Durocher
Guitar Corp. is in the business of manufacturing top-quality, steel-string folk
guitars. Durocher is a private enterprise and follows ASPE. In recent years,
the company has experienced working capital problems resulting from investments
in new factory equipment, the unanticipated buildup of receivables and
inventories, and the payoff of a mortgage on one of its manufacturing plants.
The founder and president of the company, Laraine Durocher, has tried to raise
cash from various financial institutions, but she has been unsuccessful because
of the company's poor performance in recent years. In particular, the company's
lead bank, First Provincial, is especially concerned about Durocher's inability
to maintain a positive cash position. The commercial loan officer from First
Provincial told Laraine Durocher, "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, Laraine
Durocher 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, liquidate its raw material inventories, and
arrange a sale and leaseback for major components of its equipment. These
rather costly transactions would generate lots of cash. As the chief accountant
for Durocher Guitar, it is your job to advise Laraine Durocher on this plan.
Instructions
(a)
Explain how each of these "solutions" would affect Durocher Guitar
Corp.'s statement of cash flows. Be specific.
(b)
Are there any ethical issues related to Laraine Durocher's idea?
(c)
What would you advise Laraine Durocher to do?
(a)
Selling
current assets, such as receivables to factors and selling raw material
inventories, will generate cash flows for the company although for amounts less
than their carrying values. The sale and leaseback of equipment will not
achieve the goal of increasing cash flow from operations, required by the
bank. Rather, this transaction will lead
to the reductions in future operating cash flows from the future payments of
rents. Cash obtained from selling off equipment will be reported as a cash
inflow from investing activities. Any gains generated from the sale will be
deferred and not help profitability immediately.
(b)
The
transactions that are suggested by Laraine do not cure the systemic cash
problems for the organization. In short, it may be a bad business practice to
liquidate assets, thereby incurring expenses and losses, in order to “window
dress” the cash flow statement.
The ethical implications are
that Durocher creates a short-term cash flow at the longer-term expense of the
company’s operations and financial position. Laraine’s idea creates the
illusion that the company is successfully generating positive cash flows.
(c)
Laraine
Durocher should be told that if she executes her plan the company may not
survive. While the factoring of receivables and the liquidation of inventory
will indeed generate cash, the actual amount of cash the company receives will
be less than the carrying amount of these assets. The sale and leaseback will
also generate cash which may be more or less than the related property’s
carrying amount, depending on its fair value less costs to sell. In addition, the company would still have the
future expenditure of replenishing its raw materials inventories at a cost
higher than the sales price, plus the additional expense of rent from the lease
of the equipment.
As chief accountant for
Durocher Guitar, it is your responsibility to work with the company’s chief
financial officer to devise a coherent strategy for improving the company’s
cash flow problems. One strategy may be to downsize the organization by selling
excess property, plant, and equipment to repay long-term debt. In addition,
Durocher Guitar may be a good candidate for a quasi-reorganization.
