Avery Frozen Foods owes the bank $50,000 on a line of credit. Terms of the agreement specify that Avery must maintain a minimum current ratio of 1.2 to 1, or the entire outstanding balance becomes immediately due in full. To date, the company has complied with the minimum requirement. However, management has just learned that a failed warehouse freezer has ruined thousands of dollars of frozen foods inventory. If the company records this loss, its current ratio will drop to approximately 0.8 to 1.
Whether any or all of this loss may be covered by insurance currently is in dispute and will not be known for at least 90 days—perhaps much longer. There are several reasons why the insurance company may have no liability.
In trying to decide how to deal with the bank, management is considering the following options: (1) Postpone recording the inventory loss until the dispute with the insurance company is resolved,
(2) Increase the current ratio to 1.2 to 1 by making a large purchase of inventory on account,
(3) Explain to the bank what has happened, and request that it be flexible until things get back to normal.
a. Given that the company hopes for at least partial reimbursement from the insurance company, is it really unethical for management to postpone recording the inventory loss in the financial statements it submits to the bank?
b. Is it possible to increase the company’s current ratio from 0.8 to 1 to 1.2 to 1 by purchasing more inventory on account? Explain.
c. What approach do you think the company should follow in dealing with the bank?