Question

Use the following hypothetical situation to answer questions related to long-term vs. current debt and an ethical analysis: The Tony Hawk Skate Park was built in early 2021. The construction was financed by a $3,000,000, 7% note due in 6 years, with payments of $51,147 required each month. The first year has not been as profitable as hoped. The discussion at the executive board meeting at the end of 2021 focused on the potential need to obtain additional financing. However, board members are concerned that the company's debt level at the end of 2021 will make the company appear too risky to additional lenders. The balance of the note at the end of 2021 is $2,583,026. By the end of 2022, the 12 monthly payments will reduce the balance by an additional $447,116. Separate from the note, the company has the following amounts at the end of 2021: current assets of $3,100,000; current liabilities of $2,700,000; total equity of $4,000,000.

Jim Trost, the VP of finance, tells board members that he plans to classify the full balance of the note at the end of 2021 as long-term because the full length of the note is 6 years. He explains that lenders will be more willing to let the company borrow and will offer a lower interest rate if the company reports fewer current liabilities. Plus, he plans to tell lenders that there is no problem with long-term solvency because the company's long-term profits will be used to pay its long-term debt.

Required:

a). How does Jim's decision affect the reported amount of current liabilities versus long-term liabilities as of December 31, 2021?

b). Calculate the current ratio and debt to equity ratio at the end of 2021 (a) with and (b) without Jim's assumption

c). Should Jim record the full balance of the note as a long-term liability in its balance sheet as of December 31, 2021? Why or why not?

Answer 1

a. As at December 31, 2021, Jim's decision would result in overstating long term liabilities, and understating current liabilities by $ 447,116.

b.

a. With Jim's assumption, current ratio = $ 3,100,000 / $ 2,700,000 = 1.15 : 1

Debt to equity ratio = $ ( 2,700,000 + 2,583, 026 ) / $ 4,000,000 = 1.32 times

b. Without Jim's assumption, current ratio = $ 3,100,000 / $ ( 2,700,000 + 447,116 ) = 0.99 : 1

Debt to equity ratio = 1.32 times.

c. No, Jim should not report the full balance of the note as a long term liability, as part of the note, i.e $ 447,116 is to be repaid over the next 12 months, and as such, is a short term payment obligation. Therefore, only $ 2,135,910 should be recorded as a long term liability, and $ 447,116 should be reported along with current liabilities as Long Term Liabilities ( Current ).

If Jim records the entire amount as a long term liability, the various stakeholders, particularly the creditors and lenders would be hugely misled into making incorrect economic decisions.