Manipulation of Ratios and Ethical Behavior (Case 15-67)

Pete Donaldson, president and owner of Donaldson Mining Supplies, was concerned about the firm's liquidity. He had an easy time selling supplies to the local coal mines, but had a difficult time collecting the receivables. He had even tried offering discounts for prompt payment. The outcome wasn't as expected. The coal mines still took as long to pay as before, but took the discount as well. Although he had complained about the practice, he was told that other suppliers would provide the supplies for the same terms. Collections were so slow that he was unable to pay his own payables on time and was receiving considerable pressure from his own creditors.

The solution was a line of credit that could be used to smooth his payment patterns. Getting the line of credit was another matter, however. One bank had turned him down, indicating that he already had too much debt and that his short-term liquidity ratios were marginal. Pete had begun the business with $5,000 of his own capital and a $30,000 loan from his father-in-law. He was making interest payments of $3,000 per year to his father-in law, with a promise to pay the principal back in 5 years (3 years from now).

While mulling over his problem, Pete suddenly saw the solution. By changing accountants, he could tell the next accountant that the $30,000 had been donated to the business and therefore would be reclassified into the equity section. This would dramatically improve the debt ratio. He would simply not disclose the $3,000 annual payment - or he could call it a dividend. Additionally, he would not tell the next accountant about the $6,000 of safety gear that was now obsolete. That gear could be added back, and the current ratio would also improve. With an improved financial statement, the next bank would be more likely to grant the needed line of credit.

1. Evaluate Pete Donaldson's ethical behavior.

2. Suppose that you have been hired as the chief finance officer for Donaldson Mining Supplies. You have been told that the $30,000 has been donated to the company. During the second week of your employment, the father-in law drops in unexpectedly and introduces himself. He then asks you how the company is doing and wants to know if his $30,000 loan is still likely to be repaid in 3 years. Suppose on the same day, you overhear an employee mention that the safety equipment is no longer usable because you overhear an employee mention that the safety equipment is no loner usable because regulations now require a newer and different model.

3. Assume that you have yet to prepare the financial statement for the loan application. What should you do?

4. Suppose that the financial statements have been prepared and submitted to the bank. What should you do?