Citizens Bank has just received draft financial statements from ABC Wholesalers, one of its clients. In the loan agreement between the bank and ABC, there is a covenant that requires the company to have a debt to assets ratio that does not exceed 50% and a times interest earned ratio that exceeds 5.0 times. Alex Scullion, the controller of ABC, prepared the draft statement of financial position at year end that indicated that total assets were $100,000 and total liabilities were $45,000. The draft income statement for the year showed income from operations of $120,000 and interest expense of $20,000. The income tax rate is 30%. After receiving the draft financial statements, the bank was informed by Alex's boss, Jennifer Woo, that three errors were made when the draft financial statements were prepared. They were: (1) interest of $2,500 was not accrued on a loan payable, (2) a loan payment was debited completely to the bank loan liability account when $1,800 of the payment related to interest, and (3) proceeds of $2,700 from the sale of gift cards were recorded as revenue even though the gift cards have not yet been redeemed (Hint: Use the Unearned Revenue account.)
Instructions
(a) Calculate the ratio values used for the bank's covenant tests based on the information in the original draft statements.
(b) Each one of the errors described above affects two accounts. For each error, explain which accounts are affected and by how much. In doing this, also describe if the error has caused an overstatement or understatement in those accounts.
(c) Based on your analysis in part CT10.5(b) above, determine if there is any error in the Income Tax Expense and Income Tax Payable account balances.
(d) Calculate the ratio values used for the bank's covenant tests based on revised information in the financial statements assuming that all of the errors analyzed above have been corrected.
(e) Based on your answer to part CT10.5(d) above, did ABC fail to meet either of the loan's covenant tests?
(f) Do you think that the errors made by Alex could be intentional? Why or why not?