Area II: Balance Sheet Accounts — CPA Practice Question 31

Q: What mistakes do candidates make on this CPA question?

Inverting the ratio (equity ÷ debt), misinterpreting whether the calculated ratio violates the covenant, or mathematical errors in the division

How to approach this question

Calculate debt-to-equity ratio as total debt divided by total stockholders' equity. Compare the result to the covenant requirement to determine compliance.

Full Answer

A.Yes, the debt-to-equity ratio is 1.89:1, which is below the 2.0:1 maximum✓ Correct

Debt covenants are contractual agreements that require maintaining certain financial ratios. The debt-to-equity ratio measures financial leverage. Pacific's ratio = $1,800,000 ÷ $950,000 = 1.89:1. Since 1.89 < 2.0, Pacific is in compliance with the covenant requirement.

Common mistakes

Inverting the ratio (equity ÷ debt), misinterpreting whether the calculated ratio violates the covenant, or mathematical errors in the division

Pacific Corp. has a debt covenant that requires maintaining a debt-to-equity ratio of no more than 2.0:1. At year-end, Pacific has:<br/>- Total debt: $1,800,000<br/>- Total stockholders' equity: $950,000<br/><br/>Is Pacific in compliance with its debt covenant?

How to approach this question

Full Answer

Common mistakes

Practice the full CPA FAR Practice Exam 2

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