Question

If the management of an entity is close to breaching a debt covenant that requires maintaining a certain current ratio, management may have an incentive to ________.

Answer 1

Answer: The management may have to either underestimate current asset or overstate current liabilities

Current liabilities are typically settled using current assets, which are assets that are used up within one year. Examples of current liabilities include accounts payable, short-term debt, dividends, and notes payable as well as income taxes owed.

Explanation:

An overstated balance is an account balance that is reported as having a greater balance than it actually does, while an understated balance is one that is reported as having a lesser balance than it actually does... Because an expense account is understated, net income (or loss) is overstated.

Liabilities and expenses are exaggerated to understate the amount of profit and to avoid distributing funds to shareholders and pay less tax on the taxable profits. When a company is overstating its expenses and liabilities, it is showing the untrue inflated amount of obligations and expenses to the shareholders.