CURRENT LIABILITIES AND CURRENT RATIO. The current ratio, which is discussed in Chapter 15, is one of the primary bases by which short-term creditors evaluate the ability of a company to pay its short-term obligations. The current ratio is computed by dividing current assets by current liabilities. Thus a company with current assets of $120,000 and current liabilities of $60,000 has a current ratio of “2 to 1.” Everything else being the same, the higher the current ratio, the easier it will be to secure short-term credit; that is, more short-term credit will be available at lower interest rates.

Topeka Corporation is a small manufacturer whose annual financial statements for recent years (including the year just ended) indicate a current ratio of about 1.5 to 1.

Topeka has been able to secure a limited amount of short-term credit, but bankers are cautious and charge a somewhat higher-than-average interest rate. At year-end, the auditors noted the following occurrences during their examination of the records of Topeka Corporation:

a) A large order, purchased on account, shipped F.O.B. shipping point just prior to year-end was not recorded at year-end but was recorded as a purchase in the following year.

b) A large payment of principal and interest due within the next year was not recorded as a current liability.

c) An effort was made at year-end to pay off current liabilities to the maximum extent possible.

REQUIRED:

1. What is the effect of each of the three occurrences on the current ratio? What factors might explain these three occurrences?

2. Do the three occurrences represent errors that must be corrected? Give reasons for your answers. If a correction is required, describe the correcting journal entry.

3. How would you recommend that bankers compute the current ratio?