Question :

Suppose you are an accountant at ABC Loans. Your role is to assess loan applications. As part of its continuing professional development programme ABC Loans has a process in place whereby when a loan goes into default the accountant who approved the loan is asked to review the application and approval and choose whether the loan was correctly approved. A loan that you approved in your first 6 months of working at ABC loans has now defaulted and you have received the unique application and the recommendation for approval made by you.

Loan Application

XYZ Pty Ltd a small private corporation wishes to borrow $500,000 in order to buy some new equipment. It is not expected that the purchase of this equipment will enhance profitability but it will result in the company conducting its operations in a more environmentally friendly manner. It is expected to result in a 50 percent reduction in carbon emissions.

The Financial Statements (unaudited) for the year ended 30^th June 2010 that you have been given indicate the subsequent (previous year figures are in brackets):

Current Assets                          $1,500,000          ($1,400,000)

Non-Current Assets                    4,000,000          ( 3,250,000)

Current Liabilities                        2,000,000          ( 1,600,000)

Non-Current Liabilities               2,000,000          (1,650,000)

Equity                                         1,500,000          (1,400,000)

Pre-tax Profit                               $300,000

Interest Expense                          60,000

The notes to the accounts indicate the following:

• integrated in equity is $500,000 of non-voting cumulative redeemable preference shares. The shares are redeemable at the shareholders alternative in 3 years time. The dividend rate attached to the shares is 6 percent. Dividends have been paid every year since the shares were issued.
• On 30^th June 2009 the company entered into a leasing arrangement for an item of machinery and plant. The lease arrangement involved a series of five leases with a lease term of two years each for the item of plant and machinery. As these five leases were short-term, the leases were organized by the company as operating leases. The item of machinery and plant had an estimate useful life of 10 years and a fair value of $100,000 at 30 June 2009.

Loan Approval Criteria:

Quantitative:

Debt ratio is to be lower than 0.75

Interest coverage is not to be less than 5

Return on Total Assets is not to be less than 7%

Qualitative:

Accountants are also provided some latitude in respect to the way in which they make assessments. They can consider such things as the reputation of the borrower and the function for the loan.

Quantitative criteria

From the unaudited financial information for 30 June 2010:

Total liabilities = 4,000,000 (2,000, 000 + 2,000,000)

Total assets = 5,500,000 (1,500,000 + 4,000,000)

Average assets = 5,075,000 ([5,500,000 + 4,650,000]/2)

EBIT = 360,000 (300,000 + 60,000)

Debt ratio (< 0.75) 4,000,000/5,500,000 = 0.73

Interest coverage (> 5)  360,000/60,000 = 6

Return on Assets (> 7%) 360,000/5,075,000 (Average) = 7.1%

Required

Would you approve the loan if it was offered to you for consideration now? Provide reasons.

• Were there any factors that you did not take into account when assessing the original application?
• Why were those factors significant?
• Could the non-consideration of those factors have contributed to the loan default?
• Would you take a different decision now? Why?