet. Capital leases are recorded as lease assets by lesseesand liabilities on the balance sheet and financial expenses on theincome statement. GAAP articulate extremely detailed methods ofaccounting and provide specific guidance. IFRS allow auditors as wellas financial statement reporters to make use of their own judgmentsince it does not provide for a detailed list of rules that need tobe followed.
CFOshould make use of IFRS for future lease transactions since it createroom for transparency. This is because IFRS require companies to havesignificantly expanded footnote disclosures. IFRS also apply widelyto assets with certain exceptions. Companies changing from IFRS toconverged standards may contain more leases that are classified ascapital leases than hose classified as operating leases and viceversa this result to an increased long term lease obligation on thebalance sheet. Off –the-balance sheet financing arrangements areused by companies to maintain their debt to equity ratios at lowlevels this occur especially when there is a high likelihood ofbreakage of negative debt covenants when a large expenditure isincluded.
Acompany should not adopt a single set of international accountingstandards since it may be biased in one way or another. Instead, thecompany should make use of a converged accounting standard that getrid of biasness that may be caused by the use of a single set ofinternational accounting standards.
Major implications of SAS 99
Newtraining, performance, and preparation of audits in compliance withthe set standard may result to too much higher audit fees. Initialstatements may give way to other steps like evaluation of businessrationales for unusual transaction, examining material misstatement,and reviewing of accounting estimates for biases.
Potential for a material misstatement in the financial statements
Materialmisstatement occur when an error cause users o come to incorrectconclusion in their analysis. Material misstatement can occur due toequity errors and improper expense recognition. Improper expenserecognition incorporate several accounting practices that aredesigned to net income’s overstatement either by deferring expensesfor future periods or intentionally understanding these expenses.Failure to record losses or expenses through improper capitalizationand failure to record asset impairment also lead to understatement ofexpenses. Equity errors are caused by improper accounting for stockoptions, convertible securities, earnings per share, and warrants(Pratt et al., 2006).
A recommendation to the CFO for the issuance of restated financial statement restatement
Iwould advise the CFO to issue a restated financial statementrestatement since the previous statement contains some elements ofaccounting errors, does not fully comply with the generally acceptedaccounting principles and fraud
Significant issues that can result from the failure to issue restated financial statements
Itemthat was improperly reported in the original statement fail to berecognized
Errorscannot be found and corrected by the company or auditors
Statementschanges throughout the year may arise from a change in the accountingpolicy put in place
The economic effect of restatement of the financial statements on investors, employees, customers, and creditors
Investorsare able to study the marginal significance of various items on themarket cap and operations of the company. However, restatement offinancial statements may lower investor’s confidence in a company’sproduct and services. This is because investors’ decision is highlyinfluenced y reliability, accuracy, and completeness of financialinformation that is disseminated to them by public companies (Agrawalet al., 2005). Employees who cause constant errors in financialstatements hence, calling for restatements have a high likelihood ofbeing laid off. Customers may be tempted not to buy a certainproduct or services offered by a corporation or company if theyobserve constant restatement of financial statements. This may have anegative impact on the supply and demand of such goods and services.
Agoglia,C. P., Doupnik, T. S., & Tsakumis, G. T. (2011). Principles BasedVersus Rules-Based Accounting Standards: The Influence Of StandardPrecision And Audit Committee Strength On Financial ReportingDecisions. AccountingReview,86(3), 747-767.
Agrawal,A and Sahiba C. (2005). Corporate governance and accounting scandals.Journal of Law and Economics,48, 371-406.
Boskin,M. (2012). FederalTaxReform: Mythsand Realities.New York: Barons Press.
Colvin,G. (2007). Accountingfor Stock-Based Compensation. 1995. Statementof Financial Accounting Standards No. 123. Norwalk,Conn: FASB.
Draz,D. (2011). FraudPrevention: Improving Internal Controls.Cambridge: Cambridge University.
Pratt,A & Kulsrud, J. (2006). FederalTaxation.Oxford: Oxford University Press.