As Chief Legal Counsel of Dextra Construction Company, you are reviewing with th
ID: 2601529 • Letter: A
Question
As Chief Legal Counsel of Dextra Construction Company, you are reviewing with the Controller, Dave Jackson, financial statements for the year just ended. During the review, Jackson reminds you of an existing loan agreement with Southern National Bank. Dextra has agreed to the following conditions:
· The current ratio will be maintained at a minimum level of 1.5 to 1.0 at all times.
The debt-to-equity ratio will not exceed 0.5 to 1.0 at any time.
Jackson has drawn up the following preliminary condensed balance sheet for the year just ended:
Dextra Construction Company
Balance Sheet
December 31st
(in millions of dollars)
Current Assets $16 Current Liabilities $10
Long-term Assets $64 Long-term Debt $15
Stockholders’ Equity $55
Total $80 Total $80
Jackson wants to discuss two items with you and make sure you are in agreement with him. First, long-term debt currently includes a $5 million note payable to Eastern State Bank that is due in six months. The plan is to go to Eastern before the note is due and ask it to extend the maturity date of the note for five years. Jackson doesn’t believe that Dextra needs to include the $5 million in current liabilities because the plan is to roll over the note. Second, in December of this year, Dextra received a $2 million deposit from the state for a major road project. The contract calls for the work to be performed over the next 18 months. Jackson recorded the $2 million as revenue this year because the contract is with the state; there shouldn’t be any question about being able to collect. The Chief Executive Officer of Dextra, to whom both you and Jackson report, is in agreement with the positions Jackson has taken on both these issues. Jackson wants your concurrence and support as the company’s legal counsel.
Questions
1. Based on the balance sheet that Jackson prepared, is there a legal or ethical dilemma? Why or why not? Your answer should include computations of the current and debt-to-equity ratios.
2. Who may benefit if the two items are handled as suggested by the controller? Who may be harmed? How?
What would YOU do in this situation? Even for attorneys, jobs are hard to come by in the small town where Dextra is located and you have a family to support.
Explanation / Answer
Working Note -
1.
Based on the balance sheet that Jackson prepared,
There is legal dilemma because current ratio (see working note) is not as per agreed condition with Southern National Bank
And
There is ethical dilemma too.
Jackson's decision about "Note payable to Eastern State Bank" and "Deposit from the state" are not in accordance with GAAP rule.
The Obligations whose liquidation is reasonably expected with in one year should be recognised as current liability. And
$2 million deposit from the state should be recognised as revenue in the year when Sevice is performed.
2.
It will harm Dextra Construction for breaking the loan agreement with Southern National Bank
And also
Harm the Auditor for breaking the ethics of 'True and fair View' of audited financial statements.
The balance sheet should be prepared as per GAAP rules. That means the loan should be recongnised as current liability. And $2 million deposit from the state should be recognised as customer advance under long term liability as project duration is of 18 months ( more than 1 year)
This will result the ratios (see working note) as per agreed condition with Southern National Bank
And there will be no legal and ethical dilemma.
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