What are the keys to auditing debt?
While auditing debt can be simple, sometimes it’s tricky. For instance, classification issues can arise when debt covenant violations occur. Should the debt be classified as current or noncurrent? Likewise, some forms of debt (with detachable warrants) have equity characteristics, again leading to classification issues. Is it debt or equity—or both? Additionally, leases can create debt, even if that is not the intent.
Most of the time, however, auditing debt is simple. A company borrows money. An amortization schedule is created. And thereafter, debt service payments are made and recorded.
Either way, whether complicated or simple, below I show you how to audit debt.
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:
The primary relevant debt assertions include:
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, I mean it is properly displayed as either short-term or long-term. I also mean the instrument is debt and recorded as such (and not equity). By obligation, I mean the debt is legally owed by the company and not another entity.
Keep these three 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.
As you perform your debt walkthrough ask or perform the following:
If control weaknesses exist, create audit procedures to address them. For example, if—during the walkthrough—we see that one person approves loans, deposits loan proceeds, and records the related debt, then we will perform fraud-related substantive procedures.
A company can fraudulently inflate its equity by intentionally omitting debt from its balance sheet. (Total assets equal liabilities plus equity. Therefore, if debt is not reported, equity increases.)
As we saw with Enron, some entities place their debt on another company’s balance sheet. (Enron did so using special purpose entities.) So auditors need to consider that companies can intentionally omit debt from their balance sheets.
Another potential fraudulent presentation is showing short-term debt as long-term. When might this happen? When debt covenant violations occur. Such violations can trigger a requirement to classify the debt as current. If accounting personnel are aware of the requirement to classify debt as current and don’t do so, then the reporting can be considered fraudulent.
Additionally, mistakes can lead to errors in debt accounting.
Errors in accounting for debt can occur when debt service payments are misclassified as expenses rather than a reduction of debt. Also, debt can—in error—be presented as long-term when it is current. Why? Maybe the company’s accountant doesn’t understand the accounting rules.
Some forms of debt, such as certain types of leases, can be difficult to interpret. Consequently, a company might errantly fail to record debt when required.
So, what is the directional risk for debt? An overstatement or an understatement?
The directional risk for debt is an understatement. So, audit for completeness (and determine that all debt is recorded).
Primary risks for debt include:
It’s obvious why a company might want to understate its debt. The company looks healthier. But why would a business desire to classify current debt as noncurrent? For the same reason: to make the company look stronger. By recording current debt as noncurrent, the company’s working capital ratio (current assets divided by current liabilities) improves.
As you think about the above risks, consider the control deficiencies that allow debt misstatements.
In smaller entities, it is common to have the following control deficiencies:
Another key to auditing debt is understanding the risks of material misstatement.
In auditing debt, the assertions that concern me the most are classification, completeness, and obligation. 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 debt and lease agreements—and the related accounting. Why?
As we saw above, debt covenant violations may require the company to reclassify debt from noncurrent to current. Doing so can be significant. The loan could be called by the lender, depending on the loan agreement. So, proper classification of debt can be critical.
Also, some leases should be recorded as debt. If such leases are not recorded, the company looks healthier than it is. Our audit should include procedures that address the completeness of debt and the obligations of the company.
Once your risk assessment is complete, decide what substantive procedures to perform.
My customary tests for auditing debt are as follows:
In light of my risk assessment and substantive procedures, what debt work papers do I normally include in my audit files?
My debt work papers normally include the following:
If there are questions regarding debt agreements and their presentation, I include additional language in the representation letter to address the issues. For example, if an owner loans funds to the company but there is no written debt agreement, the owner or management might verbally explain the arrangement. In such cases, I include language in the management representation letter to cover the verbal responses.
In this article we’ve 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.
Next we’ll look at how to audit equity.
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Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty years, he has primarily audited governments, nonprofits, and small businesses. He is the author of The Little Book of Local Government Fraud Prevention and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events. Charles is the quality control partner for McNair, McLemore, Middlebrooks & Co. where he provides daily audit and accounting assistance to over 65 CPAs. In addition, he consults with other CPA firms, assisting them with auditing and accounting issues.
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