Redwood Retail: Covenant Pressure and Ethical Reporting
You are the financial controller of Redwood Retail Ltd, a private company with a 31 December year end. A bank loan covenant requires a current ratio of at least 1.5 and gearing, measured as debt/(debt + equity), of no more than 40%. Draft figures are: current assets £840,000 (inventory £380,000, receivables £300,000, cash £160,000); current liabilities £600,000; total debt £700,000; equity £900,000. The CFO proposes three actions before the accounts are finalised. First, reclassify a £90,000 bank loan repayable in 10 months as non-current because refinancing negotiations are 'well advanced', although no agreement is signed at the year end. Second, recognise £50,000 of sales for goods shipped on 3 January 2025 but invoiced on 28 December 2024; the customer has a 30-day right of return and historically 20% of such goods are returned. Third, delay a £40,000 supplier payment due on 28 December until 5 January. The CFO says the bank 'only looks at the ratios' and asks you to prepare the submission.
1. Calculate the current ratio and gearing from the draft figures and assess whether the covenants are met.
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Current ratio. Current assets £840,000 ÷ current liabilities £600,000 = 1.40. The covenant requires at least 1.50, so the draft position fails.
Gearing. Debt £700,000 ÷ (debt £700,000 + equity £900,000) = 700,000 ÷ 1,600,000 = 43.75%. The covenant requires no more than 40%, so the draft position fails.
Interpretation. Both covenants are breached on the draft figures. A breach may also affect classification: if the loan becomes repayable on demand because of the breach, it should be classified as current unless a waiver or unconditional right to defer exists at the reporting date. The ratios therefore matter for both covenant compliance and presentation.
2. Evaluate each of the CFO's three proposals under accounting standards, quantifying the effect on the ratios where possible. Conclude which proposals, if any, are acceptable.
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Proposal 1: reclassify the £90,000 loan. IAS 1 requires a liability to be classified as current unless the entity has an unconditional right to defer settlement for at least 12 months after the reporting date. Negotiations 'well advanced' are not enough without a signed agreement or waiver at the year end. Reclassifying would make current liabilities £510,000 and the current ratio 840,000 ÷ 510,000 = 1.65, which appears to meet the covenant. But gearing remains 700,000 ÷ 1,600,000 = 43.75%, so the covenant is still breached. The proposal is not acceptable.
Proposal 2: recognise £50,000 of sales. IFRS 15 requires control to have transferred and revenue to be measured at the amount to which the entity expects to be entitled. Goods shipped on 3 January 2025 are likely still under the company's control at 31 December 2024. The right of return also creates variable consideration; with a 20% return history, only the amount highly probable not to reverse could be recognised, at most £40,000, with a refund liability. Even if £50,000 were recognised, current assets would rise to £890,000 and the current ratio would be 1.48, still below 1.5; gearing would be 700,000 ÷ 1,950,000 = 35.9% only if the whole £50,000 increased equity, which ignores cost of sales. The proposal is not acceptable.
Proposal 3: delay the supplier payment. If the payment is due on 28 December and is unpaid at 31 December, the payable remains and cash remains higher; there is no accrual profit effect. If the payment were made before the year end, current assets would be £800,000 and current liabilities £560,000, giving 1.43, still below 1.5. Delaying a due payment may breach supplier terms and does not fix the covenant. It is not an accounting adjustment, although legitimate supplier credit terms could be negotiated. None of the three proposals is acceptable as presented.
3. Discuss the ethical and professional issues raised by the CFO's request, including the ICAEW Code of Ethics principles and the appropriate response.
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Ethical principles. The request engages integrity, objectivity and professional behaviour. Preparing a submission that misclassifies a loan, recognises revenue before control passes, or hides a payable would be misleading. Objectivity requires the financial controller not to allow pressure from a superior to override professional judgement. Professional competence and due care require the financial statements to comply with the applicable reporting framework.
Specific risks. Reclassifying the loan without a signed right to defer could also misstate the loan as non-current when it is repayable on demand, affecting going concern and covenant disclosures. Recognising sales with a right of return without a refund liability overstates revenue, receivables and equity. Delaying a due supplier payment may be a commercial decision, but presenting it as though the liability did not exist would be false.
Response. Explain the accounting treatment to the CFO, document the analysis and the refusal to make unsupported adjustments, and escalate to the board or audit committee if the pressure continues. Do not sign or submit misleading information. Confidentiality does not prevent reporting to those charged with governance. If the company nevertheless proposes to mislead the bank, seek external professional advice and consider whether the matter must be reported under the firm's or company's whistleblowing procedures. The bank should receive the compliant figures and, if necessary, a disclosure of the covenant breach.