What classifications on financial statements affect loan applications?

Question

Lucy wants to borrow $100,000 to expand 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. Her uncle is allowing her to borrow the money at a very low interest rate, and she does not have to make any principal payments for 5 years. Due to the favorable terms of her loan from her uncle, she 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 the company’s income statement.

What are the effects of her classification on the financial statements?

Are there any ratios that might be of concern to the local bank that will be misstated by her actions?

Do you think her actions are unethical? Suppose Lucy’s uncle agrees to be a partner in the company and Lucy can afford to buy his share by repaying the $50,000 with interest. Does that change your opinion?

Answer 1

If this is the way Lucy chooses to classify the 50K-then her credit rating will look better. Although, since Lucy is using the money as business capital, it is taxable in her account. Depending whether Lucy actually spent the 50k or not would determine if it was taxable. This decision is unethical, but smart when applying for a loan. The loan officer would see that the loan was being paid off in small incraments and not only that, but Lucy's credit rating would be bad. If Lucy can not afford to pay off the loan, she did what she had to do to survive-lie. This a lose-lose situation for Lucy because she's either going to have to suffer through tax paymnents or by a hit on her credit score.