Employees involved in the accounting and control functions of organizations often face ethical dilemmas. Typically, at some point in each of these dilemmas an employee must decide whether he or she will do the right thing.

In the early 2016, several employees of Radio Star Co., Inc., (RDS) came face to face with an ethical dilemma. RDS, a South Carolina based company, manufactured undergarment, and other apparel products. Approximately one half of the company's sales were to three large merchandisers: Cotton mall (29%), Varec (11%), and Santy (9%). RDS enjoyed nearly 1400 workers in its production facilities and another forty individuals in its administrative functions. Between 2011 and 2014, RDS realized steady growth in revenues and profits. In 2011, RDS reported a net income of $1.5 million on net sales of $32 million.

Unfortunately, RDS failed to sustain its impressive profit trend in 2015 as reflected by the financial data presented for the firm in Exhibit 1. Disproportionately high production costs cut sharply into the company's profit margin during that year. These high production costs resulted from cost overruns on several large customer orders and from significant training and other startup costs linked to the opening of a new factory.

A subsequent investigation by the Securities and Exchange Commission (SEC) revealed that the company's senior executive and another high-ranking officer had refused to allow the firm to report its actual net income of $452,000 for 2015. To inflate the company's 2015 net income, these executives instructed three RDS employees to overstate the firm's year-end inventory and thereby understate its cost of goods sold. Initially, the employees were reluctant to participate in the scheme. The two executives warned the employees that unless they cooperated, the company might cease operations and dismiss its employees. After much prodding, the three employees capitulated and began systematically overstating the firm's 2015 year-end inventory.

			RMUC, Inc.
	Selected Financial Data, 2011-2015 (000s omitted)
		2015	2014	2013	2012	2011
Net Sales		$39,505	$32,167	$25,697	$21,063	$17,851
Cost of Sales		32,415	24,199	19,700	16,590	4,358
Operating expenses		5,791	4,523	3,405	2,694	2,454
Net income		452	1,529	1,153	756	378
Total Assets		24,808	14,745	11,134	6,916	5,529
Stockholder's equity		11,263	6,999	3,510	3,469	2,714
Current assets		20,924	12,678	9,648	5,779	4,639
Accounts receivable		7,115	4,725	3,734	2,608	1,290
Inventory		12,158	7,507	5,694	2,869	3,045
Current liabilities		7,302	6,999	3,510	3,469	2,714

Following the two executives instructions, the three RDS employees inflated quantity figures on selected count sheets by adding numerals to the accurate quantity figures per item which had previously recorded thereon during the physical inventory count.

The three RDS employees then multiplied the inflated quantity figures per item on the count sheets by actual unit cost per item and recorded the resulting false and inflated cost figures on the count sheets.

While the three employees were overstating RDSs inventory, the two company executives who set the scheme periodically telephoned them to check on their progress. At one point, the employees indicated that they were unwilling to continue falsifying RDS's year-end inventory quantities. The employees manufactured more than $900,000 of bogus inventory. After checking the falsified inventory count sheets, the executives forwarded them to the independent audit firm.

To further overstate RDS's inventory on December 31, 2015, the company's senior executive instructed another RDS employee to obtain a false confirmation letter from Strechlon Industries. The latter supplied RDS with most of the elastic needed in its manufacturing process. At the time, RDS had an agreement to purchase 50% of Bermuda common stock at net book value. On December 31, 2015, Bermuda has in its possession only a nominal amount of RDS's inventory. Bermuda executive agreed to supply a confirmation letter to RDS's independent auditors indicating that his firm held approximately $165,000 of RDS inventory at the end of 2015. As a condition for providing the confirmation, the Bermuda executive insisted that RDS prepare and forward to him a false shipping document to corroborate the existence of the fictitious inventory. After receiving this shipping document, the executive signed the false confirmation and mailed it to RDS's independent audit firm.

The fraudulent schemes engineered by RDS's executives overstated the firm's December 31, 2015, inventory by approximately $1,076,000. The overstatement of inventory boosted RDS's net income for 2015 by $600,000 more than the actual figure.

Near the completion of the 2015 audit, RDS's auditors asked the company's senior executives to sign a letter of representations. Among other items, this letter indicated that the executive was not aware of any irregularities (fraud) involving the company's financial statements. The letter also stated that RDS's financial statements fairly reflected its financial condition as of the end of 2015 and its operating results for that year. Shortly after receiving the signed letter of representations, RDS's audit firm issued an unqualified opinion on the firm's financial statements.

Following the SEC's discovery of the fraudulent misrepresentations in RDS's 2015 financial statements, the federal agency filed civil charges against the firm's two executives involved in the fraud. The SEC eventually settled these charges by obtaining a court order that prohibited the executives from engaging in any further violations of federal securities law.

FOOTNOTE: Subsequent to the issuance of its financial statements for the year ended December 31, 2015, the company determined that inventory as reported was misstated. The accompanying financial statements have been restated to reflect correction of such misstatement. The significant effects of restatement were to reduce inventories $1,076,000, increase the cost of sales $1,140,000, increase operating expenses $40,000, and reduce net income $607,000 from the amount reported.

Questions

1. Did the overstatement of RDS's inventory at the end of 5 materially affect the company's reported financial data for the year? Defend your answer.
2. What audit procedures might have prevented or detected the overstatements of RDS's inventory quantities at the end of 2015?
3. How did RDS's buyout option for Bermuda affect the quality of the evidence provided by the inventory confirmation letter, if all? Explain.
4. RDSs executives demanded the falsification of inventory. Construct a control system that would have prevented the executives from applying their fraudulent scheme.
5. Refer to the footnote. Did the footnote included adequately describe the misrepresentations in RDSs original financial statements for 2015? Why or why not?