Question

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?

Answer 1

Solution

Incomes of business organizations do not enjoy a steady flow. While they can be very high during certain periods, they can reach very low levels within the same financial year or subsequent years. Knowing the adverse effects such fluctuations have on businesses, financial controllers adopt the use of income smoothing strategies.

What is Income Smoothing?

Income smoothing is an umbrella term for the various techniques and methods used by accountants and financial experts for controlling or hedging the effects of high rises and sharp falls in corporate income. As is commonly used, income smoothing is often associated with clever manipulations of income or profit, creative accounting techniques and the application of generally accepted accounting principles.

However, real practice income smoothing goes beyond these. It encompasses all strategies used in hedging against high expenditure or cost and increasing business earnings or profit. These strategies range from acceptable accounting practices and generally accepted accounting principles, application of logical reasoning etc.

Examples of income smoothing techniques are; deferring business revenues during a positive year if the next year is predicted to be a tough one, choosing to recognize the expenses of a turbulent year in the next year if the next year promises to be more positive etc.

Is Income Smoothing ethical?

The term refers to a wide range of good and bad practices such that it cannot be collectively termed as legal or illegal. Whiles one business organization is using strategic means and proper accounting methods for its income smoothing, another may be using dubious or unscrupulous means for hedging its income.

Though an income smoothing practice being used by a company may be legal, it may not be ethical. Accounting has its general guidelines such as neutrality, full disclosure, comparability, consistency, recognition etc. Any income smoothing practice which violates any of these would be unethical.

In the given case, McMurphy underestimates Bad Debts Expense in some periods. In other periods, McMurphy overestimates the expense and reasons that over time, the income overstatements roughly offset the income understatements which is clearly an error or am unethical practice.

Thus, McMurphy’s practice of smoothing income is unethical.