The external auditors for Heart Health Procedures (HHP) are currently performing the annual audit of HHP’s financial statements. As part of the audit, the external auditors have prepared a representation letter to be signed by HHP’s chief executive officer

(CEO) and chief financial officer (CFO). The letter provides, among other items, a representation that appropriate provisions have been made for:

Reductions of any excess or obsolete inventories to net realizable values, and Losses from any purchase commitments for inventory quantities in excess of requirements or at prices in excess of market.

HHP began operations by developing a unique balloon process to open obstructed arteries to the heart. In the last several years, HHP’s market share has grown significantly because its major competitor was forced by the Food and Drug Administration (FDA)

to cease its balloon operations. HHP purchases the balloon’s primary and most expensive component from a sole supplier. Two years ago, HHP entered into a five-year contract with this supplier at the then current price, with inflation escalators built into each of the five years. The long-term contract was deemed necessary to ensure adequate supplies and discourage new competition. However, during the past year, HHP’s major competitor developed a technically superior product, which utilizes an innovative, less costly component. This new product was recently approved by the FDA and has been introduced to the medical community, receiving high acceptance. It is expected that HHP’s market share, which has already seen softness, will experience a large decline and that the primary component used in the HHP balloon will decrease in price as a result of the competitor’s use of its recently developed superior, cheaper component. The new component has been licensed by the major competitor to several outside supply sources to maintain available quantity and price competitiveness. At this time, HHP is investigating the purchase of this new component. HHP’s officers are on a bonus plan that is tied to overall corporate profits. Jim Honig, vice president of manufacturing, is responsible for both manufacturing and warehousing.

During the course of the audit, he advised the CEO and CFO that he was not aware of any obsolete inventory nor any inventory or purchase commitments where current or expected prices were significantly below acquisition or commitment prices. Jim took this position even though Marian Nevins, assistant controller, had apprised him of both the existing excess inventory attributable to the declining market share and the significant loss associated with the remaining years of the five-year purchase commitment.

Marian has brought this situation to the attention of her superior, the controller, who also participates in the bonus plan and reports directly to the CFO. Marian worked closely with the external audit staff and subsequently ascertained that the external audit manager was unaware of the inventory and purchase commitment problems. Marian is concerned about the situation and is not sure how to handle the matter.

Required:

1. Assuming that the controller did not apprise the CEO and CFO of the situation, explain the ethical considerations of the controller’s apparent lack of action by discussing specific provisions of the Standards of Ethical Conduct for Management Accountants.

2. Assuming Marian Nevins believes the controller has acted unethically and not apprised the CEO and CFO of the findings, describe the steps that she should take to resolve the situation. Refer to the Standards of Ethical Conduct for Management Accountants in your answer.

3. Describe actions that HHP can take to improve the ethical situation within the company.

(CMA adapted)

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