A private company has two debt covenants in place:
a. Maximum debt- to- equity ratio: Current and long- term liabilities, excluding future income taxes, are divided by total shareholders’ equity.
b. Minimum times- interest- earned ratio: Income before interest and taxes is divided by total interest expense.
For each of the accounting policy choices listed below, indicate which ratio(s), if any, would be affected, and whether the policy would increase or decrease the ratio.
1. Depreciation method is straight line, rather than declining balance.
2. Costs that could either be deferred and written off or expensed immediately are expensed immediately.
3. Interest expense could be measured using straight- line amortization for the debt discount; alternatively, the effective interest rate method could be used. The straight- line method results in lower interest expense in the early years and is the chosen policy.
4. An issue of preferred shares that has the characteristics of debt (guaranteed cash flows to the investor) is reclassified from equity to debt.
5. Warranty expense is accrued as sales are made, rather than expensing it as warranty claims are paid.
6. Revenue is recorded as goods are delivered, rather than when cash is later collected.