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, 2020, ending inventory was originally determined to be $3,265,000. However, on July 17, 2020, 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.

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 it be reported in the company's financial statements?
3. Discuss the ethical dilemma John Howard faces.  

Answer 1

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

Ans.: As the Inventory value at the year end is reduced by $3265000-$2600000=665000. The profits will be less by the difference amount and consequental profit based bonus amount will be negatively affected. Pretax Earning will also be reduced to the extent of difference amount and consequental less liability of tax @40% on difference amount.

Question:If the error is not corrected in the current year and is discovered by the auditors during the following year's audit, how will it be reported in the company's financial statements?

Ans.: No correcting journal entry is necessary, for any counterbalancing error that is detected before it has counterbalanced. If the error is discovered after it has counterbalanced, No correcting journal entry is necessary, but the financial statements should be restated so that they are not misleading. Noncounterbalancing errors are those that will not be automatically offset in the next accounting period. A correcting journal entry is necessary for a noncounterbalancing error and any applicable financial statements must be restated.

In the present case, its a counterbalancing error ie. the Inventory valuation difference has already been adjusted in the current year working.