Betsy Ross Flag 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 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 management is scrambling to improve the current ratio. The controller points out that an investment can be classified as either long-term or cash 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 management decides not to sell the investments it had reclassified as short-term. Accordingly, the company reclassifies the investments as long-term. Has management behaved unethically? Give the reasoning underlying your answer.
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