You are engaged in your second annual audit of the financial statements of the Nittany Corporation, a medium-sized manufacturing company with 25 stockholders that manufactures optical instruments. During the audit the following matter comes to your attention: The president's salary has been increased substantially over the prior year by action of the board of directors. The present salary is much greater than salaries paid to presidents of companies of comparable size and is clearly excessive. You determine that the method of computing the president's salary was changed for the year under audit. In prior years the president's salary was consistently based on sales. In the latest year, however, the salary was based on net income before taxes. The Nittany Corporation is in a cyclical industry and would have had an extremely profitable year except that the increase in the president's salary syphoned off much of the income that would have accrued to the stockholders. The president is a substantial stockholder.

1. Discuss your responsibility for disclosing this situation.

2. Discuss the effect, if any, that the situation has upon your audit report as to

a. The conformity of the financial statements with generally accepted accounting principles.

b. The consistency of the application of accounting principles.