Ethical pressure and faithful representation
Ravi is the graduate accountant at Meridian Supplies. On 28 June the finance manager, Carla, instructs him to: (1) delay recording $46,000 of supplier invoices received on 27 June until 1 July, 'so the year looks cleaner'; (2) reverse a $12,000 allowance for a doubtful debt from a customer who has missed three payments, because 'they've promised to pay'; and (3) reclassify a $90,000 five-year loan as a current liability only in a footnote, not on the face of the statement. Profit before these items is $210,000. The bank covenant requires profit above $200,000 and a current ratio above 1.5. Carla says the bank 'will understand' and that Ravi's contract renewal depends on his 'flexibility'.
1. Analyse each instruction against the qualitative characteristics and the definition of a liability. What should Ravi do?
Read the worked answer
(1) Delaying invoices. The expense and liability were incurred when the goods or services were received; the liability definition (present obligation arising from a past event) is met on 27 June. Recording it in July misstates both years - 2024-25 profit is overstated by $46,000 and the liability understated. This breaches accrual accounting, faithful representation and completeness. It is not a timing choice; it is window-dressing.
(2) Reversing the allowance. A promise to pay does not remove the evidence of three missed payments. Reversing the $12,000 allowance overstates receivables and profit. This breaches prudence and faithful representation - the receivable is stated above the amount expected to be collected.
(3) Loan classification. A five-year loan is non-current unless repayable within 12 months or a covenant breach makes it callable on demand. Disclosing it only in a note does not fix the classification; if it is genuinely current, it must appear as current on the face of the statement. Concealing it in a note breaches presentation and disclosure and understandability.
Ravi should refuse to make the entries. He should escalate to Carla in writing, then to the CFO or audit committee if she insists. He should document the instructions and his objections. The threat to his contract is irrelevant to the accounting treatment; compliance with a covenant must not be manufactured.
2. Quantify the effect of the three instructions on profit and the current ratio, and assess the ethical and legal risk.
Read the worked answer
Corrected profit: $210,000 − $46,000 (invoices) − $12,000 (allowance) = $152,000.
As instructed, reported profit = $210,000, which clears the $200,000 covenant by $10,000. Correctly stated, it falls $48,000 below the covenant. The 'improvement' is entirely accounting manipulation, not performance.
Current ratio: delaying $46,000 of invoices removes them from current liabilities, and reversing the $12,000 allowance adds to current assets. Both flatter the ratio. The $90,000 loan is excluded from current liabilities on the face of the statement. Without full figures we cannot compute the ratio precisely, but each instruction pushes it upward - so a ratio 'above 1.5' may be achieved only because liabilities are hidden.
Risk:
- Legal: misrepresenting financial statements to obtain or retain finance may constitute fraud or breach of the corporations/companies legislation and directors' duties. Lenders rely on the statements; misleading them can void the loan and trigger penalties.
- Professional: Ravi is bound by the profession's code - integrity, objectivity, and compliance with standards. He must not be associated with misleading information.
- Personal: signing off exposes Ravi to liability; refusing and documenting protects him. His contract renewal is not a legitimate basis for the entries.
Action: refuse, escalate in writing, and if the matter proceeds, seek external advice (auditor, professional body, or whistleblower channel).