In this case, you are placed in the position of the auditor conducting an audit of the financial statements of XYZ Corporation, a manufacturer headquartered in Houston, Texas. XYZs common stock is registered with the Securities and Exchange Commission (SEC) and trades on an organized exchange. Your firm has placed you in charge of this audit, and you have to decide how best to deal with some indications of fraudulent activity. You have decided that you need to refer to the American Institute of Certified Public Accountants Code of Professional Conduct as well as consult with the Partner on the audit engagement in order to determine how best to proceed with the audit.

BACKGROUND

You graduated with your Masters degree in Accountancy from a large public university recently, and went to work immediately for a small (five individuals one Partner, one Manager, and three staff members including yourself) public accounting firm in Houston, Texas. Earlier this year, you passed your last part of the Certified Public Accountant (CPA) examination, and became licensed with the Texas State Board of Public Accountancy. You are a proud member of both the American Institute of Certified Public Accountants (AICPA) and the Texas Society of Certified Public Accountants. This is your first audit of a publicly held company. It also happens to be your firms first publicly held client. Prior to accepting this audit client, your firm had only audited privately held clients. Thus, your auditing experience up to this point in time consists only of auditing privately held clients. An audit engagement letter is signed by your firm and by XYZs audit committee (a committee of XYZs board of directors) as required by the Public Company Accounting Oversight Boards (hereafter abbreviated as PCAOB) audit standards.

AUDIT ENGAGEMENT

While conducting your preliminary analytical procedures during the first few weeks on XYZs audit, you discover that XYZs accounts receivables had increased 75 percent from the previous year. As you dig deeper, and look at the accounts receivables transactions, you discover that during the third and fourth quarters, XYZ recorded sizable sales towards the end of each quarter (typically in the last 10 business days of each quarter). As far as you can determine, each of these sales were for amounts that were substantially higher than those usually recorded by XYZ. For instance, if the average sales during the third quarter was for $25,000, then the average sale recorded near the end of the third quarter was for $250,000 or more. These substantial and material sales were included in the quarter end aging of receivables reports that you were given by the client. When you examined the supporting documentation for these sales, you found supporting sales invoices that described each quarter end sale as miscellaneous charges. You were unable to find any other supporting documentation, including supporting purchase orders or supporting shipping documents. Curiously, all of the quarter end material sales for the third quarter were reversed in the first few business days of the fourth quarter. You were able to find credit memos showing that the items had been returned to XYZ. However, these credit memos also did not appear to have any supporting documentation! You wonder if something similar had happened to the substantial sales recorded during the last 10 business days of the fourth quarter. You begin to worry that there might be more going on here than you are able to detect.

You decide to meet in person with XYZs accounting manager. At your meeting with him, you ask the accounting manager about this substantial increase in sales at the end of the third

DISCLAIMER: This case is written using publicly available information to provide a setting for student learning. It is not intended to provide commentary on or evaluation of the effectiveness or appropriateness of any partys handling of the situation described. Certain names and other information has been changed in order to highlight certain issues and in order to maintain confidentiality and privacy.

quarter and the subsequent reversal of these sales in the fourth quarter. He explains that the increase was a result of sales made to five new customers for a new product that XYZ had created. He also explained that a significant number of this new product turned out to be damaged when received by these customers, and after consultation with the Chief Financial Officer (CFO), he was authorized to ask the new customers for all the items to be returned to XYZ in exchange for full credit. He said that he will personally work on finding the additional supporting documentation like the purchase orders and the shipping documents for you in the next few days. You also ask him if the miscellaneous charges sales recorded at the end of the fourth quarter were reversed via credit memos in the first few days of the first quarter of fiscal 2019. He said that he did not recall, but that he would check his files and consult with the CFO, and then get back to you.

You go back to your office, and begin to wonder... wasnt it strange that all of the shipments of the new product to the new customers contained defective units? Not only that, a majority of the units shipped to each customer must have been defective for the CFO to authorize the return of the entire shipment. There did not appear to be any production problems with any of the other products manufactured by XYZ. You have other questions and concerns. Why was there no other documentation available for the quarter end sales as well as the credit memos? Why did the accounting manager need to consult with the CFO to answer your question about the fourth quarter end sales? You begin to suspect that fraud might be taking place at XYZ. But you recall the Confidential Client Information Rule of the AICPA Code of Professional Conduct, which prohibits you from disclosing any confidential client information without the clients consent. You are also aware that your firm is going to earn a substantial audit fee from XYZ upon the completion of the audit engagement, and do not want to do anything to jeopardize the earning of this fee. You decide to go back to the office and consult the AICPA Code of Professional Conduct, and then to talk to the Partner on this audit engagement about what to do next.

DISCUSSION QUESTIONS

1. What general guidance does the AICPA Code of Professional Conduct provide to auditors faced with an ethical dilemma? Provide specific citations in your answer.

2. What relevant facts and circumstances in this case should influence your ethical decision making process?

3. What is the ethical dilemma in this case?

4. Does your audit firm appear to have any specific internal procedures in place to deal with

   ethical dilemmas? If not, what internal procedures should your firm have in place?

5. What alternative courses of action are available to you? What would be the best course of

   action for you to take in these circumstances?