Danville Bottlers is a wholesale beverage company. Danville uses the FIFO invent

Question

Danville Bottlers is a wholesale beverage company. Danville uses the FIFO inventory method to determine he cost of its ending inventory. Ending inventory quantities are determined by a physical count. For the fiscal year end June 30 2009, ending inventory was originally determined to be $3,265,000. However, on July 17, 2009, John Howard, the company's controller, discovered an error in the ending inventory count. He determined that the correct ending inventory amount 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 as a condition of the loan. By July 17, the auditors had completed their review of the financial statements which are scheduled to be issued on July 25. They did not discover the inventory error. Johns' first reaction was to communicate his finding to the auditors and to revise the financial statements before they are issued. However, he knows that his and his fellow workers' profit sharing bonus will be significantly reduced.

Question: What are 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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