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Astor Trucks Ltd builds large trucks for earthmoving and mining clients and uses a revenue recognition policy based on the percentage of work completed on each truck. This requires reliable estimates about the total time and effort required to complete the project, so the percentage completed can be reliably measured. The company has a USD 3 million 10-year loan with a bank with a fixed 10% per annum interest rate (i.e. USD 300 000 per annum). The bank has a covenant with the company that requires the 'times-interest-earned' ratio, calculated as 'EBIT/Loan interest expense', to be at or above 150%. Therefore, if EBIT drops below USD 450 000, this covenant will be breached and the full amount of the loan will become immediately due and payable. Based on your revenue calculations, the company's revenue for the period is USD 4 554 655. The EBIT for the period is USD 418 450. Over the past three years, EBIT has been approximately USD 750 000, so this is seen as a one-off drop in earnings as a result of the economic downturn, and profits should return to normal within the next 12 months. After submitting the draft accounts to the board of directors, senior management have asked you to re-check your calculations and estimates. They explain to you that the company will be in breach of its banking covenants and may become insolvent and have to 'let everyone go' if EBIT does not reach USD 450 000.
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