Question

Adventures in Wild Life conducts tours of wildlife reserves around the world. They have recently purchased a new lodge in Adak, Alaska, utilizing a 4% mortgage from Bank of Alaska. As part of the agreement they must provide an annual report showing they are achieving a current ratio of 1.2 or better. In order to ensure they achieve this ratio, the CEO requested the CFO to reclassify the long-term debt investments into brokerage accounts to allow them to sell them soon. The adjustments were done knowing the company was not planning on selling these long-term investments. The economy took a downturn and the business saw revenues drop more than 60%.

1. Explain how the move of long-term investments to brokerage investments would change the financial statements and how this movement would affect the current ratio.
2. What information on the financial statements should have shown the bank of this movement?
3. Determine if there was fraud in this movement and the type of fraud.

Answer 1

Answer:

a) Classification of assets as current assets and long term assets properly is very important in understanding the financial statements. The current assets determine the category of assets which could be realised in short term i.e within one year. However, long term assets are those which will not be realised or liquidated within one-year time. Hence the classification is very much important. In the present context long term debt investments are classified as short term to make it appear as if the company is having more liquid assets. This would increase the current assets value, and subsequently it would improve the current ratio. Current ratio is calculated in the below manner:

         =Current assets/Current liabilities

By classifying the long term debt investments into brokerage accounts the total value of current assets would improve which is in the numerator. This would improve the current ratio of the company. Since the banker stipulated that the current ratio must be maintained at 1.2:1 the company is trying to meet the condition by way of window dressing the financial statements.

b) Classified balance sheet with schedules to the financial statements have detailed information about the details of the assets and liabilities. There would be a new line item in the schedule of current assets which will contain these long term debt investments as brokerage accounts. The same amount would have appeared as a long term debt investment in previous balance sheet which would provoke a doubt regarding the classification of the item. A comparative balance sheet could throw a light regarding the same. Detailed look at the balance sheet and schedules should have shown the bank of this movement.

c)The classification of long term debt investment into brokerage accounts was done intentionally to boost the current ratio. Classification from long term to short term is allowed only if the asset could be realized in short term. Intentional classification without change in the nature of the assets falls under misclassification of assets and result in fraud by way of “window dressing”. The long term assets are misclassified intentionally to mislead the bankers it could be considered as a criminal act. The company wanted to misclassify the long term debt investments to improve the current ratio as per the agreement as they might result in penalties by the banker or might call back the loan. To avoid the call back of loan, this sort of intentional misclassification is done to mislead the banker and involves fraud by the company.