Question

Mermaid LTD's long term debt agreements make certain demands on the business. For example, Mermaid may not purchase treasury shares in excess of the balance of retained earnings. Also, long term debt may not exceed shareholder's equity, and the current ratio may not fall below 1.50. If Mermaid 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 Mermaid LTD to attract customers. Current liabilities have mounted faster than current asset, causing the current ratio to decline to 1.47. Before releasing financial statements , Mermaid's management is scrambling to improve current ratio. The controller points out that the Company owns an investment that is currently classified as long term. The investment can be classified as either long-term or short - term, depending on management's intention. By deciding to convert the investment as short-term --- a current asset. On the controller's recommendation, Mermaid's Board of Directors votes to reclassify Long-term investments as short-term.

Required:

1. What is accounting issue in this case? What ethical decision needs to be made?

2. Who are the stakeholders?

3. Analyse the potential impact on the stakeholders from the following standpoints:

3.1 Economic

3.2 Legal

3.3 Ethical

4. Shortly after the financial statements are released, sales improve; so, too, does the current ratio. As a result, Mermaid'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 acted unethically? Give reasons underlying your answer.

Answer 1

Answer 1 :

    The accounting issue, company may face;in reclassification due to :

a)   While re-classification of investment from long term to short term, the fair market value or cost of investment , whichever is lower , shall be taken to the re-classified account. Management may find the difficulty in working of computation of fair market value.

b) Security investments have to meet the following two (2) criteria to be classified as short-term investments:

• The investment is readily marketable
• Management intends to convert the investment into cash within one (1) year or operating cycle, whichever is longer.

Management need to exercise such method in converting long term investment into readily marketable , They need to find the option of liquid asset , which is struggling.

c) The fair value or other current value measurements can make the reported performance of long-term investments unnecessarily volatile, because current value measurements of such items reflect not only changing expectations of future cash flows, but also changes in the discount rate applied to the cash flows.

d) Reclassification adjustments amounts are reclassified to income statement in the current period that were recognised in
other comprehensive income in the current or previous periods.

The ethical decision management need to be made as below :

As we know that there is certain conditions putted on Mermaid LTD's through long term debt agreements , which requires not to purchase treasury shares in excess of the balance of retained earnings and long term debt may not exceed shareholder's equity and the current ratio may not fall below 1.50 , Since , the company is struggling with the managing said requirements for current ratio management , which is measured below than required 1.50 , is 1.47 . Therefore, management wants to change the constitution of long term investment as short term investment. Management is of the view that by doing such practice , the current asset will be increase so is to improve the current asset ratio. But its not ethical exercise. because they need to go through classification criteria as per standard laid down by IASB.

Also, Management need to exercise other option instead of doing such reclassification , because it tempers and manupulate the financial statement. Its not worthy exercise for the purpose of transparent financial reporting.

Answer 2: The Stakeholder for the company are :

• #1 Customers. Stake: Product/service quality and value. ...
• #2 Employees. Stake: Employment income and safety. ...
• #3 Investors. Stake: Financial returns. ...
• #4 Suppliers and Vendors. Stake: Revenues and safety. ...
• #5 Communities. Stake: Health, safety, economic development. ...
• #6 Governments. Stake: Taxes and GDP.

Answer 3:  

The potential impact on the stakeholders from the following standpoints :

3.1 Economic :

It may reduce in reputation and brand of the company in the eyes of stake holder such as supplier, money lender, investor etc. Corporate reputation is a function of the way in which a company is perceived by its stakeholders. Investor may feel unsafe for their investment in the company and reduce their investment. Money lender can increase the interest rate in the future. Supplier may negotiate with the higher prices in the short run.

3.2 Legal :

The stakeholder such as creditors , money lender can sue the company in case of default. Shareholder may feel the investment unsafe and they may exit. The policy maker of the company need to keep in mind the stakeholder interest while drafting policy. Hence , objective and business standard should be set in a proper legal frame work. otherwise, the sentiments of the stakeholder might be hurt and they can take legal proceedings. In the above situation , the company changes the character of the investment from long term to short term. It need to follow regulatory requirement set by accounting standards.

3.3 Ethical :

IT may change the perception of the stakeholder about the company ethical behavior, The stakeholder are now suspicious of management action and try to attack the management decision. it can be very difficult position for the company management.

Answer 4 : In the given problem , the company sales improve hence the current ratio also improves, after releasing financial statement. As a result, Mermaid's management decides not to sell the investments it had reclassified as short-term. Accordingly, the company reclassifies the investments as long-term.

The treatment is given not in align with the ethical policy. The reason as being :

1) it may hurt the stakeholder sentiments such as investor or shareholder , which may exit , due to improper management of company funds. Long term investments decisions are took by management for raising long term income availability , However , The firm firstly convert it into short term investment and soon it back its decision. The practice in not in conformity with the regulatory requirement by accounting standards set by IASB.

2) It raises the questions on management ability to work on working capital management or asset management.

3) It disturbs the operational behavior of the organization because the funds are diverted so frequently , sometimes , the investment may be volatile and reduction in investment value , so loss can be occur.