What are the keys to auditing debt correctly?
While auditing debt can be simple, sometimes it gets tricky. You might even get eclipsed by the accounting! The violation of covenants can darken the sky. Also, some companies keep debt off the books by structuring leases to avoid capitalization. So, put on your shades and let’s take a look at how to audit debt.
Auditing Debt — An Overview
In many governments, nonprofits, and small businesses debt is a significant part of total liabilities. Consequently, it is often a significant transaction area.
In this post, we will cover the following:
- Primary debt assertions
- Debt walkthroughs
- Directional risk for debt
- Primary risks for debt
- Common debt control deficiencies
- Risk of material misstatement for debt
- Substantive procedures for debt
- Common debt work papers
Primary Debt Assertions
The primary relevant debt assertions are:
I believe—in general—completeness and classification are the most important debt assertions. When a company shows debt on its balance sheet, it is asserting that it is complete and classified correctly. By classification, we mean it is properly displayed as either short-term or long-term.
Keep these assertions in mind as you perform your transaction cycle walkthroughs.
Early in your audit, perform a walkthrough of debt to see if there are any control weaknesses. As you perform this risk assessment procedure, what questions should you ask? What should you observe? What documents should you inspect? Here are a few suggestions.
Walkthrough Questions and Actions
As you perform your debt walkthrough ask or perform the following:
- Are there any debt covenants?
- Does the company have any covenant violations?
- If the company has violations, is the debt classified appropriately (usually current)?
- Is the company reconciling the balance sheet to a loan amortization schedule?
- Inspect amortization schedules.
- Does the company have any unused lines of credit or other credit available?
- Inspect loan documents.
- Has the company refinanced its debt with another institution? Why?
- Who approves the borrowing of new money?
- Inspect loan approvals.
- How are debt service payments made (e.g., by check or wire)?
- Are there any sinking funds? If yes, who is responsible for making deposits and how is this done?
- Observe the segregation of duties for persons:
- Approving new loans,
- Receipting new loan proceeds,
- Recording debt in the general ledger, and
- Reconciling the debt on the balance sheet to the loan amortization schedules
- Is the company required to file any periodic (e.g., quarterly) reports with the lender?
- Inspect sample quarterly debt reports, if applicable.
- Does the company have any capital leases?
- Who is responsible for determining whether a lease should be capitalized?
- What criteria is the company using to capitalize leases?
- Has collateral been pledged? If yes, what?
- What are the terms of the debt agreements?
- Has all debt of the company been recorded in the general ledger?
- Have debt issuance costs been netted against debt in the financial statements?
- Has the company guaranteed the debt of another entity?
If control weaknesses exist, create audit procedures to respond to them. For example, if—during the walkthrough—we see that one person approves loans and deposits loan proceeds, then we will perform fraud-related substantive procedures.
Companies can intentionally omit debt from their balance sheets in order to inflate their equity total. (Since total assets equal liabilities plus equity, then equity goes up if debt is omitted.)
As we saw with Enron many years ago, some entities try to move their debt to other entities. So auditors need to consider that a company may intentionally omit debt from its balance sheet.
Another potential fraudulent presentation is showing short-term debt as long-term. When might this happen? When there is a debt covenant violation. The company may need to present the debt as current when such violations occur. Here’s how to report debt covenant violations.
Additionally, mistakes can lead to errors in debt accounting.
Debt errors may occur when accounting personnel misclassify debt service payments. Also, debt can be mistakenly presented as long-term when it is current.
We also need to consider the directional risk for debt.
Directional Risk for Debt
The directional risk for debt is that it is understated. So, audit for completeness (and determine that all debt is recorded).
Primary Risks for Debt
The primary risks for debt are:
- Debt is intentionally understated (or omitted)
- Debt is not classified as current though there is a covenant default that requires such treatment
As you think about these risks, consider the control deficiencies that allow debt misstatements.
Common Debt Control Deficiencies
In smaller entities, it is common to have the following control deficiencies:
- One person performs two or more of the following:
- Approves the borrowing of new funds,
- Enters the new debt in the accounting system,
- Deposits funds from the new debt
- Funds are borrowed without appropriate approval
- Debt postings are not agreed to an amortization schedule
- The accounting personnel don’t understand the accounting standards for debt covenant violations and lease capitalization
Another key to auditing debt is understanding the risks of material misstatement.
Risk of Material Misstatement for Debt
In auditing debt, the assertions that concern me the most are classification and completeness. So my risk of material misstatement for these assertions is usually moderate to high.
My response to the higher risk assessments is to perform certain substantive procedures: namely, a review of debt covenant compliance and a review of lease accounting. Why?
A company desires to display debt as long-term (even though it is short-term). Doing so makes working capital (current assets minus current liabilities) stronger. If a debt covenant violation causes debt to be current, working capital can tank quickly. So, the temptation is to show debt as long-term even though it is technically current.
Additionally, debt issuance costs are a deduction from debt. Review the classification of these costs which prior to ASU 2015-03 were assets. See this post for more information.
And one more thing. If capital leases are not capitalized (though they should be), the debt does not appear on the balance sheet, making the company look healthier than it is. (FASB has issued a new lease standard that will require the capitalization of all leases of more than one year, but it’s not presently effective. You can see ASU 2016-02, Leases here.)
Once your risk assessment is complete, you’ll decide what substantive procedures to perform.
Substantive Procedures for Debt
My customary tests for auditing debt are as follows:
- Summarize and review all debt covenants
- Review all leases for correct classification as capital or operating
- Confirm all significant debt with the lender
- Determine if all debt is classified appropriately (as current or noncurrent)
- Agree the end-of-period balances on the balance sheet to the amortization schedule
- Review any significant accrued interest at period-end
In light of my risk assessment and substantive procedures, what debt work papers do I normally include in my audit files?
Common Debt Work Papers
My debt work papers normally include the following:
- An understanding of debt-related internal controls
- Documentation of any debt internal control deficiencies
- Risk assessment of debt at the assertion level
- Debt audit program
- A copy of all significant debt agreements (including leases and line-of-credit agreements)
- Minutes reflecting the approval of new debt
- A summary of debt activity (beginning balance plus new debt minus principal payments and ending balance)
- Amortization schedules for each debt
If there’s any question about debt agreements and their presentation, I include additional representation letter language to address the issue.
In summary, today we looked at the keys to auditing debt. Those keys include risk assessment procedures, determining relevant assertions, creating risk assessments, and developing substantive procedures. The most important issues to address are usually (1) the classification of debt (especially if debt covenant violations exist) and (2) lease accounting.
Look for my next post in The Why and How of Auditing. Next week we’ll look at how to audit equity.
If you’ve missed my prior posts in this audit series, click here.
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