Intermediate Accounting I 4a

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

Bonuses are usually based from the net income. Therefore, the bonuses will be negatively affected in case the error in ending inventory is corrected. This is because it will results in a lower inventory which in turn will result in a higher cost of goods sold as well as a lower net income. On the other hand, any error that affects net income will also affect tax hence the same effect on the pretax earnings. Therefore, the error’s effect would be an overstatement of the pretax income by ($3,265,000 – 2,600,000) $665,000.

  1. 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?

In case the error is not corrected and is discovered by the auditors, it will be reported in the company’s financial statements as a restatement thereby reflecting the correct ending inventory amount, cost of goods sold, retained earnings, and the net income. Journal entries will also be used in correcting any account balances. Auditors will also issue a disclosure note showing the error and its effect on the books and final numbers.

  1. Discuss the ethical dilemma John Howard faces

John Howard faces the ethical dilemma of recognizing his obligation in disclosing the ending inventory error to the local bank, taxing authorities, auditors, and Danville shareholders thus receiving lower bonuses or remaining quiet about the ending inventory error thus enabling him as well as the remaining company executives or employees to receive originally computed higher year-end bonuses.

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