Question

Acme Corporation uses the calendar year as their fiscal year for reporting purposes. Acme Corporation is owned 100% by Jesse Smith. Jesse Smith is quite wealthy - he has over $3 million in a personal savings account which is currently earning 2 one hundredths of 1% interest (or .0002 rate resulting in $600 per year). He also has many other investments. Acme Corporation has $300,000 of current assets. Acme has Accounts Payable of $40,000 and various Payroll liabilities totaling $109,000. Acme also has a Note Payable in the amount of $800,000. There are no other liabilities. Interest has been paid every year when due on December 31. The Note Payable is due in $200,000 installments on June 30 of each year for the next 4 years. The current interest rate on the note is 4%. However, according to the loan terms, if Acme's current ratio falls below 2, the interest rate will automatically increase to 7%. Since the note is due in installments over the next 4 years, management is presenting the Note on the balance sheet as a long term liability. Is Acme's management reporting their balance sheet appropriately? What recommendations do you have for management? How do these recommendations impact the current ratio?

Answer 1

Acme's management is not reporting the liability appropriately in the balance sheet. As per accounting conventions, any liability which is payable within 12 months of the end of the reproting period is required to be classified as current. In this case, as per the contract terms, company has to pay instalments every year and the company also does not seem to have an uncondore, right to defer the instalment. Therefore, the next instalment due has to be reported by the company as current liabilities and not as non current liability.

Re-classification of this amount as a current liability will impact the current ratio. The current liability will increase by 100,000. The revised amount of current liabilities will be (109,000+40,000+100,000)= 249,000. Current assets are 300,000. Therefore, the current ratio is (300,000/249,000)=1.2. Threfore, this reclassification will imapct the current ratio and therefore, likely to attract higher interest rate on the note payable.

Please comment for any further clarifications