Question

Brockman Guitar Company is in the business of manufacturing top-quality, steelstring folk guitars. In recent years the company has experienced working capital
problems resulting from the procurement of factory equipment, the unanticipated
buildup of receivables and inventories, and the payoff of a balloon mortgage on a
new manufacturing facility. The founder and president of the company, Barbara
Brockman, has attempted to raise cash from various financial institutions, but to
no avail because of the company’s poor performance in recent years. In
particular, the company’s lead bank, First Financial, is especially concerned
about Brockman’s inability to maintain a positive cash position. The commercial
loan officer from First Financial told Barbara, "I can’t even consider your request
for capital financing unless I see that your company is able to generate positive
cash flows from operations." Thinking about the banker’s comment, Barbara
came up with what she believes is a good plan: With a more attractive statement
of cash flows, the bank might be willing to provide long-term financing. To
"window dress" cash flows, the company can sell its accounts receivables to
factors and liquidate its raw materials inventories. These rather costly
transactions would generate lots of cash. As the chief accountant for Brockman
Guitar, it is your job to tell Barbara what you think of her plan. Answer the
following questions.
(a) What are the ethical issues related to Barbara Brockman’s idea?
(b) What would you tell Barbara Brockman?

Expert Answer

Answer 1

Answer:

(a) This is ethically wrong. Reasons provided in the explanation section

(b) It is in the company's favor to not indulge in window dressing

Explanation:

(a) To understand the ethical implications of Window Dressing, we must understand what the term implies and why it may be considered right or wrong.

Window dressing is the process of taking certain decisions or actions that would result in the improvement of a company's financial statement (e.g balance sheet/income statement etc). For example, the company might be having a bad final quarter in terms of achieving sales targets so it might resort to given unsustainable discounts or other offerings to some customers to record sales earlier. Or a company might change its depreciation policy to reflect a lower depreciation charge in order to increases reported profits.

As we can see, these are ethically wrong practices since they distort the financial position of the company that is being presented to users of the financial statements. In preparing financial statements, the issuing entity needs to ensure that the information is honest and can be fairly relied on my users of the statements as presenting the fair financial position and performance of the company. Window dressing distorts this purpose and does not provide users of the statements with the actual picture.

(b) We have already identified that Barbara's idea is unethical and therefore, should not be undertaken. Secondly, other than taking a moral view point, window dressing will also hurt a company. By factoring receivables and selling of raw materials inventories, there would be an influx of cash allowing the company to meet the bank's covenants but it does nothing to address the underlying issues of the company. There is a reason that the company is showing consistent negative cash flow position. There needs to be a thorough investigation into why there was an unanticipated buildup of receivables and inventory. Are there bad/doubtful debts? Is there over capacity? Any changes in product demand? These issues need to be resolved first.

Third, this practice is not sustainable. It might be be beneficial in the short term but cannot be sustained in the long run. The same problem may be exacerbated in the next year. Selling raw materials (in an inflationary environment) will add higher cost when the company goes on to produce finished goods in the next year.

Finally, window dressing cannot be so easily hidden under the rug. Auditors, investors and bankers can easily go through your statements and identify this barren attempt. At one point, the banker is unwilling to consider a loan application because of liquidity concerns and then immediately show  a huge surplus in cash. The decrease in inventory and receivables will be highlighted very easily which would cause a huge issue to the company in terms of its reputation,thereby putting it in deeper troubles