Richard Lange, CPA, is a sole practitioner. The largest audit client in his office is Echo Park Sportswear (EP Sports). EP Sports is a privately owned company in South Bend, Indiana with a 12-person board of directors. Richard was hired by the audit committee of the board five years ago and is proud to have them as a client. He took an immediate liking to their CEO, Michael Walker, who is also chair of the audit committee. Michael has a gregarious personality and infectious laugh, and the rest of the company’s board and management team seem to adore him.

Richard is in the process of auditing EP Sports’ financial statements for the year-ended December 31, 2021. He just discovered a related-party transaction that has him worried. For one thing, the relationship has existed for the past two years, but Richard did not discover it until now. What’s just as troubling is that Walker appears to have hidden it from him.

EP Sports bought a majority stake in Palladium Sportswear two years ago but still operates it as a separate entity, and since then has systematically failed to disclose to the private investors related-party transactions involving Walker. It seems that Walker is borrowing money from Palladium and is also deeply in debt to the CEO of that company, who is his brother-in-law. In addition, Palladium has hired relatives of Walker, most of whom are unqualified for their jobs, and pays them above-market salaries. All of this has been hidden from Richard.

Richard recently received an anonymous tip that EP Sports operates a secret off-balance-sheet cash account to pay cash bonuses to senior officers, travel and entertainment expenses and an apartment rental for Walker, as well as noncash gifts to local government officials to “grease the wheels” when permits need to be expedited in favor of the company. Richard has not followed-up on the tip yet because he is currently focused on the related-party transactions with Palladium Sportswear.

Richard just met with the CFO of EP Sports, Cynthia Riley, CPA to discuss these transactions. Riley explained that she had raised these issues with Walker but was instructed in no uncertain terms to leave them alone. Walker told Riley that she should just consider these transactions a part of his compensation package as the CEO, that they were common in privately held companies, and that she should focus her energies elsewhere. Riley told Richard she needed this job and wouldn’t jeopardize it out of a sense of “ethics.” While she did not come out and say it, Richard got the impression that Riley seemed to believe that Walker’s actions were somehow justified.

Richard is back in his office and reflecting on how best to handle this situation.

Questions

1. Who are the stakeholders in this case and what are Richard’s obligations to them?
2. What are related-party transactions? Why are related-party transactions a particularly sensitive area? What do you  think Richard should do with respect to audit obligations for these transactions?
3. Has fraud been committed in this case? Explain. If so, what are Richard’s obligations in this regard?