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Week 4 Ethics Case 9-11 p. 497 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, 2011, ending inventory was originally determined to be $3,265,000. However, on July 17, 2011, John Howard, the companys 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 plans are based on annual pretax earnings and that if he revises the statements, everyones 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 years audit, how will it be reported in the companys financial statements? 3. Discuss the ethical dilemma John Howard faces. Solution Ethics Case 9-11 Requirement 1 There will be an overstatement of pre-tax income equal to $665,000 that is calculated by getting the difference between $3,265,000 and $2,600,000. Correcting for this error will cause a lower ending inventory, which means a higher cost of goods sold and lower income for the company. Consequently, bonuses will also be adversely or negatively affected. Requirement 2 The error will be reported in the companys financial statements for the year beginning July 1, 2011 as a prior period adjustment to the beginning retained earnings balance. The financial statements for the previous year ending June 30, 2011 will have to be retrospectively restated in order to reflect the correct inventory amount, cost of goods sold, retained earnings and net income.

Requirement 3 John faces an ethical dilemma of whether to disclose the error in inventory to the various concerned parties, such as the company shareholders, the local bank, auditors and taxing authorities. If John discloses the error, it will cause a reduced net income for the company and negatively affects the year-end bonuses; if John remains quiet, he and the rest of the companys employees will receive the initially computed bonuses. This dilemma will test Johns honesty and integrity