Gross misstatement of income, ethical question

HI!
I have an ethical question. Potential new client comes to me wanting tax prep. I look at their QuickBooks and their prior year return. The business, a partnership, is on the cash basis. (Appropriately).
There is a $50K accounts payable on the books in QuickBooks for money due to their only supplier of the items they sell as of 12/31/18.
The tax return has this $50K run through the equity section as if the partners contributed $50k.
At 12/31/19, there is about $21K left on the books for this same A/P.
The prior CPA refuses to believe she did anything wrong and has told the taxpayer they don't need an amendment. I told them they do need an amendment because of the huge error.
I am considering withdrawing from the engagement because I can't file an accurate return, knowing what I know.
If I withdraw, do I have any sort of legal or ethical responsibilities regarding reporting this gross error?

Thanks for your thoughts!

Just a thought, but are they possibly keeping their books on the accrual basis of accounting, and then converting to cash for the tax return? Are they showing any inventory on the tax return balance sheet?

Just a thought, but are they possibly keeping their books on the accrual basis of accounting, and then converting to cash for the tax return?

Even if they were, the accrual-to-cash AJE wouldn't hit equity.

But...you're property right, in that, that was what the prior preparer was attempting to do, an accrual-to-cash for the tax return.

If I withdraw, do I have any sort of legal or ethical responsibilities regarding reporting this gross error?

As in, should you report this to the IRS? Because the prior preparer incorrectly prepared the return?

Yes, they kept the books on the accrual basis and used QuickBooks to show the cash basis...however, because they didn't set up A/P properly, the A/P to the supplier still showed on the cash basis books.
So the accrual to cash AJE can't be done properly for 2019 because the 2018 was debit to A/P and credit to partner contributions. The original preparer was going to reverse the journal entry and do the same entry to clear out the balance in 2019...

Yes, that was really my question: Should I report anything to the IRS (my gut says no because maybe they will take my advice and amend the return). I don't think I'm under a legal obligation to do so.

No, you are not required to report anything to IRS.

I'd be more worried about the legal ramifications of reporting the client. Personally, the thought wouldn't cross my mind based on what has been presented. Seems like the client relied on an inexperienced or sloppy preparer. This is not uncommon. Either I'd help clean it up, or I'd disengage, but I don't see any reason to report the client.

Your obligation is to decide whether to stay with the client or to disengage based on the ethical standards of your profession and office.

Yes, they kept the books on the accrual basis and used QuickBooks to show the cash basis...however, because they didn't set up A/P properly, the A/P to the supplier still showed on the cash basis books.
So the accrual to cash AJE can't be done properly for 2019 because the 2018 was debit to A/P and credit to partner contributions. The original preparer was going to reverse the journal entry and do the same entry to clear out the balance in 2019...

Yes, that was really my question: Should I report anything to the IRS (my gut says no because maybe they will take my advice and amend the return). I don't think I'm under a legal obligation to do so.

That is the most unethical thing that would happen here IMO. You have no right or responsibility to report anything as you don't have all the facts. Perhaps this occurred the year before as well in the opposite direction. Do you trust the client?

If I trust the client, I would be willing to move forward. Is there risk? Not yours, but that risk is there and you can now help the client moving forward. Id get them to sign a waiver on all things before my engagement.

If you don't trust them.. say no, move on and forget about it. This goes on millions of times a year in both directions. All we can do is our best for our clients.

When you say "turn them in" do you mean file a Form 211 (Whistleblower Claim for reward for fraud) with the IRS WB Office in Ogden UT and/or if in a participating state who has enacted a "tax fraud WB statute"?

This blows my mind that anyone would even consider reporting this to the IRS.

I merely asked what my responsibilities may be, no need to say I am being unethical. I'm trying to do the right thing and just asked for some guidance. I have never run across something like this in my life and wanted to be sure I wasn't getting myself into trouble.
I did disengage and told them to seek legal counsel regarding the gross understatement of income.

Also, I did look at 2017 tax return, too. The preparer (same person) put the A/P into Long term debt, then in 2018 made it a contribution by the partners. The owners didn't understand what she did at all.

I'm not necessarily sure they need legal counsel...

Again, what you're describing is not uncommon. Taxpayer hires a tax return preparer, usually, based on fee. This low cost tax return preparer butchers the return(s).

The taxpayer "upgrades" professionals later down the road, either voluntarily or because of notices. The taxpayer's situations is best described as a "train wreck" at the point of transition.

Amended returns ensue for the open years and the taxpayer is (eventually) on the right track.

So, would you accurately describe your problem as: the new client was listening to the prior preparer, who butchered the returns, and not you, regarding whether or not amended returns are needed? If yes, then disengaging is understandable.

I also assume you looked at the tax effect of the error on the 1040s of the partners and it warranted amended returns.

Yes, ManVsTax, you are correct. I did also look at the tax effect of the error on the 1040NRs (there were 2). The error raised other issues for their personal taxes and the fact that the partnership/LLC needed to make estimated tax payments on behalf of the foreign partners (forms 8804/8805). The sales taxes were also done incorrectly, as the business operated in multiple states. Train wreck indeed.

Also, I did look at 2017 tax return, too. The preparer (same person) put the A/P into Long term debt, then in 2018 made it a contribution by the partners. The owners didn't understand what she did at all.

Anita will you please state (in detail) the tax violation - you think - that was made.
We are guessing - did the potential client made a deduction - that (in your view) they
should not have done so?
Clearly please, step by step.

..take a deduction (sic).

Fair question - first off, thank you for posting. In my experience, tax accountants often are too scared to discuss issues, and they are the most likely to get into trouble.

But, agree with the comments above - it seems highly unethical for a tax preparer to even think about being a "whistleblower". As a professional, your obligation is to prepare returns correctly, and to inform taxpayers when you identify an issue with a prior return (and it's good practice document that communication in your files).

Regarding the question - taxpayers are permitted a fair amount of flexibility in calculating taxable income, to even assume that a prior year return was flat wrong (short of a situation like getting W-2 amounts wrong) is not fair to the taxpayer (and to the tax preparer's intellectual curiosity) just because it's not clear regarding the accounting used for the prior return. I don't see where the income "misstatement" issue arises without knowing what the item is. Balance sheets, are often messed up, but that doesn't mean income is incorrect. In addition, an "accrued" item or a "payable" DOES NOT necessarily mean that a cash-basis taxpayer couldn't take it into account; quite the opposite, the Tax Code is loaded with rules where a taxpayer's overall method of accounting does not determine the treatment for a specific item (cash vs. accrual, special methods, etc.). In addition, taxpayer's are allowed to elect treatments for many different items which change the timing of income/expense recognition. As a general rule of thumb, I would start with trying to figure out why the position is permissible, rather than why it's impermissible.

Taxpayer's often have no clue regarding accounting - if it takes me more than a sentence or two to clearly explain the issue, that means I don't understand the issue well enough; that's a failure on my part, not the client's.

Just some thoughts, thanks again for posting.