You are a CPA employed by ABC Industries, a large public construction business.

In 2018 net income (loss) was ($22.4m), in 2019 net income was $5.1m, and in 2020 net income was $7.6m. It was your sense that business had been pretty stable for those 3 years, so you were surprised to see such variation in net income.

After a little investigation you learned that a large part of the loss was due to taking a one-time $12m charge for expected losses from lawsuits. You also learned that the CEO would receive a $1m bonus each year if net income was more than $2.5m in 2018, more than $5m in 2019, and more than $7.5m in 2020. You also learned that there had been significant reversal of the $12m loss accruals in both 2019 and 2020.

You meet with your friend who is head of internal audit and talk about what you learn.

1. how would you best explain that you suspect, but cannot be sure, that there is significant, and possibly illegal, earnings management taking place?

2. What do you think you and your friend should do?