The current ratio is a liquidity ratio that measures a company’s ability to meet its current obligations using current assets. Current assets comprise of cash and all other assets that a company expects to convert into cash or sell or consume within approximately one year of the reporting date. Current liabilities comprise of all the obligations that will require cash within approximately one year of the reporting date. The ratio is computed by dividing the current assets with the current liabilities, as indicated below:
The ratio varies by company and type of industry. However, a high current ratio indicates the presence of sufficient assets to support normal business operations. According to Stickney, Weil, Schipper, and Francis (2009, p. 266), a company’s management may deliberately produce financial statements that reflect a favorable current ratio. For instance, it may delay normal purchases towards the financial year-end to increase cash balances and reduce liabilities. It may also use the money collected from noncurrent assets such as long-term loan receivables to pay up current obligations. Such actions are referred to as window dressing. The Ross’s Lipstick Company is interested in reclassifying a long-term investment as short-term, which is a form of window dressing. The reclassification will increase the value of the company’s current assets and, consequently the current ratio.
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Therefore, the reclassification will save the company from a hostile takeover by its lenders. It is worth noting that the reclassification will not necessarily result in a stronger financial position. The current ratio only reflects the true financial position of a company if the data used to compute it is accurate and legitimate. Additionally, the classification of a company’s assets does not affect the underlying factors of the company’s financial position. For instance, in Ross’s Lipstick Company’s case, the reclassification does not change the fact that the business is no longer able to attract customers and that current liabilities are growing at a higher rate than the current assets. Therefore, the reclassification will only be a short-term solution to the company’s current problem.
The company has reclassified its long-term investment as a short-term one solely to satisfy the requirements of its debt agreement. The determination for whether the managers’ action is ethical or unethical depends on whether their true intention can be ascertained with certainty. They have the desire to hold on to the investment in the long term. To this effect, they re-reclassify it as a long-term investment once the company’s sale and hence current ratio improves. This is a case of cooking the company’s books of accounts, which is unethical as it misrepresents the company’s financial position. Its management uses this technique to make lenders believe that all is well within the company and to avoid a hostile takeover.
They do not address the issues facing the company’s long-term financial position, which are declining sales, and an increased growth rate of current liabilities. However, it is worth noting that the managers may have honestly intended to dispose of the investment to meet the current obligations and, hence improve the current ratio. If this is the case, then the managers’ action is appropriate and ethical despite the fact that they later re-reclassify the investment when the need to sell it ceases to exist. The present case illustrates how much gray some issues in accounting can get. For instance, the debt agreement depends on the current ratio, which the managers control by classifying assets in a manner that enhances the current ratio. Therefore, the inability to ascertain the intention of the managers with accuracy makes it difficult to determine whether their action was ethical or unethical.
