Ethics Case 20-12 Overstatement of Ending Inventory
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Ethics Case 20-12 Overstatement of Ending Inventory
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Ethics Case 20-12 Overstatement of Ending Inventory
Why will bonuses be negatively affected? What is the effect on pretax earnings?
Correcting the ending inventory error will negatively affect the bonus. This is because correcting the ending inventory will affect cost of goods sold (COGS) and income. Research also demonstrates that overstating ending inventory reduces the COGS while increasing reported earnings (Yi et al., 2019). As such, overstating the ending inventory of the current fiscal year has a negative impact on future performance. Besides, the income statement computes gross profit by subtracting COGS from revenue, which means that overstating ending inventory leads to overstated gross profit of the business. A decrease in net income will reduce bonus because bonuses are determined by the firm’s net income. Correcting the error will also affect pretax earnings. For example, as of June 30, 2021, ending inventory was $3,265,000 but the correct ending inventory should be $2,600,000. In this scenario, the COGS will be understated by ($3,265,000-$2,600,000) $665,000, net income and pretax earnings. In other words, there will be an overstatement of pre-tax income of $665,000.
Ethics Case 20-12 Overstatement of Ending Inventory
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References
Papík, M., & Papíková, L. (2020). Detection models for unintentional financial restatements. Journal of Business Economics and Management, 21(1), 64-86. https://doi.org/10.3846/jbem.2019.10179
Yi, H. D., Park, S., & Kim, J. (2019). The effects of business strategy and inventory on the relationship between sales manipulation and future profitability. Sustainability, 11(8), 2377. https://doi.org/10.3390/su11082377.
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