Ada Fontanez is the president of a large company that owns a chain of athletic shoe stores. The company was in dire financial condition when she was hired three years ago. In an effort to motivate Fontanez, the board of directors included a bonus plan as part of her compensation package. According to her employment contract, on January 15 of each year, Fontanez is paid a cash bonus equal to 5 percent of the amount of net income reported on the preceding December 31 income statement. Fontanez was sufficiently motivated. Through her leadership, the company prospered. Her efforts were recognized throughout the industry, and she received numerous lucrative offers to leave the company. One offer was so enticing that she decided to change jobs. 

Her decision was made in late December Year 1. However, she decided to resign effective February 1, Year 2, to ensure the receipt of her January bonus. On December 31, Year 1, the chief accountant, Walter Smith, advised Fontanez that the company had a sizable quantity of damaged inventory. A warehouse fire had resulted in smoke and water damage to approximately $600,000 of inventory. The warehouse was not insured, and the accountant recommended that the loss be recognized immediately. After examining the inventory, Fontanez argued that it could be sold as damaged goods to customers at reduced prices. Accordingly, she refused to allow the write-off the accountant recommended. She stated that so long as she is president, the inventory stays on the books at cost. She told the accountant that he could take up the matter with the new president in February.

Required
a. How would an immediate write-off of the damaged inventory affect the December 31, Year 1, income statement, balance sheet, and statement of cash flows?
b. How would the write-off affect Fontanez’s bonus?
c. If the new president is given the same bonus plan, how will Fontanez’s refusal to recognize the loss affect his or her bonus?
d. Assuming that the damaged inventory is truly worthless, comment on the ethical implications of Fontanez’s refusal to recognize the loss in the Year 1 accounting period.
e. Assume that the damaged inventory is truly worthless and that you are Smith. How would you react to Fontanez’s refusal to recognize the loss?