Purchase Solution

Financial Management: Financial Statement Treatment of a Loan

Not what you're looking for?

Ask Custom Question

Lucy Shafer wants to borrow $100,000 to expand her dog-breeding business. She is preparing a set of financial statements to take to the local bank with her loan application. She currently has an outstanding loan from her uncle for $50,000. Lucy's uncle is allowing her to borrow the money at a very low interest rate, and she does not have to make any principal payments for 5 years. Due to the favorable terms of her loan from her uncle, Lucy has decided that it is not significant enough to disclose on her financial statements. Instead, Lucy has classified the $50,000 as contributed capital (equity), and the interest payments are included in miscellaneous expenses on the company's income statement.

What are the effects of Lucy's classification on the financial statements?

Are there any ratios that might be of concern to the local bank that will be misstated by Lucy's actions?

Do you think Lucy's actions are unethical? Suppose Lucy's uncle agrees to be a partner in the company and Lucy can afford to buy his share by repaying the $50,000 with interest. Does that change your opinion?

Purchase this Solution
Solution Preview

First of all: we will discuss about the situation and then, we will write the effects of Lucy's classification on the financial statement as financial statements reflect the financial position of an organization.

Effect of Classification:

The treatment of a loan as the equity will cause a change in the capital structure of the organization. The terms of a loan are quite favorable, but it may affect the actual financial position of the organization. The change in the loan position will reduce the liability section of the financial statement and will increase the equity portion of the balance sheet. It will reflect a good position of the company towards the capital providers or lenders (Friedlob & Plewa, 2006). At the same time in the income statement, where the interest expenses are shown under the heading of miscellaneous expenses, it will enhance the amount of miscellaneous expenses for the organization, but the net income will be unaffected from this act.

After discussing the impact on financial statements, now, we will discuss some ratios, which may misstate ...

Solution provided by:
Ashish Sharma, MBA (IP)
Education
  • MBA (IP), International Center for Internationa Business
  • BBA, University of Rajasthan
Recent Feedback
  • "Thank You so much! "
  • "Always provide great help, I highly recommend Mr. Sharma over others, thanks again. "
  • "great job. I will need another help from you. "
  • "first class!"
  • "Thank you for your great notes. Will you be willing to help me with one more assignment? "
Purchase this Solution
Free BrainMass Quizzes
Basics of corporate finance

These questions will test you on your knowledge of finance.

IPOs

This Quiz is compiled of questions that pertain to IPOs (Initial Public Offerings)

Team Development Strategies

This quiz will assess your knowledge of team-building processes, learning styles, and leadership methods. Team development is essential to creating and maintaining high performing teams.

Production and cost theory

Understanding production and cost phenomena will permit firms to make wise decisions concerning output volume.

Introduction to Finance

This quiz test introductory finance topics.

View More Free Quizzes
Related BrainMass Solutions

  • Financial Statement Fraud: Ficitious Revenues and Other Forms

    - Documentation and Information to obtain - Loan covenants - Management compensation structure or contract This solution provides a detailed discussion of three financial statement fraud schemes.

  • Personal financial statements

    The Statement of Cash Flow: It tells about the cash inflows and outflows that occurred over a period of time. Three decisions: 1) Quantum of leverage Financial risk or leverage is the risk that results from the use of debt.

  • Lease capital or operating, impact on FS, differ under IFRS?

    Your discussion is 250 words and contrasts the bright line tests of FASB versus the principle-based standard for IFRS and how they may result in different treatment. The financial statement impact of the different treatments are mentioned.

  • Statement of cash flows,

    for a loan Banks use the statement of cash flow as an indicator of the financial strength of an organization (e.g., and, thus, the ability to pay the loan payments), when the organization is applying for a bank loan.

  • Tootsie Roll Industries Inc. Loan Package

    Loan Package Read the financial statement for Tootsie Roll Industries Inc.

  • Statement of Financial Accounting Standards

    311829 Statement of Financial Accounting Standards Select one (1) Statement of Financial Accounting Standards (1 - 159) Which is : Statement No. 65 - Accounting for Certain Mortgage Banking Activities Answer the following: 1.

  • FASB Codification System Eight Data Bases

    When providing guidance and direction to management concerning business decisions and how accounting treatment of these decisions will impact the financial treatment of these decisions, which data base would you rely upon to give management the proper

  • Effects of Lucy's Classification on the Financial Statements

    I The effects of Lucy's classification on the financial statement Lucy has decided that it is not significant to disclose this loan on his financial statements.

  • Auditing and Attestation

    If the auditor confirms inventory pledge under loan agreement he is carrying out a procedure related to the classification of inventory and understanding financial statements.

View More Related Solutions