Question

Question 1 Mermaid Ltd.’s long-term debt agreements make certain demands on the business. For example, Mermaid may not purchase treasury shares in excess of the balance of retained earnings. Also, long-term debt may not exceed shareholders’ equity, and the current ratio may not fall below 1.50. If Mermaid 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 Mermaid Ltd to attract customers. Current liabilities have mounted faster than current assets, causing the current ratio to decline to 1.47. Before releasing the financial statements, Mermaid’s management is scrambling to improve the current ratio. The controller points out that the company owns an investment that is currently classified as long-term. The 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, Mermaid can classify the investment as short-term – a current asset. On the controller’s recommendation, Mermaid’s board of directors votes to reclassify long-term investments as short-term.

Requirements: a) What is the accounting issue in this case? What ethical decision needs to be made?

b) Who are the stakeholders?

c) Analyse the potential impact on the stakeholders from the following standpoints:

- Economic

- Legal

- Ethical

d) Shortly after the financial statements are released, sales improve; so, too, does the current ratio. s a result, Mermaid’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 acted unethically? Give the reasoning underlying your answer.

Answer 1

Answer 1(a)

As per the accounting standards, an investment can be classified as short term provided following two conditions are met:

1. It is liquid - example of liquid investment is equity shares listen on a stock exchange that is frequently traded

2. Management intends to sell the investment within one year

Unless both the conditions are satisfied an investment cannot be classified as short term investment.

The accounting issue here is that till the last financial year the said investment was classified as a long term investment which means the management did not intend to sell it within an year. However, just to ensure the current ratio does not fall below 1.5, they are now contemplating to reclassify the investment as short term and increase the current asset, which will increase the current ratio since current ratio = current asset/current liability

The above reason cannot be the ground of reclassifying an investment. The same can be included as a short term investment provided management has all the intentions of selling it within an year and also if the instrument is liquid. Also such a change will have to explicitly be called out in the financial statements.

The ethical decision to be made here is whether management actually intends to sell the investment. If not, then the same should not be reclassified. Else, this would qualify as manipulation of financial statements just to ensure that the lender does not takeover the company. Reclassifying the investment on the said ground would mean material misstatement of facts and would qualify management guilty of the same.

Answer 1(b)

Stakeholder includes everyone who is directly or indirectly influenced by the company's financial statements. It includes the lenders, the creditors, the debtors, all other third party with whom the company interacts. Also, it includes all shareholders of the company or any intended investor who wishes to invest in the company. All employees, promoters are also internal stakeholders of the company. In this case, the biggest impacted stakeholder would be the lender who has provided long term debt to the company since because of this unethical reclassification the real picture of current ratio would never be known to the lender.

Answer 1(c)

Economic standpoint - The stakeholders would definitely be adversely impacted because of this decision. The lenders would not take control of the company and in a situation where the current ratio keeps on falling due to change in consumer demand the company might fail to pay off its debt. Not only the lenders even investors are impacted negatively since this could lead to a fall in the market value and reputation of the company

Legal standpoint - Legally, all the stakeholders can question the management on this decision since it is the responsibility of the management to ensure all material disclosures are made and ensure that financials reflect true and fair picture of the state of the company.

Ethical standpoint - Ethically, it is wrong from managements point of view to take such a decision. A stakeholder invests or transacts with a company on the basis of trust that it has with the management. Under the given scenario, management has made an attempt to not disclose the true picture of the company and hence have acted unethically.

Answer 1(d)

Yes, the management has acted unethically. This act proves that management had reclassified the investment as short term only to manage current ratio and they had no intention of selling the investment within a year.

As explained above, investments can only be classified as short term only when the management has an intention of selling it within a year. This decision should be independent of the sales numbers or the current ratio.

By reclassifying the investment earlier the management did not let financials reflect true and fair picture of the company. This is one of the primary responsibilities of a management. Reclassification cannot be done on the whims and fancies of the management. It has to following the accounting standard and policies set. It should be independent of how sales numbers are or what is the current ratio pre and post classification.

Sales improvement means higher cash or accounts receivable which means higher current asset and hence higher current ratio. Just because the objective of the management was to not let current fall below 1.5, they manipulated with the classification of an investment which was always long term.