Ethics Case 20-12. Danville Bottles is a wholesale beverage company. Danville us

Question

Ethics Case 20-12.

Danville Bottles 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, 2018, ending inventory was originally determined to be $3,265,000. However, on July 17, 2018, 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. 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.

John’s 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 fellow worker’s profit-sharing plans are based on annual pretax earnings and that if he revises the statements, everyone profit sharing bonus will be significantly reduced.

Required:

Why will bonuses be negatively affected? What is the effect on pretax earnings?

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?

Discuss the ethical dilemma Howard faces?

Explanation / Answer

The bonuses will be negatively affected because bonuses are calculated and paid based on profit and lower the inventory will give rise to profit and consequently the bonuses . If the ending inventory figure is not revised to $2.6m from $3.265m, then the bonuses would be negatively affected. Non revision of ending inventory will not affect the pretax earnings, as any change in ending inventory will effect the pretax earnings. Lower the inventory will raise the earnings and vise-versa. In the following year, the adjustment entry would be made after the bottom line of Net Income in the financial statement of the following year. John Howard, would faces the dilemma of ethical issues as intentionally they try to revise the ending inventory figure to lower figure to have benefits on bonus front.

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