You are one of the accountants at Grace Manufacturing Company. Grace has a $ 50

Question

You are one of the accountants at Grace Manufacturing Company. Grace has a $ 50 million loan with Lone Star Bank. One of the stipulations on the loan is that Grace must have a current ratio of 1.5; in other words, Grace’s current assets must be at least one and one-half of the current liabilities. Based on the preliminary financial statements for the year just ended, Grace will violate the stipulation. Violation will negatively affect current and future loans.

The accounting staff has identified two options to fix the problem that include:

1. Reclassifying “long-term investments” as “short- term investments.” Doing this would require a statement from management that the intention is to sell the property within one year. Actually, Grace intends to hold the investment for several years, and the classification would be changed back to long-term next year when the threat of loan violation has disappeared.

2. Reclassifying certain short-term loans as long- term on the basis that Grace will refinance the loans. Technically, this is true. However, Grace has no formal refinancing commitment and will not have one until at least six months from now.

Present the findings of the accounting staff to the Board of Directors. What points will you emphasize in your presentation? What is your recommendation?

Explanation / Answer

The findings:

The company want to maintain a current ratio ( current assets/ current libilities) to be 1.5 .For this purpose it is exploring two options first being classifying long term investments as short term which will increase the current assets hence increase in ratio , the other being classifying short term obligations to long term effect being reducing current liabilities and hence increase in current ratio

First option is not valid on the ground that the company does not intend to sell them on short term hence it will be unfair picture of the financial statements

Second option is also not valid

for this it needs to fulifll certain conditions

1) Long term re- finaincing should be the basis for short term loans

2) It should be supported by an ability to consummate the refinancing

hence my recommendation would be to do so so that short temr loans can be refinanced as long term

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