Chemical Waste Treatment, Inc., a fast-growing company that disposes of chemical wastes, 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 company must reduce the balance outstanding on its line of credit to one-half the total 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 will not meet the ratio requirements on our line of credit in 2007 because interest expense was $1.2million 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 reduce the credit line by $400,000.” The president says, “This is a serious situation. To pay our ongoing bills, we need our bank to increase our line of credit, not decrease it. What can we do?” “Do you recall the $500,000 two-year note payable for equipment?” replied the controller. “It is now classified as ‘Proceeds from Notes Payable’ in cash flows provided 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 would increase cash flows from operations to $3.7 million and put us over the limit.” “Well, do it,” ordered the president. “It surely doesn’t make any difference where it is on the statement. It is an increase in both places. It would be much worse for our company in the long term if we failed to meet this ratio requirement.”
What is your opinion of the president’s reasoning? Is the president’s order ethical? Who benefits and who is harmed if the controller follows the president’s order? What are management’s alternatives? What would you do?