Ross’s Lipstick Company’s long-term debt agreements make certain demands on the
ID: 350510 • Letter: R
Question
Ross’s Lipstick Company’s long-term debt agreements make certain demands on the business. For example, Ross may not purchase treasury stock in excess of the balance of retained earnings. Also, long-term debt may not exceed stockholders’ equity, and the current ratio may not fall below 1.50. If Ross fails to meet any of these requirements, the company’s lenders have the authority to take over management of the company. Changes in consumer demand have made it hard for Ross to attract customers Current liabilities have mounted faster than current assets, causing the current ratio to fall to 1.47. Before releasing financial statements, Ross’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 management’s intention. By deciding to convert an investment to cash within one year, Ross can classify the investment as short-term-a current asset. On the controller’s recommendation, Ross’s board of directors votes to reclassify long-term investments as short-term.
Requirements
What effect will reclassifying the investments have on the current ratio? Is Ross's true financial position stronger as a result of reclassifying the investments?
Shortly after the financial statements are released, sales improve; so, too, does the current ratio. As a result, Ross's management decides not to sell the investments it had reclassified as short-term. Accordingly, the company reclassifies the investments as long-term. Has management behaved unethically? Give the reasoning underlying your answer.
Your written assignment should be a minimum of two pages and a maximum of four pages, typed double spaced, Times New Roman font size 12, with one inch margins on all sides.
Explanation / Answer
Answer1)
Reclassifying an investment means, in and out of the investment from one security and to invest in a different security. Generally this is done to improve the current ratio of the company. By looking at the case it seems like, board of directors wants to take out and restructure the investment in short term investment than putting all investment in long tern instruments. By doing so they want to decrease the current liability by increasing the current assets and thus wants to increase the current ratio.
As of now the current ratio of the company is 1.47 however the ratio should not be less than 1.50, to overcome this scenario, company wants to increase the current assets so the ratio will come over and above of 1.5. But by doing so board is overlooking the actual current ratio and what they want is an act of window dressing of the balance sheet, which is unethical for the company.
Answer 2)
As discussed above, current ratio is a ratio of current assets and current liability, every company needs to maintain this ratio as far as it investments are concerned.
In our case, company’s current ratio is 1.47 which is below its threshold. To improve this ratio, company is trying to restructure its investment. To restructure, company is investing in short term investment rather than investing in long term. By doing so company will incur more cash by the end of the short term period and hence will improve the current ratio of the company by improving current assets. Hence the higher current ratio will improve financial statement of the company.
Answer 3)
In my opinion, what R’s company is doing is not ethical, what they are doing here is not improving the financial statement/base of the company.
Current ratio = current assets/current liability.
As per the above equation, if our current assets increase our ratio will increase. However this ratio does not give a clear picture of companies’ debt, cash and other investment schedules. In our case, once we restructure the investment in short term rather than investing in long term, the financial ratio will be adjusted as per the companies need and it will not reflect the actual position of the company.
By investing in short term, the current asset will increase and hence the ratio will increase, which will strengthen the financial statement, however this is not the right way of improving the ratios. Some investors may think, looking at the current strategy, that the managers are not unethical and they might geneuily sell the assets in short term period, however if they instead of selling assets, again invest in long term than it will create a nuisance in the balance sheet and thus can be treated as unethical.
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