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

1. 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?

2. 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 reclassified the investments as long-term. Has management behaved unethically? Give the reasoning underlying of your answer.

Step by step solution

01

Effect of reclassification on investment:

The current ratio is calculated by dividing the current assets by current liability. Current assets include short-term investment, cash, inventory, prepaid expenses, accounts receivable, etc. As the value of current assets increases, the value of the current ratio improves. The reclassification of investment from long-term to short-term improves the current assets' position, leading to a better current ratio. Hence the position of the current ratio improves.

02

Analysis whether management is ethical or unethical

Management is behaving unethically because to improve the current ratio management is reclassifying investment to show better picture which is misrepresentation of actual results.

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