Ross’s Lipstick Company’s long-term debt agreements make certain demands on the
ID: 2591591 • 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.
a. 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?
b. 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.
Explanation / Answer
There are certain conditions governing the debt arrangements of the company and as such these must be strictly observed, whatever the circumstances otherwise it would be violating the GAAPs:
On the controller’s recommendation, Ross’s board of directors votes to reclassify long-term investments as short-term.
Impact on Balance Sheet:
Non- current Assets
Equity
Retained earnings
Long term investments
Long Term Liabilities
Current Assets
Current Liabilities
The fact that management changed its mind when the sales picked up and current ratio became better itself proves that it was merely window dressing to make the current ratio appear to be healthy ie. > 1.50
Therefore, it seems to be that management is violating both conditions to suit the conditions temporarily, and it turns out alright because sales became better.
But the question is “what if sales did not improve?” There would be different circumstances and management would be held responsible
Non- current Assets
Equity
Retained earnings
Long term investments
Long Term Liabilities
Current Assets
Current Liabilities
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