The purpose of this assessment is to identify the impact of reclassifying invest
ID: 2471964 • Letter: T
Question
The purpose of this assessment is to identify the impact of reclassifying investments on the current ratio.
Harrenhal Inc.’s long-term debt agreements make specific demands on the business. For example, Harrenhal may not purchase treasury stock in excess of the balance of retained earnings. In addition, long-term debt may not exceed stockholders’ equity, and the current ratio may not fall below 1.50. If Harrenhal fails to meet any of these requirements, the company’s lenders have the authority to take over the management of the company.
Changes in consumer demand have made it hard for Harrenhal to attract customers. Current liabilities have mounted faster than current assets, causing the current ratio to fall to 1.47. Before releasing financial statements, Harrenhal’s management is scrambling to improve the current ratio. The controller points out that an investment can be classified as either long term or short term, depending on the management’s intention. By deciding to convert an investment to cash within one year, Harrenhal can classify the investment as short-term—a current asset. On the controller’s recommendation, Harrenhal’s board of directors votes to reclassify long-term investments as short term.
Based on this information, discuss the effect of reclassifying investments on the current ratio. Is Harrenhal’s true financial position stronger because of reclassifying the investments? Why or why not?
Shortly after the financial statements are released, the sales improve and so does the current ratio. As a result, Harrenhal’s management decides not to sell the investments it had reclassified as short term. Accordingly, the company reclassifies the investments as long term.
Has the management behaved unethically? Give the reasoning underlying your answer and recommend alternatives that the management could have used.
Explanation / Answer
The reclassification of long term investment as short term investment just for the sake of increasing its current assets and to increase the current ratio is not ethical because this does not shows the true position of the company.
If the company actually wants to sell the investment within a year to improve its debt ratio then the reclassification of long term investment to short term investment is correct.
But after the financial statements are released the company has decided to reclassify the investment as long term investment which shows that the company has mislead the financial statement by classifying the long term investment as short term investment and which is unethical in the part of the company.
If the company has not sold the investment just because the sales have improved and therefore company wants to hold the investment for more than a year then reclassification of investment as long term is appropriate. Therefore it is hard to prove the management intention behind this.
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