Ethical Dilemma What’s an expense?

Many years ago, Wilson Blowhard founded a communications company. The company became victorious and grew by expanding its customer base and acquiring some of its competitors. Actually, most of its growth resulted from acquiring other companies. Mr. Blowhard is adamant regarding continuing the company’s growth and increasing its net worth. To accomplish these goals, the business’s net income should continue to increase at a rapid pace.

If the company’s net worth continues to rise, Mr. Blowhard plans to sell the company and retire. He is, thus, focused on improving the company’s profit any way he can.

In the communications business, companies often employ the lines of other communications companies. This line usage is an important operating expense for Mr. Blowhard’s company.

Commonly accepted accounting principles need operating costs like line employ to be expensed as they are acquired each year. Each dollar of line cost reduces net income by a dollar.

After reviewing the company’s operations, Mr. Blowhard concluded that the company didn’t currently need all of the line use it was paying for. It was actually paying the owner of the lines.

Now so that the line use would be accessible in the future for all of Mr. Blowhard’s anticipated new customers. Mr. Blowhard instructed his accountant to capitalize all of the line cost charges and depreciate them over 10 years. The accountant reluctantly followed Mr. Blowhard’s instructions and the company’s net income for the current year showed a significant raise over the prior year’s net income. Mr. Blowhard had found a manner to report continued enlargement in company’s net income and increase the value of company.

Required

a. How does Mr. Blowhard’s scheme affect the amount of income that the company would otherwise report in its financial statements and how does the system affect the company’s balance sheet?

b. Give explanation of your answer.