ETHICS AND CURRENT LIABILITIES

Many long-term loans have contractual restrictions designed to protect the lender from deterioration of the borrower's liquidity or solvency in the future. These restric- tions (typically called loan covenants) often take the form of financial-statement ratio values. For example, a lending agreement may state that the loan principal is immedi- ately due and payable if the current ratio falls below 1.2. When borrowers are in dan- ger of violating one or more of these loan covenants, pressure is put on management and the financial accountants to avoid such violations.

Jim is a second year accountant at a large publicly-traded corporation. His boss approaches him and says, ‘‘Jim, I know why we increased our warranty liability, but it puts our current ratio in violation of a loan covenant with our bank loan. I know the bank will pass on it this time, but it's a big hassle to get the waiver. I just don't want to deal with it. I need you to reduce our estimate of warranty liability as far as possible.''

Required:

1. How would lowering the estimate of warranty liability affect the current ratio?

2. How should Jim respond to his boss?

3. Given that Jim's employer is a publicly-traded corporation, what safeguards should be at Jim's disposal?