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Financial Accounting Concepts - Essay Example

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As a condition for the loan, the bank has required that the company maintain a Current Ratio (current assets divided by total current liabilities) of at least 1.50. On December 15th, the company comptroller…
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Financial Accounting Concepts
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A company has borrowed $3,000,000 to expand its production plant. As a condition for the loan, the bank has required that the company maintain a Current Ratio (current assets divided by total current liabilities) of at least 1.50. On December 15th, the company comptroller reports that the costs of expansion have brought the current ratio down to 1.40. The Board is considering what might happen if the business reports this ratio to the bank. One solution is to report revenue from a new sales contract that is scheduled to take effect in January.
How would recording this revenue in December affect the current ratio?
Is it ethical to record the revenue transaction in December?
What accounting principle is relevant to this situation?
What course of action should the company take?
Current ratio helps assess a company’s ability to meet short-term liabilities. The higher the current ratio the greater is the company’s ability to pay its bills. It is also a tool which also helps make rational decisions in keeping with a company’s objectives. This is the reason why the bank insisted that they maintain a current ratio of 1.5. This would also enable the bank to keep a track on the company’s functioning.
The accounting principle relevant here is conservatism. Conservative accounting can only cause temporary increase in the company’s earnings. The effect is temporary and the actual may differ and hence not considered a good indicator of subsequent earnings. Conservative accounting would raise questions about not only the balance sheet but also about the income statement. Accounting conservatism only helps to reduce disclosure.
According to me it would he unethical to record the revenue of the new sales contract in December. It is always advisable to be honest with the bank because the relation with a bank is a long-term one. If the bank found out on its own it would reflect badly on the company and then the bank would be very cautious in all future transactions also. Manipulation may not be intended by the company but banks would be cautious in all future reporting by the company incase they found out.
If the company records this revenue in December the current ration would increase. They could complete the contract in December itself and raise the bill. Once the bill is raised, whether they receive cash for it or it remains as current receivables, the current ratio goes up. In this case there is nothing wrong. But as can be seen it is already the 15th December. Would it be possible to complete the contract within this period? Besides, credit has to be given to the party so cash payments cannot be expected.
But in the event that the contract is executed in January and considered in December just for the sake of reporting, it would be a false statement. It is after all an estimated sales and receivables. Receivables are assets only in so far as they can be collected in a reasonable period of time. It is not sure when the realization would take place and whether the complete realization would be possible.
In my opinion the company, under the circumstances, should report the actual to the bank and with a note on the sales contract which is to be executed in January. The report should also highlight the expected earnings, giving details of the value of the contract, the realization period and with a projection how the current ratio would immediately rise up. The bank would understand that it is a temporary phase and would give due consideration to the company which is very essential to maintain a healthy relationship with the bank. Information to the bank should neither be negative nor should there be suppressed reporting. Read More
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