Problem

Maxwell Isaac has just been hired as the controller for Crossroad Enterprise. To become familiar with the company, Maxwell is reviewing the financial statements for 2015. The previous controller completed the year-end financial statements before he left and mailed them to the holder of the long-term bonds as required by the debt covenants. Maxwell is dismayed to find several errors in the financial statements. The previous control, Walter Zone, prepared several adjusting entries on January 10, 2016. The explanation for these entries were "to avoid default on the debt covenant". Walter had recognized revenue on a large order received on December 28 but shipped on January 3, and had reduced depreciation expense by $2,300,000. Both of these items were designed to increase earnings per share to the required amount.

Answer the following questions:

a. What is the accounting and ethical problem for Maxwell? What pressure does Maxwell face?

b. Based on your knowledge of accounting standards, what is the appropriate accounting treatment for these items?

c. Identify the stakeholders affected by the errors in the financial statements presented to the bondholders. Who benefits? Who is harmed? Is there a conflict of interest between the stakeholders?

d. What alternatives are available to Maxwell? Is it worse to admit to the bondholders that your predecessor made a mistake than to hide it?

e. What would you do? Why?