Chapter 6, Problem 5ATC

ATC 6-5 Ethical Dilemma What’s an expense?

Several years ago, Wilson Blowhard founded a communications company. The company became successful and grew by expanding its customer base and acquiring some of its competitors. In fact, most of its growth resulted from acquiring other companies. Mr. Blowhard is adamant about continuing the company’s growth and increasing its net worth. To achieve these goals, the business’s net income must continue to increase at a rapid pace.

If the company’s net worth continues to rise, Mr. Blowhard plans to sell the company and retire. He is, therefore, focused on improving the company’s profit any way he can.

In the communications business, companies often use the lines of other communications companies. This line usage is a significant operating expense for Mr. Blowhard’s company. Generally accepted accounting principles require operating costs like line use to be expensed as they are incurred each year. Each dollar of line cost reduces net income by a dollar.

After reviewing the company’s operations, Mr. Blowhard concluded that the company did not currently need all of the line use it was paying for. It was really paying the owner of the lines now so that the line use would be available in the future for all of Mr. Blowhard’s expected new customers. Mr. Blowhard instructed his accountant to capitalize all of the line cost charges and depreciate them over 10 years. The accountant reluctantly followed Mr. Blowhard’s instructions and the company’s net income for the current year showed a significant increase over the prior year’s net income. Mr. Blowhard had found a way to report continued growth in the company’s net income and increase the value of the company.

Required

a. How does Mr. Blowhard’s scheme affect the amount of income that the company would otherwise report in its financial statements and how does the scheme affect the company’s balance sheet? Explain your answer.

b. Review the AICPA’s Articles of Professional Conduct (see Chapter 4) and comment on any of the standards that were violated.

c. Review the fraud triangle discussed in Chapter 4 and comment on the features of the fraud triangle that are evident in this case.