Question4 ABC Ltd has a debt covenant in place requiring that its return on assets (ROA) ratio must always be at least 10%. The covenant defines return on assets as net profit before tax, divided by total tangible assets. At year-end before finalising the trial balance, and before taking any of the actions proposed below, ABC's net profit before tax is $1,100,000 and the total tangible assets are $12,000,000 and so the ROA is less than the required 10 %. According to positive accounting theory, ABC Ltd which of these actions is the company most likely to take? Increase Allowance for Doubtful Debts by $900,000. In the current year, the company’s share portfolio increased in fair value by $900,000. Classify this share portfolio as fair value through P&L In the current year, the company’s share portfolio increased in fair value by $900,000. The company had made an irrevocable election to classify this share portfolio as fair value through OCI. Shorten the useful life of Property Plant & Equipment to increase depreciation by $900,000. Do not impair intangible assets by $900,000. ResetMaximum marks: 1 Flag question undefined

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BlackTom AI · Accepted Answer

We start by restating the situation and the five potential actions in plain terms to ensure each option is evaluated on its own merits.
Option 1: Increase Allowance for Doubtful Debts by $900,000.
- This action would be an expense increase (a higher allowance reduces net profit before tax). Since ROA is net profit before tax divided by total tangible assets, increasing expenses lowers net profit and would typically reduce ROA unless asset bases change in the same period. For meeting a debt covenant that requires ROA to be at least 10%, this action would worsen the covenant position, not improve it.
- Misconception to avoid: some might think increasing an allowance could somehow boost apparent profitability, but in standard accounting, higher allowances reduce earnings, thus harming the ROA metric used by the covenant.

Option 2: In the current year, the company’s share portfolio increased in fair value by $900,000. Classify this share portfolio as fair value through P&L.
- If gains are recognized in the profit and loss (FVTPL), net profit before tax would rise by $900,000, directly increasing ROA (numerator) while the asset base remains the same or grows with the revaluation, depending on accounting rules. This would improve the covenant position in the current period.
- From a positive accounting theory (PAT) perspective, managers are assumed to prefer choices that improve reported earnings and compliance with debt covenants when such actions are legitimate under accounting standards. Opting for P&L recognition of gains directly boosts earnings and thus ROA, making this option attractive for covenant relief.

Option 3: The company had made an irrevocable election to classify this share portfolio as fair value through OCI.
- Gains or losses on assets classified as OCI do not flow through net profit before tax; they go to other comprehensive income and do not affect the PBT line or ROA in the current period. Therefore, this would not improve the ROA figure used in the covenant, making it unattractive if the goal is to meet the 10% threshold in the short term.
- This is a classic mechanism to smooth earnings or avoid direct earnings volatility, but it does not help satisfy the covenant measure tied to PBT.

Option 4: Shorten the useful life of Property, Plant & Equipment to increase depreciation by $900,000.
- Accelerating depreciation increases depreciation expense, reducing net profit before tax. A lower numerator reduces ROA, worsening the covenant position rather than improving it.
- It also represents an earnings management technique, but one that defeats the objective of raising ROA to meet a minimum value.

Option 5: Do not impair intangible assets by $900,000.
- Choosing not to recognize impairment would keep asset values higher, which increases the denominator in ROA. If net profit remains unchanged, a higher asset base would tend to reduce ROA, not improve it. This choice does not support meeting the covenant threshold and would be counterproductive relative to the goal of maintaining ROA at or above 10%.

Across all options, the one that most directly elevates the ROA by increasing reported earnings (the numerator) while keeping the asset base stable is the option involving classifying the $900,000 fair value increase as fair value through profit or loss. The other choices either reduce earnings, fail to affect earnings in a way that helps the covenant, or reduce ROA through other accounting adjustments.

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