Several years ago, Wilson Blowhard founded a communications company. The company became successful and grew by expanding its customer base and acquiring some of its competitors. In fact, most of its growth resulted from acquiring other companies. Mr. Blowhard is adamant about continuing the companys growth and increasing its net worth. To achieve these goals, the businesss net income must continue to increase at a rapid pace.

If the companys net worth continues to rise, Mr. Blowhard plans to sell the company and retire. He is, therefore, focused on improving the companys profit any way he can.

In the communications business, companies often use the lines of other communications companies. This line usage is a significant operating expense for Mr. Blowhards company. Generally accepted accounting principles require operating costs like line use to be expensed as they are incurred each year. Each dollar of line cost reduces net income by a dollar.

After reviewing the companys operations, Mr. Blowhard concluded that the company did not currently need all of the line use it was paying for. It was really paying the owner of the lines now so that the line use would be available in the future for all of Mr. Blowhards expected new customers. Mr. Blowhard instructed his accountant to capitalize all of the line cost charges and depreciate them over 10 years. The accountant reluctantly followed Mr. Blowhards instructions and the companys net income for the current year showed a significant increase over the prior years net income. Mr. Blowhard had found a way to report continued growth in the companys net income and increase the value of the company.

Required

1. How does Mr. Blowhards scheme affect the amount of income that the company would otherwise report in its financial statements and how does the scheme affect the companys balance sheet? Show your formula. Explain your answer.

2. Review the AICPAs Articles of Professional Conduct (see chapter 2 of the text) and comment on any of the principles that were violated.

3. Review the elements of the fraud triangle (see chapter 2 of the text) and comment on which of these features are evident in this case. Please do not just recite the elements of the fraud triangle. Analyze how Blowhards actions reflect the elements of the fraud triangle.