Problem

Henry Monterrey, a CPA employed by a small public accounting firm, prepared the financial statements and related tax returns during the first four years of operation for Thick-N-Chewy, Inc. This closely held company owns a chain of three candy stores located throughout the city. Aggregate annual revenues are 65 percent from delivery sales and 35 percent from in-store sales. Revenues increased by 12 percent in year two and 9 percent in year three. While preparing the annual statements and tax return for the current year, Monterrey noticed revenues were up 34 percent while cots of goods sold increased only 5 percent over the previous year. Taking note of this large increase, Monterrey began to investigate possible causes.

The CPA recalculated his original computations and found them to be correct. He then reviewed invoices for the goods purchases, thinking the cost of goods purchased could have decreased on a per unit basis, thus explaining the disproportionate increase in revenues and cost of goods sold. Instead, Monterrey found a per-unit increase in the price of goods. He knew that he would need to check any changes in volume and price as well. Monterrey, believing he needed an answer to his question before he could publish the financial statements and sign the tax return, called a meeting to discuss the issue with the three brothers who worked as store managers and who were also majority shareholders.

After showing the brothers his unusual findings and inquiring about possible explanations, one of the brothers responded by saying that they had initiated cost saving measures to reduce the materials cost expense. The brother added that be did not appreciate being called into a meeting to answer unimportant questions about why they are making more money. On his way out, another brother said, "Rather than questioning our good business sense, you should be glad that we are making more money because you might now be able to charge more for your services."

Sensing that he had received a less than truthful answer, Monterrey began talking with some of the long-time employees of the stores to determine if any increase in revenues. Did volume go up substantially while costs were held fairly constant? Was there a major price increase with volume holding steady? The consistent answer was that they had been making candy the same way since the parlors opened and that there had been no significant change in price and only a modest increase in volume.

When he was back at his office, Monterrey was looking through the Thick-N-Chewy file when he came across a newspaper article indicating that two sales clerks had been arrested for selling a controlled substance in one of the stores. Although there was no suggestion in the article that store management had been involved in the drug sales, Monterrey realized that if the candy stores were laundering drug money it could explain the large increase in revenues while price and volume remained steady.

1.) What are the ethical issues?
2.) What should Monterrey do?