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.
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 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.
As you perform your debt walkthrough ask or perform the following:
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.
The directional risk for debt is that it is understated. So, audit for completeness (and determine that all debt is recorded).
The primary risks for debt are:
As you think about these 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 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.
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’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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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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