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

1.

Answer:- Pete Donaldson's behavior of misrepresenting his father-in-law debt as loan and manipulating the financial statement is totally unethical. Since he was going through bad financial conditions so in order to get a credit line approved by the bank he wanted to submit a company financial statement hiding all obsolete safety equipment and loan interest misleading it as a donation. But this cannot be considered as a donation since he was paying an interest of $3,000per year and has to pay back the principal in 5 years to his father-in-law.

2.

a)

Answer:- Assuming I have been selected as the accounted to prepare the financial statement and came to know that Mr. Pete has taken a loan from his father-in-law and it wasn't a donation then I would definitely not have prepared the statement the way Donaldson wants and try to make him understand about all the legal complication that can take place for interchanging loan to equity. Even the use of obsolete safety equipment to increase the value of the assets can lead the company in trouble which can even ruin the brand name. Thus, I have to make Donaldson convinced that preparing such financial statements would violate many ethical standards which is not good for the long-term survival of the company.

b)

Answer:- If I come to know about the fact once the financial statement was submitted and approved by the bank then I would request Donaldson to give the correct financial statement or return the loan. If he refuses then either I have to accept the false statements which are unethical or consult the attorney and inform the bank about the issue. This may alert the bank to take the immediate and right action.

3.

Answer:- If Pete consult me about his problems, then I would give him the following suggestions:-

1. To give discounts only to early payment and not to everyone.
2. To look for other options in the credit line.
3. Approach father-in-law and give ownership in the company, this can even convert the loan to equity and the application of the loan could be submitted in a legal way.