Question :
Specialty Metals, Inc., a fast-growing corporation that makes metals for equipment manufacturers, has an $ 800,000 line of credit at its bank. One section in the credit agreement says that the ratio of cash flows from operations to interest expense must exceed 3.0. If this ratio falls below 3.0, the corporation must reduce the balance outstanding on its line of credit to one- half the net line if the funds borrowed against the line of credit exceed one- half of the total line. After the end of the fiscal year, the company's controller informs the president: "We may not meet the ratio needs on our line of credit in 2010 because interest expense was $ 1.2 million and cash flows from operations were $ 3.2 million. Also, we have borrowed 100 % of our line of credit. We do not have the cash to decrease the credit line by $ 400,000." The president says, "This is a big situation. To pay our ongoing bills, we require our bank to increase our line of credit, not decrease it. What will we do?" "Do you recall the $ 500,000 two- year note payable for equipment?" replied the controller. "It is now organized as 'Proceeds from Notes Payable' in cash flows given from financing activities in the statement of cash flows. If we move it to cash flows from operations and call it 'Increase in Payables,' it could increase cash flows from operations to $ 3.7 million and put us over the limit." "Well, do it," ordered the president. "It definitely doesn't make any difference where it is on the statement. It is an increase in both places. It could be much worse for our company in the long term if we failed to convene this ratio requirement."
What is your choice of the controller and president's reasoning? Is the president's order ethical? Who benefits and who is harmed if the organizer follows the president's order? Evaluate are management's alternatives? What would you do?