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Cornerstones of Financial Accounti...

4th Edition
Jay Rich + 1 other
ISBN: 9781337690881

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BuyFindarrow_forward

Cornerstones of Financial Accounti...

4th Edition
Jay Rich + 1 other
ISBN: 9781337690881
Textbook Problem
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Ethics and Current Liabilities

Many long-term loans have contractual restrictions designed to protect the lender from deterioration of the borrower’s liquidity or solvency in the future. These restrictions (typically called loan covenants) often take the form of financial-statement ratio values. For example, a lending agreement may state that the loan principal is immediately due and payable if the current ratio falls below 1.2. When borrowers are in danger of violating one or more of these loan covenants, pressure is put on management and the financial accountants to avoid such violations.

Jim is a second year accountant at a large publicly traded corporation. His boss approaches him and says,

"Jim, I know why we increased our warranty liability, but it puts our current ratio in violation

of a loan covenant with our bank loan. I know the bank will pass on it this time, but it’s a big

hassle to get the waiver. I just don’t want to deal with it. I need you to reduce our estimate of

warranty liability as far as possible."

Required:

How would lowering the estimate of warranty liability affect the current ratio?

To determine

Concept introduction:

Warranty Expense:

A company may issue warranty with the sale of its product which bounds the company to replace or repair in case of quality failure according to the terms of the warranty. The provision for the estimated warranty liability is made at the time of sale of the products and warranty expense is recorded. This provision is utilized at the time of performing the warranty contract.

Current Ratio:

Current Ratio is measure of the company’s ability to pay off its current liabilities using its current assets. It is calculated by dividing the total current assets by total current liabilities. The formula of the current ratio is as follows:

Current Ratio=Current assetsCurrent liabilities

To indicate:

The effect of lowering the warranty liability on the current ratio.

Explanation

Current Ratio is measure of the company’s ability to pay off its current liabilities using its current assets. It is calculated by dividing the total current assets by total current liabilities...

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