CASE - It's Not Right, but at Least It's Consistent

Our Little Secret is a small manufacturer of swimsuits and other beach apparel. The company is closely held and has no external reporting obligations, other than payroll reports and income tax returns. The company's accounting system is grossly inadequate. Accounting records are maintained by clerical employees with little knowledge of accounting and with many other job responsibilities. Management has decided that the company must hire a competent controller, who can establish and oversee an adequate accounting system.

Amy Lee, CPA, has applied for this position. During a recent interview, Dean Frost, the company's director of personnel, said, "Amy, the job is yours. But you should know that we have a big inventory problem here."

"For some time now, it appears that we have been understating our ending inventory in income tax returns". No one knows when this all got started, or who was responsible. We never even counted our inventory until a few months ago. But the problem is pretty big. In our latest tax return-that's for 2010-we listed inventory at only about half its actual cost. That's an understatement of, maybe, $400,000.

"We don't know what to do. We sure don't want a big scandal-tax evasion, and all that. Maybe the best thing is to continue understating inventory by the same amount as we did in 2010. That way, taxable income will be correctly stated in future years. Anyway, this is just somethingI thought you should know about."

Instructions -

a. Briefly identify the ethical issues raised for Lee by Frost's disclosure.

b. From Lee's perspective, evaluate the possible solution proposed by Frost.

c. Identify and discuss the alternative ethical courses of action that are open to Lee.