It was 9:30 A.M. on a Monday morning when the call came through. Hi Dr. Mitchell, do you have a minute? Sure, the professor replied. I am one of your former students, but if you dont mind, I would prefer to remain anonymous. I think it is best for both of us if I not reveal my name or company to you. I am concerned that the senior executives of the company where I serve as controller just provided our local bank fraudulently misstated financial statements. I need some fast advice about what to do. Currently, I am on my cell phone and need help evaluating my next step before I head to my office this morning. May I briefly describe whats going on and get some input from you? she asked. Go ahead, let me see if there is some way I can help, responded Dr. Mitchell. I am the controller of a privately-held, small, start-up company that I joined three and onehalf months ago. On Friday of last week, the companys chief executive officer (CEO), the vice president of operations, and the chief financial officer (CFO) met with representatives of the bank that funds the companys line of credit. One of the purposes of the meeting was to provide our most recent quarterly financial statements. The company is experiencing a severe cash shortage, and the bank recently halted funding the line of credit until we could present our most recent operating results. It was at that meeting, just three days ago, that our senior executive team knowingly submitted financial statements to the bank that overstated sales and receivables accounts. Earlier on Friday, prior to the bank meeting, I vehemently refused to sign the commitment letter required by the bank because of my concerns about the inclusion of sales transactions to customers on account that I knew did not meet revenue recognition criteria specified by GAAP. I explained to the CEO and CFO that I believed including those transactions in the quarterly results would constitute fraud. They continued to insist that the financial statements needed to reflect the transactions, because without them, the bank would not continue funding the line of credit. They accused me of living in an ivory tower and emphasized that companies booked these kinds of transactions all the time. Although they acted like they appreciated my desires for perfection and exactness, they made me feel like it was my lack of experience in the real world that kept me from having a more practical perspective to a common business practice. Unfortunately, none of the senior executives have accounting-related backgrounds. I am the top-level accounting person at the company.

Over the weekend I had time to think about the situation, and now I am even more convinced that this is clearly fraud. My CEO and CFO have been arm-twisting the accounting staff to book sales transactions before sales occur. They have recorded sales transactions for some of our customers who regularly do business with us. The problem is, however, the customers have not placed any orders with us for those transactions. Rather, the CEO and CFO are anticipating that the orders will be coming in very soon based on the customers' prior ordering history. But, at this point no orders have been received and no goods have been shipped related to the sales included in the financials that have been submitted to the bank. The CEO and CFO noted that booking these kinds of credit sales transactions is a common business practice, even if it isnt technically compliant with GAAP given that the transactions represent sales expected in the very near future, perhaps even next week. As it turns out, the CEO even instructed the accounts payable clerk, while I was out of the office for a couple of days, to record entries the CEO had handwritten on a piece of paper. The accounts payable clerk has never worked with sales and receivables. The CEO told the clerk, who works part time while finishing his accounting degree at your university, not to mention the entries to me, unless I specifically asked. In that event, the clerk was supposed to tell me that the entries related to new sales generated by the CEO and that all was under control. Fortunately, the student clerk is currently taking your auditing course, where financial statement fraud is a topic, and he was uncomfortable with what had transpired. He immediately updated me on the day I returned about what had happened. These bizarre entries make up almost half of our first quarters sales. Of course, given that these are quarterly financial statements, they are unaudited. Because we are not a publicly traded company, our external auditor has not performed any kind of interim review of the interim financial statements.

Do you think this is limited to just one quarter? Dr. Mitchell asked. I think so, the caller replied. As I mentioned, I joined the company three and a half months ago. One of my first tasks involved closing out the prior fiscal year and assisting the external auditors with the year-end audit. As best I can tell, these unusual activities began just recently given our poor results in the first quarter of this year. Our company is a start-up enterprise that has been operating at a net loss for a while. Just last week, the bank stopped clearing checks drawn off the company account. They werent necessarily bouncing them, but they were not funding the line of credit until the first quarter results were presented on Friday. Interestingly, the bank immediately started funding the line late Friday and, I understand based on phone calls with my staff this morning, the bank is continuing to fund the line this morning. I really think the earnings misstatements first occurred this quarter and that the prior year audited financial statements are not misstated. Unfortunately, I had to sign a bank commitment letter only two weeks after joining the company. That commitment letter related to funding the loan right at the close of the last fiscal year. So, my signature is on file at the bank related to prior-year financial results. But, given the current events, I refused to sign the documents delivered to the bank on Friday. One of my accounting clerks resigned last week due to similar concerns. Our vice president of human resources (HR) discussed the resignation with me after learning about the clerks concern during a final exit interview. I might add, however, that the HR vice president is the wife of the CEO. Anyway, Im just not sure what responsibilities I have to disclose the earnings misstatements to outside parties. I am considering all sorts of options and thought I would see what advice you could offer. What do you think I should do, Dr. Mitchell?

Answer the following Case Analysis questions:

[4] What types of audit procedures could an external auditor perform that might help the auditor detect this fraudulent activity?

[5] People who study instances of financial statement fraud often note that three conditions are generally present for fraud to occur. First, the person perpetrating the fraud has an incentive or pressure to engage in fraud. Second, there is an opportunity for that person to carry out the fraud. Third, the persons attitude or ethical values allows the perpetrator to rationalize the unethical behavior. Describe examples of incentive, opportunity, and attitude conditions that were present in this situation.

[6] In 2014, the AICPA's Professional Ethics Executive Committee adopted a revised Code of Professional Conduct that is effective December 15, 2014. Briefly describe how the new Code is structured and indicate where would you find guidance about the importance of integrity.

[7] (a) What would you recommend to the caller if you were Dr. Mitchell? (b) What are the risks of continuing to work with

[11]One of the environmental factors affecting judgment is the "rush to solve" judgment trap. Briefly describe that trap and how it applies to the situation affecting the anonymous caller.