Question

Case 15-67 Manipulation of Ratios and Ethical Behavior

Pete Donaldson, president and owner of Donaldson Mining Supplies, was concerned about the firm’s liquidity. He had an easy time selling supplies to the local coal mines, but had a difficult time collecting the receivables. He had even tried offering discounts for prompt payment. The outcome wasn’t as expected. The coal mines still took as long to pay as before, but took the dis- count as well. Although he had complained about the practice, he was told that other suppliers would provide the supplies for the same terms. Collections were so slow that he was unable to pay his own payables on time and was receiving considerable pressure from his own creditors.

The solution was a line of credit that could be used to smooth his payment patterns. Getting the line of credit was another matter, however. One bank had turned him down, indicating that he already had too much debt and that his short-term liquidity ratios were marginal. Pete had begun the business with $5,000 of his own capital and a $30,000 loan from his father-in-law. He was making interest payments of $3,000 per year to his father-in-law, with a promise to pay the principal back in 5 years (3 years from now).

While mulling over his problem, Pete suddenly saw the solution. By changing accountants, he could tell the next accountant that the $30,000 had been donated to the business and therefore would be reclassified into the equity section. This would dramatically improve the debt ratio. He would simply not disclose the $3,000 annual payment—or he could call it a dividend. Additionally, he would not tell the next accountant about the $6,000 of safety gear that was now obsolete. That gear could be added back, and the current ratio would also improve. With an improved financial statement, the next bank would be more likely to grant the needed line of credit.

Required:

1. Evaluate Pete Donaldson’s ethical behavior.

2. Suppose that you have been hired as the chief finance officer for Donaldson Mining

   Supplies. You have been told that the $30,000 has been donated to the company. During the second week of your employment, the father-in-law drops in unexpectedly and introduces himself. He then asks you how the company is doing and wants to know if his $30,000 loan is still likely to be repaid in 3 years. Suppose also that on the same day you overhear an employee mention that the safety equipment is no longer usable because regulations now require a newer and different model.

a. Assume that you have yet to prepare the financial statements for the loan application. What should you do?

b. Suppose that the financial statements have been prepared and submitted to the bank. In fact, that morning, you had received a call from the bank, indicating that a decision was imminent and that the line of credit would likely be approved. What should you do under these circumstances?

3. Suppose that Pete invites you in as a consultant. He describes his problem to you. Can you think of a better solution?

Answer 1

Manipulation or mis-representing financial statements is not only unethical but also a punishable offence.

The Issue: Donaldson Mining Supplies's working capital position is very bad because of delayed collections , that too at a discount, due to peer behaviour. To meet his payables, Pete Donaldson attempts to get a line of credit sanctioned by the bank, by submitting company financials, mis-presenting debt from his father-in-law as donations, ie.equity or own funds.So, he also needs to hide interest expense on the loan.Also he wants to add an obsolete asset item , back in teh list of assets , to improve the assets total.

a.Now that the accountant had come to know that the amount is a loan from the father-in-law.So, his duty is to impress upon Donaldson that inter-changing the account head from loan to equity , will have many legal complications as well.

If that $ 30000 is treated as equity, it conveys ownership rights to the father-in law -- which has requirements such as filing with company-law boards & issue of share certificates , etc.

Moreover, interest expenses are tax deductible, where as dividends are not, as they are given out of the income after tax.

Also inflating the asset value , with that of an obsolete safety gear, will land the company , in trouble, if the banks come for inspection of dcelared assets --- which may spoil the name of the company permanently

Even the safety audit people will object to the use of this supply , by mining companies & the latter may shift loyalties , if such practices are followed.

The accountant should explain on all the above lines & impress upon Donaldson, that for long-term survival & reputation, the short-term issues should not be complicated.

& submit a factual liquidity position , explaining concrete future steps as to collection of pending receivables.

b If they had already been submitted to the bank, based on which the call has come,he has no other option , but to carry out all activities that are necessary to make the statement come true, ie. Issue shares to the father-in-law , convert debt into equity & replace teh safety gear ----all done at the earliest

3. As a consultant, before doing as in b. I would suggest to work out the options to appoint a capable credit collector, to collect all the receivables , in time --to be strict with discounts only to early payment customer accounts---- after sufficient interaction with the other suppliers , in the area.

The best solution will be to improve the cash position, within the company, instead of account manipulation--that will put an end to futher chaos.