The Consignment Sale and the 'Verbal' Refinancing at Sanaa Ltd
Sanaa Ltd, a wholesaler, is finalising its financial statements for the year ended 31 December. It reports current assets of Ksh 20,000,000 and current liabilities of Ksh 15,000,000 - a current ratio of 1.33, comfortably above the 1.25 minimum in its bank covenant. Two items concern you. First, current assets include a receivable of Ksh 3,000,000 for goods shipped on 28 December to a distributor on a sale-or-return basis; the goods cost Ksh 2,400,000 and were recorded as a sale with cost of sales recognised, even though the distributor has no obligation to keep them and can return them at will. Second, current liabilities include a Ksh 6,000,000 bank loan repayable in ten months; the finance director has reclassified it as non-current because the bank has 'verbally indicated' it will refinance, and a facility letter may be signed in March. No going-concern assessment has been prepared.
1. Recompute the current ratio on the correct accounting treatment and comment on covenant compliance.
Read the worked answer
Item 1 - sale-or-return goods. Control has not passed and the distributor has no obligation to keep the goods, so no sale has occurred. Reverse it:
- Remove the receivable: current assets −3,000,000.
- Restore the goods to inventory (they are still Sanaa's): current assets +2,400,000.
- Reverse the revenue and cost of sales: profit falls by 600,000 (the margin wrongly taken).
Net effect on current assets: −600,000 → 19,400,000.
Item 2 - the loan. A loan repayable in ten months is a current liability unless Sanaa has a right, at the reporting date, to defer settlement for at least twelve months. A verbal indication is not a right. Reclassify Ksh 6,000,000 back to current: current liabilities 15,000,000 + 6,000,000 = 21,000,000.
Corrected current ratio = 19,400,000 ÷ 21,000,000 = 0.92.
Compliance: the covenant is breached. The reported 1.33 was produced by (a) recognising revenue before control passed and (b) classifying a short-term loan as long-term on the strength of a conversation. Neither is a matter of judgement within a range - both are departures from the accounting framework. The bank should be told; a covenant breach can trigger cross-default on other facilities.
2. Advise the finance director whether the reclassification of the loan is acceptable, and what disclosure is required.
Read the worked answer
The reclassification is not acceptable on the present facts. Classification follows the entity's right at the reporting date, not its intentions:
- The loan matures in ten months, inside the twelve-month window, so it is current.
- A verbal indication from a bank officer is not a right to defer settlement; bank staff move, credit committees decline, and the 'indication' binds nobody.
- If a refinancing agreement is completed before the financial statements are authorised for issue, the position can be presented differently - but no agreement exists yet, and a letter 'possibly' signed in March is after the likely authorisation date.
What the director should do:
- Keep the Ksh 6,000,000 in current liabilities.
- Disclose the loan terms, the maturity, and the status of refinancing negotiations as at the authorisation date, so users can see the risk themselves.
- Pursue the facility letter immediately and, if signed before authorisation, revisit the classification with evidence in hand.
- Reconsider the covenant disclosure: a breach that has not been waived must be disclosed, and the bank's waiver, if any, obtained in writing.
On the revenue item: the sale-or-return shipment should not be recognised until the distributor sells the goods or the return period lapses; recognise it on a consignment basis, with the goods in inventory and the margin deferred.
3. Explain the going-concern implications of the restated position and the work you would expect before signing the report.
Read the worked answer
Why going concern is now in play. On restatement, current liabilities of Ksh 21,000,000 exceed current assets of Ksh 19,400,000 (ratio 0.92), and a Ksh 6,000,000 loan falls due within ten months with no committed refinancing. Add the covenant breach, which the bank could use to demand repayment or to cross-default other facilities, and the indicators in ISA 570 are present: net current liability position, imminent maturity, breach of covenant, and no assessment by the directors.
Directors' responsibility. They must assess going concern over at least twelve months from the date of approval and document it. 'A positive bank balance at year end' is not an assessment.
Auditor's work:
- Obtain the directors' assessment and the cash-flow forecast supporting it; test the assumptions (sales growth, debtor collection, supplier terms) for reasonableness.
- Obtain written confirmation from the bank of the facility, its amount, its conditions and any waiver of covenant - do not accept the FD's account of a phone call.
- Assess mitigations: asset sales, shareholder support, cost cuts. Are they committed or aspirational?
- Consider whether the disclosures are adequate; if a material uncertainty exists and is properly disclosed, include a Material Uncertainty Relating to Going Concern section under ISA 570 rather than modifying the opinion.
- If disclosures are inadequate, or the going-concern basis is not appropriate, modify the opinion accordingly - a qualified or adverse opinion, depending on pervasiveness.
- Document the reasoning, since the restatement points to management bias and the whole file may be reviewed by the bank or a regulator.