Fast Ed's auto showroom sells cars. Fast Ed's bank requires the company to submit quarterly financial statements in order to keep its line of credit. Note Receivable and Accounts Receivable are 50 percent of current assets. Therefore, Bad-Debt Expense and Allowance for Doubtful Accounts are important accounts.
Fast Ed's president, Ed Edwards, likes net income to increase in a smooth pattern rather than to increase in some periods and decrease in other periods. To report smoothly increasing net income, Edwards underestimates bad-debt expense in some accounting periods. In other accounting periods, Edwards overestimates the expense. He reasons that the income overstatements roughly offset the income understatements over time.
Required: Is Fast Ed's practice of smoothing income ethical? Give your reasons, mentioning any accounting principles that might be violated.
Fast Ed's practice is not ethical and it violates GAAP's reasonableness principle. According to GAAP, bad debt estimates and allowances for doubtful accounts must be based on reasonable numbers, which essentially means the numbers must be as accurate as ...
This solution explains if Fast Ed is practicing ethical or unethical income smoothing, and discusses if there is ever a legitimate reason for income smoothing, and discusses the accounting principles involved.