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 letting her borrow the money at a very low interest rate, and she does not need to make any principal payments for five years. Due to the favorable terms of the 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, and the interest payments are included in miscellaneous expenses on Lucy’s income statement.

1.What are the effects of Lucy’s classifications of her uncle’s loan and the related interest payments on the financial statements?

2. Are there any ratios that might be of interest to the local bank that will be misstated by Lucy’s actions?

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

Answer 1

1) What Lucy is doing is called misrepresentation of financial statements. This will reduce the company's borrowed funds and increase its equity. This is a very critical information as the investor will be lead in believing that Lucy's has enough cpital to cover all its liabilities. However, the case is just the opposite.

2) The most important ratio that will be of use to the local bank is the debt equity ratio which is misrepresented by this representation of funds. The bank will be falsely informed about the situation that lucy has enough money to cover its liabilities however the bank will not be unaware of the higher debt and lower equity in the books.

3) Yes, Lucy's actions are unehical as they are not giving a true and fair presentation of company's financial condition. If her uncle becomes a partner then my opinion will surely change as it is his money and will be counted as his capital which is the true case.