You are on the accounting staff of Chisos Manufacturing Company. Chisos has a $100 million loan with Rio Grande National Bank. One of the covenants associated with the loan is that Chisos must maintain a current ratio greater than 1.5.
As of January 20, 2013, preliminary financial statement numbers for the year ended December 31, 2012, have been compiled. It looks like Chisos will violate the current ratio loan covenant. Violation could be very costly in two ways. First, Rio Grande National Bank has historically raised the interest rate one-half of a point on loans with covenant violations. Second, a violation will increase the perceived riskiness of Chisos and make future borrowing more costly.
The 2012 financial statement numbers are just preliminary, and the senior accounting staff of Chisos has discussed the following two options to avoid violation:
1. Reclassify "long-term investment property" as "short-term property held for sale." Doing this would require a statement from management that the intention is to sell the property within one year. Actually, Chisos intends to hold the property for several more years, and the property classification would be changed back to long term next year when the threat of covenant violation has hopefully disappeared.
2. Reclassify certain short-term loans as long-term on the basis that Chisos will refinance the loans. Technically, this is true. However, Chisos has no formal refinancing commitment and will not have one until sometime in June. You have been chosen to present the findings of the accounting staff to the board of directors. What points will you emphasize in your presentation?