Question

E-Z Loan, Co. makes loans to high-risk borrowers. E-Z borrows from its bank and then lends money to people with 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 owner 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.

Requirements: (Part A: 50 points maximum; part B: 50 points maximum)

A. 1. Critically analyze the relevant factors in this case.

     2. Include in your analysis

who, other than O’Conner, could be harmed by this theft and in what ways could they be harmed; and

the role accounting plays in this situation.

Answer 1

E-Z Loan, Co. makes loans to high-risk borrowers :

Is McMurphy’s practice of smoothing income ethical? Why or why not?

Answer : E-Z Loan’s practice of smoothing income is unethical because the owner deliberately underestimates Uncollectible-Note Expense in some periods and overstates the expense in other periods. The purpose is to manipulate income. Instead, the company should be using accounting information, specifically the company’s past collection history, to develop a consistent method of reporting bad debt expense, such as is done with accounts receivable.  This would be in conformance with the principles of consistency and reliability, and would represent the business truthfully to his bank lender.

1. Critically analyze the relevant factors in this case.

2. Include in your analysis,who other than O’Conner, could be harmed by this theft and in what ways could they be harmed; andthe role accounting plays in this situation.

Answer :

Req. 1

Potential buyers might be harmed if they acquire the business and later find they have less cash than indicated by the statements.

Req. 2

Accounting plays the critical role of providing information to persons who do business with O’Conner. A common way for a business to represent itself to outsiders is through its financial statements. People make business and financial decisions based on the information reported in these statements. To serve their intended purpose, financial statements must be complete and accurate.