Overstatement of ending inventory Danville Bottlers is a wholesale beverage comp
ID: 2371843 • Letter: O
Question
Overstatement of ending inventory
Danville Bottlers is a wholesale beverage company. Danville uses the FIFO inventory method to determine the cost of its ending inventory. Ending inventory quantities are determined by a physical count. For the fiscal year-end June 30, 2011, ending inventory was originally determined to be $3,265,000. However, on July 17, 2011, John Howard, the company's controller, discovered an error in the ending inventory count. He determined that the correct ending inventory amunt should be $2,600,000.
Danville is a privately owned corporation with significant financing provided by a local bank. The bank requires annual audited financial statements which are scheduled to be issued on July 25. They did not discover the inventory error.
John's first reaction was to communicate his finding to the auditors and to revise the financial statements before they are isued. However, he knows that hsi and his fellow worker' profit-sharing plans are based on annual pretax earnings and that if he revises the statements, everyone's profit sharing bonus will be signifcantly reduced.
Required:
1) Why will bonuses be negatively affected? What is the effect on pretax earnings?
2) If the error is not corrected in the current year and is discovered by the auditors during the following year's audit, how will the error be reported in the company's financial statements?
3) Discuss the ethical dilemma Howard faces.
Explanation / Answer
The ending inventory that was determined on June 30 is $3,265,000
Actual ending inventory was determined to be $2,600,000
Therefore, ending inventory of $665,000 ($3,265,000 - $2,600,000) was reported wrongly in the financial statements.
Inventory valuation and income measurement are interrelated. If the inventory is not correctly valued, it will result in a wrong measurement of income and financial position.
The cost of goods sold is directly affected by the cost assigned to the ending inventory.
Gross profit = Sales - Cost of goods sold
Cost of goods sold = Opening Stock + Net pruchases - Ending inventory
If a higher value is assigned to the ending inventory, the cost of goods sold will decrease and hence the gross profit will increase. This error effects P&L A/c and Balance sheet as well.
An error in the value of year-end inventory will casue misstatements in Cost of goods sold, Gross profit, Net iprofit , Current assets and the owner's equity becasue the ending inventory of one year is the beginning inventory of next year.
Therefore, an error will carry forward and casue the P&L A/c for the next year to be incorrect. The effect of this error will be to overstate the net income for the current period. The error will be counterbalanced in the next year and the net profit will be understated becasue the beginning inventory will be overstated by $665,000.
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