Crazy Eddie, Inc., a discount consumer electronics chain, seemed to be missing $52 million in merchandise inventory. “It was a shock,” the new management was quoted as saying. It was also a memorable swindle. Investors lost $145.6 million when the company declared bankruptcy. A count turned up only $75 million in inventory, compared with $126.7 million reported by former management. Net sales could account for only $6.7 million of the difference. At the time, it was not clear whether bookkeeping errors in prior years or an actual physical loss created the shortfall, although at least one store manager felt it was a bookkeeping error because security was strong. “It would be hard for someone to steal anything,” he said. Former management was eventually fined $72.7 million.

1. What is the effect of the misstatement of inventory on Crazy Eddie’s reported earnings in prior accounting periods?

2. Is this a situation you would expect in a company that is experiencing financial difficulty? Explain.