Davidisthenewaccountantforacompanythatbuildssmallaeroplanesforhobbyenthusiasts Thecompany,HobbyAeroLtd,employs200people About3yearsago,thecompanyunderwentamajorexpansion of its aeroplane building facilities because of increased demand for its aeroplanes fromoverseasbuyers Todothis itborrowed $10 million throughaloanwith abank Theloanagreementcontainsthefollowingclauses HobbyAeroistomaintainacurrentratioofatleast2 1 Theafter taxprofitmarginmustbeatleast10percent Ifthe companyfailstomeeteither ratioinanyyear, the$10million isimmediatelypayable Last year the government removed a 20 tariff on small aeroplanes and the company has haddifficulty competing against international competitors Consequently, the company has had toreduceitsprofitmarginstocompete with overseas suppliers ThefollowingareextractsofthepreliminaryfinalresultsforHobbyAeroLimited BALANCESHEET Assets $Amount (inmillions) CURRENTASSETS Cash 5m Accountsreceivable 45m Inventory 150m NONCURRENTASSETS Building Cost$400mLess Accumulateddepreciation$100m 300m Goodwill 100m TotalAssets 600m Liabilities CURRENTLIABILITIES Accountspayable 70m Incometaxpayable 30m NONCURRENTLIABILITIES Bankloan 400m Totalliabilities 500m INCOMESTATEMENT Totalsalesrevenue 100m Net profit aftertax 10 5m Afterreviewingtheaccounts,Davidfoundthefollowingissues One small hobby plane that was still unsold at year end is recorded as inventory in the balancesheetat$50m However,Davidiscertainthatthemostthisplane couldbesoldfor is$20m An overseas customer owing the company $10 million has recently informed HobbyAero Ltdthattheyareinseverefinancialtroubleandwillonlybeabletopayhalftheamountowing Thebalanceintheprovisionfordoubtfuldebtsis only$1m Thesetwoitemshavenotbeenreflected inthepreliminaryfinalresults Asyouareanaccountingstudent,youhavebeenaskedtoadviseonthefollowing Explain to David how the accounts receivable and inventory should be valued on the financialstatement Afterapplyingthecorrectmeasurementbasis,determinetheeffectoftheadjustment oftheaccountsreceivableand inventoryon (1)profit and(2)assets Explain to David the effect of the adjustment to accounts receivable and inventory on theCurrent ratio and the after tax profit margin Will the change in these ratios have an effect ontheloanagreementwiththebank

The Answer is in the image, click to view ...

Answered step by step

Verified Expert Solution

Link Copied!

Question

1 Approved Answer

Posted on Nov 18, 2024

Davidisthenewaccountantforacompanythatbuildssmallaeroplanesforhobbyenthusiasts.Thecompany,HobbyAeroLtd,employs200people.About3yearsago,thecompanyunderwentamajorexpansion of its aeroplane-building facilities because of increased demand for its aeroplanes fromoverseasbuyers.Todothis itborrowed $10 million throughaloanwith abank. Theloanagreementcontainsthefollowingclauses: HobbyAeroistomaintainacurrentratioofatleast2:1 Theafter-taxprofitmarginmustbeatleast10percent Ifthe companyfailstomeeteither ratioinanyyear, the$10million

Davidisthenewaccountantforacompanythatbuildssmallaeroplanesforhobbyenthusiasts.Thecompany,HobbyAeroLtd,employs200people.About3yearsago,thecompanyunderwentamajorexpansion of its aeroplane-building facilities because of increased demand for its aeroplanes fromoverseasbuyers.Todothis itborrowed $10 million throughaloanwith abank.

Theloanagreementcontainsthefollowingclauses:

HobbyAeroistomaintainacurrentratioofatleast2:1
Theafter-taxprofitmarginmustbeatleast10percent

Ifthe companyfailstomeeteither ratioinanyyear, the$10million isimmediatelypayable.

Last year the government removed a 20% tariff on small aeroplanes and the company has haddifficulty competing against international competitors. Consequently, the company has had toreduceitsprofitmarginstocompete with overseas suppliers.

ThefollowingareextractsofthepreliminaryfinalresultsforHobbyAeroLimited:

BALANCESHEET
Assets	$Amount (inmillions)
CURRENTASSETS
Cash	5m
Accountsreceivable	45m
Inventory	150m
NONCURRENTASSETS
Building Cost$400mLess Accumulateddepreciation$100m	300m
Goodwill	100m
TotalAssets	600m
Liabilities
CURRENTLIABILITIES
Accountspayable	70m
Incometaxpayable	30m
NONCURRENTLIABILITIES
Bankloan	400m
Totalliabilities	500m

INCOMESTATEMENT
Totalsalesrevenue	100m
Net profit aftertax	10.5m

Afterreviewingtheaccounts,Davidfoundthefollowingissues:

One small hobby plane that was still unsold at year-end is recorded as inventory in the balancesheetat$50m.However,Davidiscertainthatthemostthisplane couldbesoldfor is$20m.
An overseas customer owing the company $10 million has recently informed HobbyAero Ltdthattheyareinseverefinancialtroubleandwillonlybeabletopayhalftheamountowing.Thebalanceintheprovisionfordoubtfuldebtsis only$1m.

Thesetwoitemshavenotbeenreflected inthepreliminaryfinalresults.

Asyouareanaccountingstudent,youhavebeenaskedtoadviseonthefollowing:

Explain to David how the accounts receivable and inventory should be valued on the financialstatement.Afterapplyingthecorrectmeasurementbasis,determinetheeffectoftheadjustment oftheaccountsreceivableand inventoryon:(1)profit and(2)assets.

Explain to David the effect of the adjustment to accounts receivable and inventory on theCurrent ratio and the after-tax profit margin. Will the change in these ratios have an effect ontheloanagreementwiththebank?