Problem:
John Warren wants to borrow $100,000 to expand his restaurant business. John is preparing a set of financial statements to take to the local bank with his loan application. John currently has an outstanding loan from his father for $50,000. John’s father is allowing him to borrow the money at a very low interest rate, and he does not have to make any principal payments for 5 years. Due to the favorable terms of his loan with his father, John has decided that it is not significant to disclose this loan on his financial statements. Instead, John has classified the $50,000 as contributed capital (equity), and the interest payments are included in miscellaneous expenses on the company’s income statement.
1. What are the effects of John’s classification on the financial statement?
2. Are there any ratios that might be of concern to the local bank that will be misstated by John’s actions?
3. Are John’s actions unethical?
4. Suppose John’s father agrees to be a partner in the company and John can afford to buy his shares by repaying the $50,000 with interest. Does that change your opinion of John’s actions?