Eugene Wright is CFO of Caribbean Cruise Lines. The company offers luxury cruises. It's near year-end, and Eugene is feeling kind of queasy. The economy is in a recession, and demand for luxury cruises is way down. Eugene doesn't want the company's current ratio to fall below the 1.0 minimum stated in its debt covenant with First Federal Bank. If the company reports a current ratio below 1.0 at year-end, First Federal may require immediate repayment of its $8 million loan, which is not due for another two years.
At the end of the year, Caribbean Cruise Lines reports current assets of $10.1 million and current liabilities of $10 million. These amounts include advanced payments of $1 million from customers in December for cruises to be provided the following summer. Instead of treating the $1 million as deferred revenue, Eugene decided to count the cash received as revenue. He reasoned that cash has already been collected and the company has a long history of providing cruises, so customers will be provided their cruise as scheduled and the company will have cash to pay the bank in the future.
Required:
1. Understand the reporting effect: How does Eugene's decision affect the reported amount of current assets and current liabilities at the end of December?
2. Specify the options: Calculate the current ratio assuming the $1 million is treated as (a) service revenue or (b) deferred revenue.
3. Identify the impact: Does Eugene's decision have an effect on First Federal Bank?