Harry's Hamburgers Ltd. (HHL) is a chain of fast-food restaurants. A few years ago, the company decided it didn't want to own any new restaurants. Rather, when a new restaurant opens up, it is owned by a franchisee rather than the company. A franchisee is an individual investor who owns the land, building, furniture, and other assets and operates the restaurant. In return, the franchisee pays HHL a royalty fee, based on a percentage of sales, for the right to use the HHL name and products under a franchise agreement. If the franchisee needs funds to help build the restaurant, they can borrow money from HHL for a one-year period by signing a note receivable to HHL.
Selected items from the 2018 HHL financial statements along with comparative amounts from 2017 are shown below (in thousands of dollars):

Accounts receivable consist only of royalties receivable from franchisees. During 2018, accounts receivable amounting to $100,000 were written off.
The notes receivable are from franchisees, and are due within one year. During 2018, notes amounting to $1.5 million were received from new franchise operators and these are still outstanding. Also during 2018, notes of $800,000 were collected in full. A number of notes were dishonoured during the year, but the company's new vice-president of finance believes that all of these are recoverable, so no allowance for doubtful notes was set up. In the past, no dishonoured note has ever been collected.
The company's bank requires HHL to maintain a current ratio of 1.5:1.
Instructions
(a) Based on the above information, calculate the company's current ratio for 2018 and 2017. Does it currently meet the bank's requirement?
(b) Reconstruct the Allowance for Doubtful Accounts and Notes Receivable accounts.
(c) Do you believe the allowance is adequate for accounts receivable? Explain.
(d) Do you think that an allowance should be recorded for notes receivable? Why or why not? If you believe that an allowance should be set up, what amount should be recorded? (Hint: Calculate the amount of dishonoured notes).
(e) If an allowance for the doubtful notes was to be recorded based on your answer to part CT8.4(d), recalculate the company's 2018 current ratio. How do you think the bank would react to this?
(f) Based on a review of the information provided above, do you think that HHL's liquidity has improved or deteriorated in 2018?

Transcribed Image Text:

2018 2017 Cash Accounts receivable Allowance for doubtful accounts Notes receivable $ 1,300 $ 2,900 6,000 5,000 (400) (500) 2,7002,000 Inventory at company-operated stores 1,000 1,100 10,600 10,500 6,800 5,100 60,000 50,000 Total current assets Current liabilities Net credit sales