Many long-term loans have contractual restrictions designed to protect the lender from deterioration of the borrower’s liquidity or solvency in the future
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:1. How would lowering the estimate of warranty liability affect the current ratio?2. How should Jim respond to his boss?3. Given that Jim’s employer is a publicly-traded corporation, what safeguards should be at Jim’s disposal?
