1. Cambridge Construction Company follows the percentage-of-completion method for reporting long-term contract revenues. The percentage of completion is based on the cost of materials shipped to the project site as a percentage of total expected materials costs. Cambridge's major debt agreement includes restrictions on net worth, interest coverage, and minimum working capital requirements. A leading analyst claims that "the company is buying its way out of these covenants by spending cash and buying materials, even when they are not needed." Explain how this may be possible.
2. Can Cambridge improve its Z score by behaving as the analyst claims in Question 1? Is this change consistent with economic reality?
1. This may be possible because since revenues and expenses of this contract of the project are recognized only as a percentage of work completed during the year, Cambridge may use as much cash as possible to make it look as though the project is not profitable. Of course this would be by tying down materials which lower the firm's net worth as it would be ...
This solution discusses how using the cost of materials shipped to the project site to determine percentage-of-completion can be manipulated by Cambridge's management in 252 words.