Reference no: EM132837950

Question - Facts: There are two affiliated Companies: a Plumbing Supplies Wholesaler ("PS") and a Heating and Air Conditioning Wholesaler ("HVAC"); HVAC is 51% owned by Sister A ("A") and 49% owned by Sisters B ("B") and C ("C"); PS is 51% owned by B and C and 49% owned by A. Both PS & HVAC have December 31st year-ends. The Companies are both privately held and are located in and around a large Midwestern City. Both companies are S Corporations - the annual net income flows through to the 3 owners personal income tax returns.

PS has 1 large location in the City; HVAC has 7 locations in and around the City.

HVAC has been in business for over 30 years and has always been very profitable.

PS sells imported merchandise which is at the low end of the market. PS has been in business for 10 years. Since it was formed, PS has generally operated about breakeven; the current year, 20X1, is the first year PS has a large loss.

Your Audit Firm is currently auditing both PS and HVAC for the year ended December 31, 20X1. The Audit Fee for both audits in the aggregate is $60,000.

Starting with the current year, 20X1, PS received significant financial support from HVAC in the form of cash advances.

PS and HVAC have a joint asset-based lending agreement with a strong prominent Bank. Borrowing capacity fluctuates based upon eligible collateral of each Company (primarily inventories and accounts receivable). PS has only modest borrowing capacity remaining on its portion of the lending arrangement. Total bank debt at 12/31/20X1 is $20,000,000.

While auditing fixed assets, you notice current year additions are negligible.

While observing the year-end 12/31/20X1 physical inventory at the largest HVAC branch, you notice a brand new gasoline driven forklift truck being operated in the enclosed warehouse. The client branch Manager tells you such forklifts need special EPA approved pollution devices to operate inside. When you inquire about the cost, the branch manager tells you it was about $50,000. When you ask whether the other branches acquired similar forklifts, he responds "yes - all 7." When asked, he obtains all 7 invoices & furnishes them to you. He also tells you "I do not know where the Corporate Controller for both Companies, Bob, put them in the accounting records." You immediately realize the $350,000 purchase for 7 forklifts was coded to cost of goods sold at Corporate.

Bob has the strong support of the three Owners of the 2 Companies.

During the Corporate Audit in February, 20X2, you tell Bob you would like to speak to the Accounts Receivable Manager for both Companies. Bob says "that is unnecessary - I will tell you anything you want to know about Accounts Receivable. We do not need an allowance for doubtful accounts."

You wait until Bob is out of the office one day and meet with the Accounts Receivable Manager; she informs you about a number of material problem accounts receivable for both PS and HVAC.

All companies are private, unless stated otherwise.

Required -

1. What should the Accounting firm proceed about the $350,000 of forklift trucks which were expensed by the Corporate Controller? Bob, of course, tells you he and the owners were merely being aggressive. Per Bob, the owners wanted to minimize their income taxes by expensing rather than capitalizing the forklifts. Have Bob and the Owners "crossed the line?" Be specific.

2. What should your Accounting Firm proceed about the allowance for doubtful accounts situation and the Corporate Controller's attempt to prevent your Accounting Firm from meeting the Accounts Receivable Manager? Be specific.

3. What are the implications for continuing to audit these two Companies?