LONG-TERM DEBT AND ETHICS You are the CFO of Diversified Industries. Diversified has suffered through four or five tough years. This has deteriorated their financial condition to a point that they are in danger of violating two loan covenants related to their largest loan, which is not due for 12 more years. The loan contract says that if Diversified violates any of these covenants, the loan principal becomes immediately due and payable. Diversified would be unable to make this payment, and any additional loans taken to repay this loan would likely be at sufficiently higher rates, forcing Diversified into bankruptcy.

An investment banker suggests forming another entity (called ‘‘special purpose entities’’ or SPE) and transferring some debt to this SPE. Structuring the SPE very carefully will have the effect of moving enough debt off Diversified’s balance sheet to keep the company in compliance with all their loan covenants. The investment banker assures you that accounting rules permit such accounting treatment.

Required:

How do you react to the investment banker?

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