Halstead Trading: year-end adjustments and a bank covenant
Halstead Trading Ltd's draft statement of profit or loss for the year ended 31 March 20X5 shows profit before tax of £186,000. No corporation tax has yet been provided; the rate is 19%. Four items remain unadjusted. (i) Inventory includes 600 components at cost £40 each; since the year end the supplier has cut its list price, and the components can now be sold for £26 each after incurring £2 each of selling costs. (ii) A customer owing £12,000 was placed into liquidation on 14 April 20X5, before the financial statements were approved; no provision exists. (iii) A machine costing £96,000 was bought on 1 October 20X4 and no depreciation has been recorded; the policy is 25% per annum on a reducing-balance basis, charged for the period of ownership. (iv) Rent of £33,000 was paid on 1 January 20X5, covering the 15 months to 31 March 20X6, and has been charged in full. Draft current assets are £380,000 and draft current liabilities £250,000. The bank covenant requires profit before tax of at least £160,000 and a current ratio of at least 1.4.
1. Compute the adjusted profit before tax, the tax charge, the profit for the year, and the restated current ratio.
Read the worked answer
(i) Inventory: NRV = £26 − £2 = £24; cost £40 → write down 600 × £16 = £9,600. (ii) Bad debt: £12,000 (the liquidation is an adjusting event - it evidences a condition existing at the year end). (iii) Depreciation: 96,000 × 25% × 6/12 = £12,000. (iv) Rent: 33,000 ÷ 15 = £2,200 per month; 3 months used (to 31 March 20X5), so expense £6,600 and prepayment £26,400 → profit increases £26,400.
Adjusted PBT = 186,000 − 9,600 − 12,000 − 12,000 + 26,400 = £178,800. Tax at 19% = £33,972. Profit for the year = £144,828.
Current ratio: current assets 380,000 − 9,600 − 12,000 + 26,400 = £384,800. Current liabilities 250,000 + 33,972 (tax payable) = £283,972. Ratio = 1.355.
So the profit covenant (£160,000) is met with £18,800 of headroom, but the liquidity covenant (1.4) is breached.
2. Explain the accounting reasoning behind each adjustment, and advise how the covenant breach should be handled.
Read the worked answer
Inventory - IAS 2/FRS 102 require the lower of cost and net realisable value. NRV is expected selling price less costs to complete and sell, so £26 − £2 = £24. This is prudence applied to a known fall in value, not a discretionary write-off: the loss belongs to the period in which the value fell.
Bad debt - the liquidation of a balance existing at 31 March is an adjusting event after the reporting period; the receivable was already impaired at the year end.
Depreciation - the accruals concept requires the cost of the machine to be spread over the periods benefiting from it; six months' ownership must be charged, on the reducing-balance basis the company has adopted consistently.
Rent - accruals, not cash. Only three months' benefit has been consumed; £26,400 is a prepayment (a current asset), not an expense.
Covenant - the breach is a fact and must be disclosed; the directors should open discussions with the bank early and present the restated figures and a cash forecast. Reclassifying liabilities, deferring the write-down or grossing up current assets to reach 1.4 would misstate the accounts and would itself be a breach of duty.