Terry Dorsey started Dorsey Hardware a tiny hardware store two years ago and has struggled to make it successful. The first year of operations effected in a substantial loss in the second year there was a small net income. His initial cash investment was almost depleted for the reason that he had to withdraw money for living expenses. The current year of operations looked a lot better. His customer base was growing as well as seemed to be loyal. To raise sales but Terry had to invest his remaining funds and the proceeds of a USD 40000 bank loan into doubling the size of his inventory and purchasing some new display shelves and a new truck.

At the end of the third year Terry's accountant asked him for his ending inventory figure as well as later told him that initial estimates indicated that net income and taxable income for the year would be approximately USD 80000. Terry was delighted until he educated that the federal income taxes on that income would be about USD 17250. He told the accountant that he didn't have enough cash to pay the taxes and couldn't even borrow it since he already had an outstanding loan at the bank.

Terry asked the accountant for a copy of the income statement figures consequently he could see if any items had been overlooked that might reduce his net income. He observes that ending inventory of USD 160000 had been deducted from cost of goods available for sale of USD 640000 to arrive at cost of goods sold of USD 480000. Net sales of USD 720000 as well as expenses of USD 160000 couldn't be changed. However Terry hit on a scheme to reduce his net income. The subsequently day he told his accountant that he had made an error in determining ending inventory and that its correct amount was USD 120000. This lower inventory amount would raise cost of goods sold by USD 40000 and reduce net income by that same amount. The resultant income taxes would be about USD 6000 which was just about what Terry had paid in estimated taxes. To validate his action in his own mind Terry used the following arguments (a) federal taxes are too high, and the federal government seems to be taxing the little guy out of existence (b) no harm is really done because when the business becomes more profitable I will use correct inventory amounts and this loan from the government will be paid back (c) since I am the only one who knows the correct ending inventory I will not get caught and (d) I bet lots of other people do the same thing.