Ethical Issue - E-Z Loan Co. makes loans to high-risk borrowers. E-Z borrows fro

Question

Ethical Issue - E-Z Loan Co. makes loans to high-risk borrowers. E-Z borrows from its bank and then lends money to people who have bad credit. The bank requires E-Z Loan to submit quarterly financial statements in order to keep its line of credit. E-Z’s main asset is Accounts Receivable. Therefore, Bad Debts Expense and Allowance for Bad Debts are important accounts.

Slade McMurphy, the controller of E-Z Loan, wants net income to increase in a smooth pattern rather than increase in some periods and decrease in others. To report smoothly increasing net income, McMurphy underestimates Bad Debts Expense in some periods. In other periods, McMurphy overestimates the expense. He reasons that over time, the income overstatements roughly offset the income understatements.   Is McMurphy’s practice of smoothing income ethical? Why or why not?

Explanation / Answer

Mc Murphy's practice of smoothing income is highly unethical. The reasons for the same are mentioned below:

-Firstly, EZ Loan Co. borrows from the bank and then lends money to people having bad credit.

-As the money is lent to people having bad credit, the possibility of bad debts is extremely high.

-EZ Loan Co. wants to show a smooth pattern of income so that it's credibility with the bank won't be affected. However, it is to be noted that underestimating bad debts in some periods, thereby overstating profit and misguiding the bank is not an ethical practice. similarly, overstating bad debt expenditure and understating profits is also not correct. This amounts to windowdressing of financial statements and is not acceptable at all.

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