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Ethical Issues with Modifying Financial Statements

Ethical issue
Effect of decisions on ratio
XYZ's (name of the company) long term debt agreement makes certain demands on the business. For example, XYZ 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 XYZ fails to meet any of those requirements, the company's lenders have the authority to take over management of the company.
Changes in customer demand have made it hard for XYZ to attract customers. Current liabilities have mounted faster than current assets causing the current ration to fall to 1.47. Before releasing financial statements, XYZ'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, XYZ can classify the investment as short term - a current asset. On the controller's recommendation, XYZ's board of director's votes to reclassify long - term investments as short-term

Requirements

1. What effect will reclassifying the investments have on the current ratio? Is XYZ's true financial position stronger as a result of reclassifying the investments?
2. Shortly after the financial statements are released, sales improve and so, too, does the current ratio, As a result, XYZ'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 reason underlying the answer

Solution Preview

Ethical issue - Effect of decisions on ratio

XYZ's (name of the company) long term debt agreement make certain demands on the business. For example, XYZ 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 XYZ fails to meet any of those requirements, the company's lenders have the authority to take over management of the company.
Changes in customer demand have made it hard for XYZ to attract customers. Current liabilities have mounted faster than current assets causing the current ration to fall to 1.47. Before releasing financial statements, XYZ'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 ...

Solution Summary

An examination of changing long term assets to short term assets and the impact on the current ratio. Also, a management's decision to reclassify long term assets into short term assets can be viewed as either ethical or unethical.

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