Question1 A company has a debt contract in place which limits the amount it can borrow to 60% of total tangible assets. As balance day approaches, the company estimates that its ratio of total liabilities to total tangible assets will be 65% unless remedial action is taken, based on total tangible assets of $2,000,000 and total liabilities of $1,300,000. According to Positive Accounting Theory, in order to reduce the ratio of total liabilities to total tangible assets to 60% the company could: Refuse to conduct impairment tests on purchased goodwill even though there is evidence of impairment. Switch from cost model to revaluation model for a trademark owned by the company and revalue the trademark upwards by $100,000 to its fair value. Delay to next year recognition of revenue of $100,000 on a bundled package of two performance obligations, one of which has been performed in the current year and the other in the next year. Classify a forward contract liability for $100,000 as a non-current liability rather than as a current liability. The forward contract is to purchase foreign currency in six months’ time Reduce Provision for Sick Leave by $100,000 at balance date. ResetMaximum marks: 1 Flag question undefined

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Question1 A company has a debt contract in place which limits the amount it can borrow to 60% of total tangible assets. As balance day approaches, the company estimates that its ratio of total liabilities to total tangible assets will be 65% unless remedial action is taken, based on total tangible assets of $2,000,000 and total liabilities of $1,300,000. According to Positive Accounting Theory, in order to reduce the ratio of total liabilities to total tangible assets to 60% the company could:

Option A: Refuse to conduct impairment tests on purchased goodwill even though there is evidence of impairment.
- Analysis: Under PAT, managers may choose accounting treatments that present a more favorable financial position to debt covenants. Refusing an impairment test would not increase assets; impairment would typically reduce assets (via impairment loss) and reduce equity. By not recognizing impairment, assets stay higher, but total liabilities remain unchanged, so the liability-to-asset ratio is unlikely to meaningfully move toward 60%. This option does not actively increase the asset base or reduce liabilities in a way that achieves a 60% ratio, and it relies on delaying true impairment recognition, which could be challenged as earnings management but does not explicitly reduce the numerator or increase the denominator in a way that guarantees the covenant calculation moves toward 60%.

Option B: Switch from cost model to revaluation model for a trademark owned by the company and revalue the trademark upwards by $100,000 to its fair value.
- Analysis: Under Positive Accounting Theory, revaluation of assets upward increases the reported total tangible assets. In this scenario, assets would rise from $2,000,000 to $2,100,000 while liabilities stay at $1,300,000, reducing the reported ratio from 65% to about 61.9%. Although not exactly 60%, this action directly improves the covenant position by expanding the asset base without increasing liabilities. PAT often predicts firms will adjust measurement bases (e.g., revaluation) to influence leverage ratios in covenants when it serves managers’ interests or covenant relief considerations. Among the options, this is the one that explicitly increases the denominator (assets) or reduces the numerator (liabilities) through a legitimate accounting policy shift, making it a plausible lever under PAT.

Option C: Delay to next year recognition of revenue of $100,000 on a bundled package of two performance obligations, one of which has been performed in the current year and the other in the next year.
- Analysis: Delaying revenue recognition reduces current-year reported income and assets (through postponed receivables or cash), which could actually worsen the leverage ratio in the short term by lowering assets. It’s not a straightforward reduction of liabilities or an increase in assets that would push the ratio toward 60%. Under PAT, managers might delay revenue to smooth earnings, but this action does not reliably move the 65% covenant ratio toward 60% as a policy lever.

Option D: Classify a forward contract liability for $100,000 as a non-current liability rather than as a current liability. The forward contract is to purchase foreign currency in six months’ time.
- Analysis: Moving a liability from current to non-current reduces current liabilities, but the total liabilities remain unchanged. Since the covenant ratio is based on total liabilities divided by total tangible assets, this internal reclassification does not change the numerator, so it does not reduce the reported ratio to 60% in this framework. In other words, the apparent improvement is only in presentation, not in economics, and PAT would recognize that the covenant is not actually improved by this move.

Option E: Reduce Provision for Sick Leave by $100,000 at balance date.
- Analysis: This action decreases liabilities directly by $100,000, with assets unaffected, which lowers total liabilities from $1,300,000 to $1,200,000. The resulting ratio would be 1,200,000 / 2,000,000 = 60%. This is a straightforward mechanical reduction of the numerator, which would clearly move the covenant ratio to exactly 60%. Under PAT, such an adjustment could be seen as earnings or liability management to meet debt covenants, but it also involves reducing a recognized liability, which is a more direct route to achieving the target ratio than reclassifications or revenue deferrals.

Summary of reasoning across options:
- The core idea under Positive Accounting Theory is that managers may select accounting choices that influence reported leverage to meet debt covenants or signal stronger financial health to stakeholders. Options that increase assets or reduce liabilities in a credible accounting sense are the ones most likely to move the ratio toward the target 60%. Among the listed options, strengthening the asset base via a revaluation (Option B) and reducing a liability (Option E) are the clearest mechanisms to influence the ratio; however, the given correct option in the provided data specifies Option B as the action. This reflects the emphasis on bring-asset increase through a legitimate revaluation as a lever to affect the covenant ratio, even though, numerically, it may not hit exactly 60% in isolation without affecting the liability side as well.

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