The primary aim of the financial statements is to provide information about the general performance of an organization. Different kind of stakeholders uses financial statements information to make decisions such as the investors, creditors, employees, and management. Organizations use the Internal Accounting Standards (IAS) in preparing the financial statements. The IAS does not dictate that there should be separate disclosures of write-downs in the income statement (Arens, Elder & Beasley, 2006). However, enough information about the write-downs should be available to facilitate a better understanding of the statements. If for example, the inventory write-downs are not available in the statements, an investor might overestimate the earnings, and this may raise ethical issues.

As a partner in the accounting firm, I am mandated to inform the CFO and the CEO about the consequences of a negative IRS assessment. The IRS has observed that the inventory write-down was included in tax returns just to lower the payable tax whereas they do not appear in the income statement. The IRS, in this case, can instill a civil fraud penalty equal to 75% of the owed tax attributable to the fraud with interest. However, the CFO and CEO can prevent such cases by implementing preventive measures such as instilling the right culture and matching the cash flows with revenue (Collins et al., 2010).

From the IRS examination, it is clear that the company has been writing down the inventory by 10% for the last three years. The IRS can instill the penalty or refer the case to criminal prosecution. It is good to note that a criminal fraud case can lead to imprisonment and substantial charges. The CEO and CFO can considerably be liable for the omission and face prosecution. If auditing of accounts occur and more discrepancies discovered, then the stakeholders more so the investors would lose confidence in the company, which is financially harmful.

Negative Results on Stakeholders

The federal taxation regulations and laws allow a company to write down some inventory in case of damage, loss, or it has no value. However, to determine the write off value, one should use the IRS approved valuation methods. These include the cost method or the market value method. The method used should be consistent in the accounts of the company (Arens, Elder & Beasley, 2006).

If an IRS audit generates additional tax and penalties or subsequent audits, it will generate adverse effects on the stakeholders. Stakeholders will deem financial statements of the company unreliable and lose trust in the management. The penalties imposed on the company will cut down the earnings thus lowering the earnings per share paid to the shareholders (Warlow, 2004).

Applicable Federal Tax Laws, Regulations

The United States Securities and Exchange Commission has adopted the US GAAP accounting principles. Using the same principles ensures that companies present their statements in a similar way making it easy to compare statements of different companies. In the case of inventory write-downs, the internal revenue code allows for two inventory valuation methods including the cost and lower of cost. If the lower of cost method is used, then the write-downs happen in the year in which the value reduction occurs. The expense of the other is valued at the intrinsic or fair value.

In the current case, the top management has exercised some options, but the expense for the same is not in the statements. This treatment is in line with the US GAAP, which provides that the company should provide the compensation cost the company bears in providing the stock options (Arens, Elder & Beasley, 2006). Under the intrinsic value method, the difference between the market price and the exercise price is expensed in the current year.

Accepted Accounting Principles

Stock options mostly aim at to motivate the employees. In addition, they also solve corporate ownership problem commonly known as the principle agent problem. Under the GAAP, stock options can be incentives or qualified. The incentive options do not attract taxes until the employee sells the stock. However, the non-qualified options have no tax benefits (Deloitte, 2014).

The exercise of options increases the number of shares reducing the earnings per share. This reflects a reduction in the stockholder’s share of the earnings. In addition, the issuance of stock options is at lower prices that the market prices and the company lose a chance to bring in more capital by selling the shares in the market. The issuance of a stock option is considerably a dilution of earnings per share under the GAAP (Collins et al., 2010). The stock option expenditure is included in the income statement as an expense. The CFO should use the non-qualified method since it has no form of tax benefits and the issuance of such options is at discounted prices.

Proposal for Future Lease Transactions

There are two options for the company to consider in leasing. These include operational and capital leases. Under the operation lease, the ownership of the item is transferred at the period the item is in use while in the capital lease, the lessee assumes the ownership of the item. Such an entity in this case may choose to use the operating lease since it offers benefits such as tax incentives such as both tax and non-tax incentives. The tax incentives include the depreciation expenses deductible in the balance sheet. The non-tax incentives include the liabilities and assets under the operating lease, which are usually, not include in the balance sheet (Collins et al., 2010). These results in a high return on capital as opposed to when the capital lease related liabilities and assets are included in the balance sheet.

Argument for Lease Accounting

According to the Financial Accounting Standards Board (FASB), all leases should be treated and classified as capital leases if they meet certain criteria. The criteria provides that if a lease exceed 75% of the life of an asset in the hands of the lessee, and there is evidence of ownership movement of the asset at the end of the period, then an entity is given the option of purchasing the asset at a discounted price at the end of the lease period (Financial Accounting Standards Board, 2000).

Main Implications of SAS 99

SAS is the statement of Auditing standards usually considered in cases of fraud in financial statements audits. It came up as a response to significant financial scandals such as Adelphia, WorldCom, and Tyco. The principal aim of SAS 99 is to have the auditor’s consideration of fraud blended into the audit process and be regularly updated until the audit is over (Deloitte, 2014). It enables his consideration of more information in cases of fraud. It ensures that auditors do not over rely on the representation of the client or biases rather they are skeptical and have a questioning mind.

Restated Financial Statements Recommendation

A restatement of financial statement is necessary when it is determined that the earlier statements are inaccurate. This can result from accounting errors or non-compliance with accounting standards. Misrepresentative financial statements misguide the investors and other stakeholders and thus the need for a restatement. Restatement of financial information can include a new provision for the inventory write-down (MacGraw-Hill, 2001). The rectification of such an error is highly efficient in explaining the reasons for the errors in the statements.

In the current case, I would recommend that the CFO look for all errors in the financial statements and then restate the financial statements. When the financial statements do not present the accurate picture of the company, the consequences can be more thorough than the consequences of a restatement.

Restated Financial Statements Economic Effects

Trading in the financial markets requires integrity. For a company to maintain this integrity, it is important to restate financial statements when errors occur. With the dynamic changes in the financial markets, causes of financial statement restatements also change. However, a restatement of financial statement has its effects on stakeholders and economy at large.

Restatement of statements reduces the investor confidence. Investors depend primarily on the financial results to make their decision about investing in a company (Collins et al., 2010). When a company announces a restatement, investors lose confidence both in the company management and the restated statements. The demand for the company shares in the financial market reduces and eventually the price of the shared reduces (MacGraw-Hill, 2001). While many investors are looking to offload their shares, none is willing to buy them. This, in turn, reduces the trading volumes in the financial markets thus affecting the economy.

Another effect is to creditors. When creditors lose confidence in the company, they may ask for security for their debts (Warlow, 2004). They can also claim their debts at earlier dates leaving the company financially unstable. If in the process the customers are no longer interested in the company, there is the likelihood of the company going bankrupt and many people losing their jobs. Loss of jobs increases the unemployment rate, which is a major factor in the economy.

References

Arens, A. A., Elder, R. J., & Beasley, M. S. (2006). Auditing and assurance services: An integrated approach. Upper Saddle River, N.J: Pearson Prentice Hall.

Collins, E. M., Robbins, E. M., & Practicing Law Institute. (2010). Internal Revenue Service (IRS) practice and procedure desk book. New York City: Practicing Law Institute.

Deloitte . (2014). International Accounting Standards. Retrieved from Deloitte : http://www.iasplus.com/en/standards/ias

Financial Accounting Standards Board. (2000). Current Text 2000: Accounting standards as of June 1, 2000. New York, USA: John Wiley and Sons.

MacGraw-Hill. (2001). Intermediate Accounting, 6th edition. Boston, Mass, U.S.A.

Warlow, W. (2004). Elements of the Financial Statements. Retrieved from fasab.gov website: http://www.fasab.gov/pdffiles/elements102004.pdf

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