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Jane T (LLC)
Jane T (LLC), Former straight A Student - Now Mom
Category: Homework
Satisfied Customers: 8435
Experience:  Degrees in Eng., econ; JD (law), MBA, former valedictorian & winner of academic scholarship
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Ethical Issue E-Z Loan Company makes loans to high-risk

Customer Question

Ethical Issue

E-Z Loan Company makes loans to high-risk borrowers. E-Z borrows from its banks 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 Notes Receivable. Therefore, Uncollectible Note Expense and Allowance for Uncollectible Notes are important accounts.

Slade McQueen, the owner of E-Z Loan Company, 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, McQueen overestimates the expense. He reasons that over time the income overstatements roughly offset the income understatements.

Is McQueen's practice of smoothing income ethical? Why or Why not?
Submitted: 6 years ago.
Category: Homework
Expert:  Jane T (LLC) replied 6 years ago.

DearCustomer

 

When overestimating an account directly results in giving parties who rely on the financial results, and the integrity of those results, to make decision, there is not doubt that deceit and lying are involved. Moreover, because of the reliance on those lies, which the person responsible for making the financial statements is aware of, there is a direct impact on the safety or risk that the other party is taking. To increase the risk someone takes, without letting that person determine whether they want to take that additional risk, is unethical. In fact, if this company were subject to Sarbanes Oxley, this "overestimating" may be illegal.

 

When financial statements are prepared quarterly, such "overestimates" can serve to severely misrepresent income and available amounts of cash and accounts receivable. Quarterly statements are required where risk is viewed as high and those statements are supposed to accurately state the condition of a business at a specific date. Where accounts do not accurately reflect the true condition of the business there is no way a lender can take proper precautions.

Jane T (LLC), Former straight A Student - Now Mom
Category: Homework
Satisfied Customers: 8435
Experience: Degrees in Eng., econ; JD (law), MBA, former valedictorian & winner of academic scholarship
Jane T (LLC) and 7 other Homework Specialists are ready to help you
Customer: replied 6 years ago.
Great job! Thank you so much for help me out. I feel happy and impress with your work.
Hugo
Customer: replied 6 years ago.
Can you please clarify this for me?" - is this correct: Here are a recent student comment.
Integrity definitely becomes an issue for anyone that conducts this type of behavior and any person in business, unfortunately GAAP supports the behavior as long as the company operates within the structure set up. The disheartening part of this entire process is that many people never know what financial statements are accurate and which ones are not: many people invest in companies because they believe the financial statements posted quarterly or annually are correct.


Customer: replied 6 years ago.
Most-recent answer: Is this correct?

Unfortunately, McQueen's decision to proceed with ethical smoothing can be considered an ethical one as long is it is structured within the confines of the GAAP. Though the process does not show the TRUE picture of what the current income looks like for the E-Z Loan Company, they can be reported. The future income, which is captured currently in Notes Receivable, can be moved from the future into the present period. To offset the income, discretionary costs can be moved to a future period.
Expert:  Jane T (LLC) replied 6 years ago.

DearCustomer

 

The question asked what was ethical, not what was legal. Moreover, even if GAAP principles, which may have been written prior to Sarbanes-Oxley end up creating a Sarbanes-Oxley violation due to misinformation, then that may still be illegal. GAAP indicates what is allowed, but it is not a judge of ethics, it is only a list of rules.

Jane T (LLC), Former straight A Student - Now Mom
Category: Homework
Satisfied Customers: 8435
Experience: Degrees in Eng., econ; JD (law), MBA, former valedictorian & winner of academic scholarship
Jane T (LLC) and 7 other Homework Specialists are ready to help you
Customer: replied 6 years ago.
Hi Jane, thanks a lot again for your help. I feel happy and impress with your work.
Hugo
Customer: replied 6 years ago.
Hi Jane, I have a discussion topic and I have to respond at least two other post teammates comments. This is the next on the same subject. Thanks.
Teammate comment:
A prime example of these actions can be seen in the real estate market. Far too many banks, brokerage companies and several financiers have gone bankrupt for these same actions. Banks have performed income smoothing, representing false information to the world, and all the while the bank is not doing well. The result: foreclosure on many homes because the lending institution could not survive...
Expert:  Jane T (LLC) replied 6 years ago.

DearCustomer

 

I agree that banks are equally to blame for the banking problems today with mortgages, especially because they faced the same problem in the 1970s and have only repeated the same mistakes 30 years later. The biggest problem they had was not so much that they tried to smooth their incomes, but that, instead, they wanted to make it look like they had huge incomes, and created new mortgages to sell them off so that their fee income and loan generation incomes were very high. Their other largest problem was that in order to make those fees and incomes appear so high, they lowered their credit standards and made loans to persons they knew could not afford those loans. That idea was great, as long as the economy was doing well and interest rates stayed low because when the payments on the loans got to high, the lender would just "refinance" (earning new income) and the payments, for a time, would again be lowered.

When the interest rates finally rose, this practice ended. The financial statements hid many, many hidden "secrets."

Jane T (LLC), Former straight A Student - Now Mom
Category: Homework
Satisfied Customers: 8435
Experience: Degrees in Eng., econ; JD (law), MBA, former valedictorian & winner of academic scholarship
Jane T (LLC) and 7 other Homework Specialists are ready to help you
Customer: replied 6 years ago.
Thank you Jane, job well done! Your comments are very encouraging. I will be submitting the next teammate comments on Saturday.
Hugo
Customer: replied 6 years ago.
Hi Jane, I have other post, on the same subject. I Want To Hear Your Opinion. Thanks.
Post:
Income smoothing is used by companies who prefer to report a steady flow of growth in profit rather than show volatile profits with dramatic rises and falls. This is achieved by overstating liabilities against asset values in good years so that these provisions can be reduced; thereby improving reported profits in bad years.

Arguments against this practice are that:
1. If the trading conditions of a business are in fact volatile then investors have a right to know this
2. Income smoothing may conceal long-term changes in the profit trend.
3. Income smoothing is an active manipulation of earnings toward a predetermined target.
4. Some smoothing devices can affect cash flow

Some accept income smoothing as a justifiable activity. One argument for this practice is that smoothed income presents management’s best estimate (within the Financial Reporting System) of the Company’s Long-Term Profitability


Whether or not Income smoothing is “unethical or ethical’, I believe it depends upon management intentions. If Income Smoothing is not intended to be deceptive there is no Ethical Problem. If it is deceptive in some way, is it ethically unjustifiable.

The altered income statement is an assertion when the motivation is to inform, not to mislead, with respect to the company’s Long- term profitability. It is not neutral, but it is not lying either. If the motivation is mixed, and includes increasing profitability, or other aspect of economic performance that management does not even believe, but is trying to get others to believe; then, it is lying and unethical.

FASB, SFAC No. 2, 1980 states:
...It is, above all, the Predetermination of a Desired
Result and the Consequential Selection of Information
To induce that Result, that is the Negation of Neutrality in
Accounting.

To be Neutral, Accounting Information Must Report
Economic Activity as Faithfully as Possible, Without
Coloring the Image it communicates for the Purpose of
Influencing Behavior in Some Particular Direction.


IASB, Framework of IAS Financial Statements, 1989
Information Asymmetry regarding Long-term Profitability states:

...To Be Reliable, the Information Contained in Financial
Statements must be Neutral, that is, Free from Bias.
Financial Statements are Not Neutral If, by the Selection
or Presentation of Information, they Influence the Making
Of a Decision or Judgments in order to achieve a Predetermined Result or Outcome.
Expert:  Jane T (LLC) replied 6 years ago.

DearCustomer

 

Is the above complete, it seems it was cut off?

 

Customer: replied 6 years ago.
Hi Jane,
Yes. That's all she wrote!.
Customer: replied 6 years ago.
Jane,I just want a simple comment to that post.
Expert:  Jane T (LLC) replied 6 years ago.
THIS ANSWER IS LOCKED!
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Jane T (LLC), Former straight A Student - Now Mom
Category: Homework
Satisfied Customers: 8435
Experience: Degrees in Eng., econ; JD (law), MBA, former valedictorian & winner of academic scholarship
Jane T (LLC) and 7 other Homework Specialists are ready to help you
Customer: replied 6 years ago.
Jane, thank you again. You have done a very good job!
Hugo.
Customer: replied 6 years ago.
Jane, thank you again. You have done a very good job! Hugo.

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