Lucy Shafer wants to borrow $100,000 to expand her dog-breeding business. She is preparing a set of financial statements to take to the local bank with her loan application. She currently has an outstanding loan from her uncle for $50,000. Lucy’s uncle is letting her borrow the money at a very low interest rate, and she does not need to make any principal payments for five years. Due to the favorable terms of the loan from her uncle, Lucy has decided that it is not significant enough to disclose on her financial statements. Instead, Lucy has classified the $50,000 as contributed capital, and the interest payments are included in miscellaneous expenses on Lucy’s income statement.
1. What are the effects of Lucy’s classifications of her uncle’s loan and the related interest payments on the financial statements?
2. Are there any ratios that might be of interest to the local bank that will be misstated by Lucy’s actions?
3. Do you think Lucy’s actions are unethical? Suppose Lucy’s uncle agrees to be a partner in the company until Lucy can afford to buy his share by repaying the $50,000 with interest. Does that change your opinion?