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 scram-

bling 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 inten-

tion. By deciding to convert an investment to cash within one year, Ross can classify

the investment as short-terma 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 reclassifies the invest-

ments as long-term. Has management behaved unethically? Give the reasoning

underlying your answer.