Ethics Case : 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 yearend June 30, 2016, ending inventory was originally determined to be $3,265,000. However, on July 17, 2016, 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 it be reported in the company's financial statements?
3. Discuss the ethical dilemma John Howard faces.