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 the cost of its ending inventory. Ending inventory quantities are determined by a physical count. For the fiscal year-end June 30, 2013, ending inventory was originally determined to be $3,265,000. However, on July 17, 2013, 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. 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 and his fellow workers' profit-sharing plans are based on annual pretax earnings and that if he revises the statements, everyone's profit sharing bonus will be significantly 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

Requirement 1

Bonuses will be negatively affected because if the error is corrected, a lower ending inventory results in higher cost of goods sold and lower income. The effect of the error would be an overstatement of pre-tax income by $665,000 ($3,265,000 - 2,600,000).

Requirement 2

It will be reported as a prior period adjustment to the beginning retained earnings balance for the year beginning July 1, 2011. Financial statements for the year ending June 30, 2011, will be retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings.

Requirement 3

Ethical Dilemma:

Should John recognize his obligation to disclose the inventory error to Danville shareholders, the local bank, auditors, and taxing authorities or remain quiet, enabling him and other company employees to receive originally computed year-end bonuses?

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