Subsequent events, covenant breach and going concern at Harborline Retail Ltd
Harborline Retail Ltd has a 31 December 2024 year end. Draft financial statements show profit before tax of $8.4 million, current assets of $22 million, current liabilities of $20 million, and total assets of $60 million. The company has a bank loan with a covenant requiring a current ratio of at least 1.20; if breached, the loan becomes repayable on demand. On 15 February 2025, a customer that represented 18% of receivables at 31 December 2024 entered administration; the receivable was $2.1 million and no allowance had been recognised. On 20 February 2025, Harborline agreed to sell a loss-making division for $9 million; the sale had not been contemplated at year end. On 25 February 2025, the finance team discovered that inventory costing $600,000 had been counted twice in the 31 December 2024 count. The financial statements are due for issue on 15 March 2025. Management believes the going concern basis remains appropriate because the bank has not yet demanded repayment.
1. Classify each subsequent event and calculate revised profit before tax for 2024. Explain each adjustment.
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Customer administration: this is potentially an adjusting event because the customer's deteriorating financial condition may have existed at 31 December 2024. The receivable of $2.1m was not recoverable in the light of the administration, and no allowance had been recognised. The 2024 financial statements should recognise an impairment loss of $2.1m, reducing profit before tax.
Inventory double count: this is an adjusting event because it corrects an error in the 31 December 2024 inventory count. Inventory and profit before tax are reduced by $600,000.
Division sale: this is a non-adjusting event. The sale was agreed in February 2025 and was not contemplated at year end. It does not change 2024 assets or liabilities. If material, it is disclosed in the notes, and the division may be presented as a discontinued operation in 2025 if the IFRS 5 criteria are met.
Revised profit before tax = $8.4m - $2.1m - $0.6m = $5.7m.
2. Calculate the revised current ratio and assess the covenant position. Explain the effect on classification of the bank loan.
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Revised current assets = $22m - $2.1m receivables - $0.6m inventory = $19.3m. Revised current liabilities remain $20m before any reclassification of the bank loan. Revised current ratio = $19.3m / $20m = 0.965.
The covenant requires at least 1.20. The revised ratio is 0.965, so the covenant is breached on the adjusted 2024 figures. The breach makes the loan repayable on demand unless the bank provides a waiver or the terms are renegotiated before the financial statements are issued.
If the loan is repayable on demand, it is classified as current rather than non-current. That increases current liabilities and reduces the current ratio further. The covenant breach is therefore not a presentational issue; it affects both classification and going concern assessment.
3. Assess management's conclusion that the going concern basis remains appropriate. State the disclosures and further work required.
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Management's view that the bank has not demanded repayment is not enough. The covenant breach gives the bank a contractual right to demand repayment. Unless a waiver or revised facility is obtained before the financial statements are issued, there is a material uncertainty over going concern.
Harborline should assess cash flow forecasts, headroom, the bank's intentions and the possibility of refinancing. It should also consider the effect of the customer loss and the division sale. If the bank provides a waiver that extends at least twelve months from the date of approval, the going concern basis may remain appropriate, but the breach and waiver are disclosed.
If no waiver is obtained and repayment could be demanded, the going concern basis may still be appropriate only if management concludes that repayment is not probable and the bank will not act. Otherwise, the financial statements may need to be prepared on a different basis. IAS 1 requires disclosure of the material uncertainty, the events and the plans to mitigate them. The auditors will need evidence of the bank's position before signing the audit report.