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.

Requirements

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?

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.

Your written assignment should be a minimum of two pages and a maximum of four pages, typed double spaced, Times New Roman font size 12, with one inch margins on all sides.

Answer 1

Answer (a) An investment should be classify under short term investment if following both conditions fulfilled by an investment-

1.         Investment nature should be readily realizable.

2.         It intended to be held for not more than one year from the date on which the date on

            which such investment is made.

If Company convert short term investment to long term investment then current ratio will improve, because company current assets increase from this conversion. But from this conversion   company financial position will remain same because –

•           A company total asset will remains unchanged due to conversion.

•           Company current investment will provide same return like interest, dividend etc as providing before conversion.

•           Company income generation capacity and retained earnings will also remain

unchanged, because short term investment not use in production process.

Answer (b) when company financial position and current ratio improve then management

decides the investments not sales. Accordingly, the company reclassifies the investments

long-term to short term is absolutely unethical. And pervious conversion of long term to

short term was also unethical because-

• Management cannot be classify any investment as long term or short term by his discretion. There should take a reasonable base to convert a investment from long term to short term and vice versa. For improve his current assets and current ratio this is not a reasonable base.

• Management should show a investment under long term investment if any investment held more than one year from date on which the date on which such investment is made. If there is reasonable base for re-classify, that investment should be valued on following value.

1.         Long term to short term conversion= cost or carrying amount at the date of transfer, whichever is lower.

2.         Short term to long term transfer= cost or fair value amount at the date of transfer, whichever is lower.