The Cooperative's Stale Stock and the Lending Covenant
Mwangaza SACCO holds a loan to Kijani Cereals Ltd of KES 8,400,000, secured by a first charge over inventory. Kijani's audited accounts for the year just ended show inventory of KES 12,000,000 and a current ratio of 1.9:1, comfortably above the 1.5:1 covenant. During a routine site visit, the credit officer observes that roughly 40% of the inventory is maize flour with a printed best-before date that passed four months ago, stored in a leaking warehouse. Kijani's finance officer says the stock is still valued at cost because 'it will be sold to animal feed processors at a discount' and refuses to adjust. The borrower has also just requested a KES 3,000,000 overdraft increase to cover a cash shortfall, blaming delayed payments from a single government buyer that accounts for 70% of sales. The SACCO's policy requires classification of the account within 30 days of any adverse information.
1. Assess whether the covenant compliance figure of 1.9:1 can be relied upon, and explain the accounting and credit implications of the stale inventory.
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Reliance on the ratio. The current ratio is only as good as the carrying amount of its numerator. Under IAS 2, inventory must be measured at the lower of cost and net realisable value (NRV). Expired maize flour held in a leaking warehouse has an NRV almost certainly below cost: it can only move to feed processors at a steep discount, and some may be unsaleable. If 40% of KES 12,000,000 (KES 4,800,000) is written down - say to 30% of cost - the write-down of roughly KES 3,360,000 reduces current assets to about KES 8,640,000.
Recalculating the ratio. If current liabilities were about KES 6,316,000 (derived from 12,000,000 ÷ 1.9), the adjusted ratio becomes 8,640,000 ÷ 6,316,000 ≈ 1.37:1 - a breach of the 1.5:1 covenant.
Credit implications.
- The security is impaired: the charge over inventory secures less than the loan balance once NRV is applied.
- The refusal to adjust is itself adverse information (possible misstatement, management bias), triggering the 30-day classification rule.
- The single-buyer concentration (70% of sales) is a separate credit risk that the ratio does not capture.
- The overdraft request is a liquidity symptom, not a cause; lending more against overstated collateral worsens exposure.
Action. Require an independent stock count and NRV assessment, treat the account as watch-listed pending reclassification, and decline or condition the overdraft on a credible cash-flow plan and buyer diversification.
2. The finance officer argues that no adjustment is needed because the goods 'will still be sold'. Evaluate this argument and state the audit/credit treatment you would recommend.
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The argument is not sound. 'Will be sold' is not the test. IAS 2 requires NRV - estimated selling price less costs to complete and costs to sell. Selling expired flour to feed processors involves a deep discount, handling and transport costs, and possibly disposal costs for unsaleable portions. The relevant question is whether the expected net proceeds cover the carrying amount, not whether a sale occurs at all.
Additional weaknesses in the argument.
- Storage in a leaking warehouse raises the possibility of contamination and further value loss.
- Holding cost and obsolescence continue to accrue while the goods sit.
- The claim is unsupported by any quotation or contract from feed processors; it is an assertion, not evidence.
Recommended treatment.
- Obtain written quotations or contracts from feed processors to support NRV.
- Write inventory down to NRV in the current period; the loss is recognised in profit or loss.
- Disclose the write-down and the valuation basis in the notes.
- For credit purposes, value the collateral at forced-sale NRV, not cost.
- If management refuses, treat it as a scope/management-integrity issue and escalate under the SACCO's classification policy.