On March 18, 2009, Mountain State Sporting Goods, Inc., held its annual meeting of directors and shareholders at Shawnee Bay Resort, located on the shores of Kentucky Lake. The primary purpose of the annual meeting was to review the company's year-end (Dec. 31, 2008) financial statements, precisely its financial condition, and yearly performance. The company's general manager Thomas Workman, and CPA Charles Hess presented the company's financial report. They responded to questions regarding the company's failure to meet projections and its current economic instability. Other issues for discussion included a request by the general manager to increase the company's line of credit and enhance employee benefits. Following a heated exchange between the directors and Workman and Hess, both matters were tabled pending an independent assessment of the company's operations. Both Workman and Hess were excused from the remainder of corporate business, including the election of directors and officers.

Immediately following the annual meeting, the company's two shareholders, brothers Robert and Nathaniel Smith, contacted attorney Dwane Peoples, a former federal prosecutor, to discuss their suspicions of fraudulent activity. The shareholders' suspicions were sparked by observations of the general manager's lavish lifestyle, specifically a new home, new cars, and the recent purchase of an exotic vacation home with the company's CPA, Hess. People's staff, including an in-house CPA, developed the following case profile. Information contained in this profile, including historical operations, projections, statements, and Workman's representations, came from a business valuation report as of December 31, 2006, supporting work papers, and interview notes provided by the Certified Valuation Analyst (CVA).

Background InFormAtIon

organization and ownership Mountain State Sporting Goods is a Kentucky corporation organized by J.D. Smith in 1993. Following J.D.'s death on December 15, 2006, day-to-day management was assigned (via an employment contract, effective January 1, 2007) to Thomas A. Workman, a long-term employee, and assistant manager under J.D.

Ownership of the company's stock was inherited equally (50/50) by J.D.'s two childrenRobert and Nathaniel, both full-time college students (ages 18 and 19, respectively). During the administration of J.D.'s estate, the business was valued at $350,000* by a CVA, using the capitalization of earnings method. All parties considered the methodology employed and the value conclusion reasonable, including the IRS and Workman. The date of valuation was December 31, 2006.

According to the terms of his employment contract with the company, Workman must facilitate the preparation of annual (audited) financial reports with supporting schedules and footnotes. Said financial statements are presented at the company's annual board of directors meeting. The company files its annual federal income tax return as an S corporation via Form the 1120S, wherein profits and losses flow to its shareholders. The company has one store located at 33 Park Drive, Beaver Creek, Kentucky. This is the company's second location since its inception. The move to the new site (on March 1, 2006) was managed by J.D. before his death and motivated by adding a new profit centera pawn shop. The facility is leased from Black Oak Realty (an unrelated party), with an option to purchase at its appraised value ($240,000) at the end of the first three-year term.

According to J.D.'s projections, the new location and pawnshop activity would complement the company's existing offerings and result in revenue growth of 10% in 2006, 15% in 2007, and 10% in each of the following three years. J.D.'s projections directly attributed 50% of the increased revenue to the pawn component. Significantly, any increase in profits was accumulated in a sinking fund to fund a 20% down payment on the building upon exercise of the purchase option. J.D.'s projections and actual results are presented in Table 7-1.

table 7-1 | Gross RevenuesProjected Versus Actual Year

Projected Sales*

2005 2006 2007 2008 2009 2010 N/a

$2,210,000 $2,541,500 $2,796,000 $3,075,500 $3,383,000

Actual Sales**

$2,007,185 $2,195,901 $2,339,496 $2,513,479 N/a

N/a

* Source: J.D.'s business plan and supporting financial forecasts. ** Source: Financial statements.

* $518,500 before application of a marketability discount (32.5%).

Projected Growth*

N/a 10% 15% 10% 10% 10% 177

Actual Growth

7.72% 9.4% 6.54% 7.44% N/A

Jewelry Firearms

Tools

Games & Game Systems Electronics

Other Source: Valuation report as of Dec. 31, 2006.

and Nathaniel does not actively participate in management but attends annual BOD meetings to review financial statements prepared and presented by the company's auditor, Charles Hess, CPA.

According to Workman, his compensation is determined by his employment contract, which specifies a base salary of $50,000 plus 1% of all sales exceeding projections. To date, the company has failed to meet these projections. A comparison of projected sales to reported sales is presented in Table 7-1.

Key Employees, compensation, and Benefits The company has an average of eight employees, including Workman's spouse, Anita, and his 17-year-old daughter, Mia. Anita and Mia share in-house accounting duties and responsibilities. Before J.D.'s death, these duties were performed by Sue Bryant, who retired shortly after that. No other key employees have been identified. The company offers statutory benefits (Social Security, Workers' Compensation, SUTA, and FUTA) and one week of paid vacation. Only Workman receives health insurance benefits.

SIgnIFIcAnt AccountIng poLIcIES

method of Accounting The company employs the accrual method of accounting. Under the accrual method, income is accounted for (recognized) when earned. It is not the actual receipt but rather the right to receive. Expenses are recognized as incurredthat is, when all events have occurred that fix the amount of the item and determine the liability to pay. As explained by Hess, the IRS requires taxpayers that maintain inventories to employ the accrual method of accounting.

Inventory Accounting Inventory is usually the most significant current asset of a business, and its proper measurement is necessary to ensure accurate financial statements. If an inventory is not measured correctly, expenses and revenues cannot be appropriately matched. When the ending list is incorrect, the following balances on the balance sheet are also wrong: list, total assets, and owners' equity. The cost of merchandise sold and net income on the income statement is incorrect when ending inventory is inaccurate.

The two most common inventory systems are the periodic and perpetual systems. In December 2006, the company abandoned its perpetual system and converted to a standard inventory method after J.D.'s death. Under this method, a purchases account is used, and the beginning inventory is unchanged during the period (month, quarter, or year). At the end of an accounting period, the inventory account is adjusted by closing out the beginning inventory and recording the ending inventory, as determined by a physical list. The company's current practice is to conduct a physical inventory at the end of each year, adjusting the cost of goods sold (COGS) and ending the list accordingly. As presented by Workman, the perpetual system maintained by J.D. before his death was too complex, too time-consuming, and not cost-justified. Moreover, the company's auditor did not object and, in fact, encouraged the change.

Method of Valuing Ending Inventory The valuation of inventory can be a complex process that requires the determination of (a) the physical goods to be included; (b) the costs to be included; (c) the cost flow assumption to be adopted, (that is, cost or lower of cost or market); and (d) the accounting cost flow assumption to be adopted (specific identification, LIFO, FIFO, or moving-average). The company employs the FIFO cost flow assumption. The company includes in its physical inventory all items on-premises (or in transit) for which it has legal title, except forfeited pawn items. The company employs the lower cost or market method in valuing its ending inventory, and items identified as unsellable due to obsolescence or condition are valued at bona fide selling prices, as determined by Workman.

Accounting Functions Effective January 1, 2007, all accounting functions and day-to-day accounting activities have been processed by the company's in-house personnel, Anita and Mia, and supervised by Workman, as the company's manager. Hess prepares annual financial reports and related income tax returns.

What conditions would support the reasonableness of the shareholders' suspicions of fraud?