You are aware that your nonpublic audit client is under pressure to meet financial covenants from its lenders; specifically, the lenders review the company's interest coverage ratio and debt$-$service coverage ratio annually. In performing year$-$end audit procedures, you notice a formula error in the client's spreadsheet used to calculate its inventory costs, and it appears that general and administrative $("$G&A$")$ expenses $($unrelated to production$)$ are being capitalized into the reported cost of the inventory. You compute the magnitude of these capitalized G&A costs and realize that these costs make the difference between the company meeting its lender$-$required covenants and failing those covenants.

 

 

Required:

$1.$ Review the GAAP for inventory costing to confirm your understanding of whether the client's practice is consistent $/$ not consistent with GAAP.

$2.$ Describe how the debt$-$service ratio and interest coverage ratio are calculated. What impact would an overstatement of inventory have on these ratios?