Category Archives for "Auditing"

SAS 134
Jul 20

SAS 134 Unmodified and Modified Audit Opinions

By Charles Hall | Auditing

In this post, you’ll gain an understanding of unmodified and modified audit opinions using the guidance from AU-C Section 700, Forming an Opinion and Reporting on Financial Statements and AU-C 705, Modifications to the Opinion in the Independent Auditor’s Report. SAS 134 (and other SASs) amended these sections resulting in new audit opinions for periods ending after December 15, 2021. 

There are four potential audit opinions:

  1. Unmodified
  2. Qualified
  3. Disclaimer
  4. Adverse

Video Overview of Audit Opinions

This video provides an overview of the four opinions:

Unmodified Opinion

If there are no material misstatements, then you will issue an unmodified opinion. The unmodified opinion says the financial statements are presented fairly. 

Example SAS 134 Unmodified Opinion

A sample unmodified audit opinion follows:

[Date]

INDEPENDENT AUDITOR’S REPORT

[Appropriate Addressee]

[Entity Name]

Opinion

We have audited the financial statements of [Entity Name], which comprise the balance sheets as of December 31, 2020 and 2019, and the related statements of income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the financial statements.

In our opinion, the accompanying financial statements present fairly, in all material respects, the financial position of [Entity Name] as of December 31, 2020 and 2019, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.

Basis for Opinion

We conducted our audits in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of [Entity Name] and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Responsibilities of Management for the Financial Statements

Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error.

In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about [Entity Name]’s ability to continue as a going concern for one year after the date that the financial statements are available to be issued.

Auditor’s Responsibilities for the Audit of the Financial Statements

Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance but is not absolute assurance and therefore is not a guarantee that an audit conducted in accordance with GAAS will always detect a material misstatement when it exists. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. Misstatements are considered material if there is a substantial likelihood that, individually or in the aggregate, they would influence the judgment made by a reasonable user based on the financial statements.

In performing an audit in accordance with GAAS, we:

    • Exercise professional judgment and maintain professional skepticism throughout the audit.
    • Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, and design and perform audit procedures responsive to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements.
    • Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of [Entity Name]’s internal control. Accordingly, no such opinion is expressed.
    • Evaluate the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluate the overall presentation of the financial statements.
    • Conclude whether, in our judgment, there are conditions or events, considered in the aggregate, that raise substantial doubt about [Entity Name]’s ability to continue as a going concern for a reasonable period of time.

We are required to communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit, significant audit findings, and certain internal control-related matters that we identified during the audit.

Firm Signature

Modified Opinions

If material misstatements are present, then a modified audit opinion is necessary. Modifications can also occur when you are unable to obtain sufficient appropriate audit evidence; for instance, when a scope limitation is present. 

Modified Opinion

Definitions

AU-C 705 defines a modified opinion as a (1) qualified opinion, (2) an adverse opinion, or (3) a disclaimer of opinion. 

Another key definition in AU-C 705 is that of pervasiveness. This term is used in the context of misstatements; so if a material misstatements are present, you’ll want to know if they are pervasive. Two factors–material misstatements and pervasiveness–affect the type of opinion to be issued. Additionally, the ability or inability to obtain sufficient appropriate audit evidence affects the type of opinion to be issued. A misstatement (or possible misstatement) is pervasive if:

  • It’s not confined to specific accounts or items of the financial statement, or
  • If confined, the amount represents a substantial portion of the financial statements, or
  • If in relation to disclosures, the information is fundamental to the users’ understanding of the financial statements

For example, if material misstatements are present for inventory, receivables, and debt, they are pervasive. Or if, in another example, inventory makes up 60% of total assets and a material misstatement is present in that area, then it’s pervasive. Lastly, if key disclosures are not appropriately communicated or if they are omitted, then that is pervasive. 

Now, let’s look at the three modified opinions. 

1. Qualified Opinion

Suppose your audit reveals inventories are materially misstated, the client does not record your proposed audit adjustment, and there are no other material misstatements. If this is your situation (a material misstatement exists that is not pervasive), then audit standards allow for the issuance of a qualified opinion.

modified opinion

Here is sample qualified opinion language (this is not the full opinion):

Qualified Opinion

We have audited the financial statements of ABC Company, which comprise the balance sheets as of December 31, 20X1 and 20X0, and the related statements of income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the financial statements.

In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section of our report, the accompanying financial statements present fairly, in all material respects, the financial position of ABC Company as of December 31, 20X1 and 20X0, and the results of its operations and its cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.

Basis for Qualified Opinion

The Company has property with impaired value. The impairment occurred in 20X9. Accounting principles generally accepted in the United States of America require that impaired assets be written down to their fair market value. The Company continues to reflect the property at cost. If the property was stated at fair value upon impairment, total assets and stockholder’s equity would have been reduced by $X,XXX,XXX as of December 31, 20X1 and 20X0, respectively. 

2. Adverse Opinion

Now let’s suppose that you are auditing a consolidated entity, and your client is not willing to include a material subsidiary and which, if included, would have a pervasive impact on the statements.

Adverse opinion

Here is sample adverse opinion language (this is not the full opinion):

Adverse Opinion

We have audited the consolidated financial statements of ABC Company and its subsidiaries, which comprise the consolidated balance sheet as of December 31, 20X1, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for the year then ended, and the related notes to the financial statements.

In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion section of our report, the accompanying consolidated financial statements do not present fairly the financial position of ABC Company and its subsidiaries as of December 31, 20X1, or the results of their operations or their cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.

Basis for Adverse Opinion

As described in Note X, The Golfing Company has not consolidated the financial statements of its subsidiary Easy-Go Company that it acquired during 20X1. This investment is accounted for on a cost basis by The Golfing Company. Under accounting principles generally accepted in the United States of America, the subsidiary should have been consolidated. Had Easy-Go Company been consolidated, many elements in the accompanying consolidated financial statements would have been materially affected. The effects on the consolidated financial statements of the failure to consolidate have not been determined.

3. Disclaimer of Opinion

Finally, let’s suppose you are performing an audit in which insufficient audit information is provided with regard to receivables and inventories (both of which are material) and that the misstatements have a pervasive impact on the financial statements as a whole.

disclaimer of opinion

Here is sample disclaimer of opinion language (this is not the full opinion):

Disclaimer of Opinion

We were engaged to audit the financial statements of ABC Company, which comprise the balance sheet as of December 31, 20X1, and the related statements of income, changes in stockholders’ equity, and cash flows for the year then ended, and the related notes to the financial statements.

We do not express an opinion on the accompanying financial statements of ABC Company. Because of the significance of the matters described in the Basis for Disclaimer of Opinion section of our report, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion on these financial statements.

Basis for Disclaimer of Opinion

The Company’s accounting system was hacked during the year by an unknown party, resulting in a series of changes in accounting entries. Additionally, the Company was unable to restore the accounting system. As a result of these matters, we were unable to determine the adjustments that were necessary to correct the balance sheet, statement of income, changes in stockholder’s equity, and cash flow statement as of and for the year ended December 31, 20X1.

Effective Date of SAS 134

The new SAS 134 opinions are required for periods ending on or after December 15, 2021. 

Resolving Conflict with Clients

If, as described above, you have a client that is unwilling to post a material audit adjustment, consider creating a draft of the opinion and providing it to them. This is not a threat, just a way to clearly communicate the effect of not posting the adjustment. 

Before doing anything, allow the client to fully explain their position. A modified opinion may not be necessary once you understand the facts. But if after the discussion, the you are still convinced there is a material misstatement, a modified opinion may be necessary.

In some cases, you may want to consider withdrawing from the engagement. Consult with your legal counsel before doing so.

Audit Opinion Research

Deciding on the opinion is often the most important decision you will make in an audit. So, do your research, and, if needed, consult with others to gain assurance about your decisions. AU-C 705: Modifications to the Opinion in the Independent Auditor’s Report provides several sample opinions; so refer to those as you create any modified opinions including qualified, adverse, or disclaimer. See AU-C 700: Forming an Opinion and Reporting on Financial Statements for information about unmodified opinions. 

If you need to add an emphasis of matter or other matter paragraph for issues such as a lack of consistency, see my article.  

Accountant’s ipad
Jul 11

Audit Mistakes: Seven Deadly Sins

By Charles Hall | Auditing

Seven deadly audit sins can destroy you. These audit mistakes kill your profits and effectiveness.

You just completed an audit project, and you have another significant write-down. Last year’s audit hours came in well over budget, and—at the time—you thought, This will not happen again. But here it is, and it’s driving you insane.

Insanity: doing the same thing year after year but expecting different results.

Are you ready for better results?

Audit Mistakes

Here are seven deadly (audit) sins that cause our engagements to fail.

Audit mistakes

1. We don’t plan

Rolling over the prior year file does not qualify as planning. Using canned audit programs is not planning.

What do I mean? We don’t know what has changed. Why? Because we have not performed real risk assessment such as current year walkthroughs. We have not (really) thought about current year risks of material misstatement.

Each year, audits have new wrinkles.

Are there any fraud rumors? Has the CFO left without explanation? Have cash balances decreased while profits increased? Does the client have a new accounting program or new staff? Can you still obtain the reports you need? Are there any new audit or accounting standards?

Anticipate issues and be ready for them with a real audit plan.

2. SALY lives

Elvis may not be in the house, but SALY is.

Performing the same audit steps is wasteful. Just because we needed the procedure ten years ago does not mean we need it today. Kill SALY. (No, I don’t mean your staff member; SALY stands for Same As Last Year).

I find that audit files are like closets. We allow old thoughts (clothes) to accumulate without purging. It’s high time for a Goodwill visit. After all, this audit mistake has been with you too long. So ask yourself Are all of the prior audit procedures relevant to this year’s engagement?

Will better planning require us to think more in the early phases of the engagement? Yes. Is this hard work? Yes. Will it result in less overall effort? Yes.

Sometimes the Saly issue occurs because of weak staff.

3. We use weak staff

Staffing your engagement is the primary key to project success. Excellent staff makes a challenging engagement pan out well. Poor staff causes your engagement time to balloon–lots of motion, but few results. Maybe you have smart people, but they need training. Consider AuditSense.

Another audit mistake is weak partner involvement.

4. We don’t monitor

Partners must keep an eye on the project. And I don’t mean just asking, “How’s it going?” Look in the audit file. See what is going on. In-charges will usually tell you what you want to hear. They hope to save the job on the final play, but a Hail Mary often results in a lost game.

As Ronald Reagan once said: Trust but verify.

Engagement partners need to lead and monitor. They also need to provide the right technology tools.

5. We use outdated technology

Are you paperless? Using portable scanners and monitors? Are your auditors well versed in Adobe Acrobat? Are you electronically linking your trial balances to Excel documents? Do you use project management software (e.g., Basecamp)? How about conferencing software (e.g., Zoom)? Do you have secure remote access to audit files? Do you store files securely in the cloud (e.g., Box)? Are you using data mining software such as Idea? Do you send electronic confirmations

Do your staff members fear you so much that they don’t give you the bad news?

6. Staff (intentionally) hide problems

Remind your staff that bad news communicated early is always welcome.

Early communication of bad news should be encouraged and rewarded (yes, rewarded, assuming the employee did not cause the problem).

Sometimes leaders unwittingly cause their staff to hide problems. In the past, we may have gone ballistic on them–now they fear the same.

And here’s one last audit mistake: no post-engagement review.

7. No post-engagement review

Once our audit is complete, we should honestly assess the project. Then make a list of inefficiencies or failures for future reference.

If you are a partner, consider a fifteen-minute meeting with staff to go over the list.

Your ideas to overcome audit mistakes

What do you do to keep your audits within budget?

Auditing Equity
Jun 22

Auditing Equity: Why and How Guide

By Charles Hall | Auditing

Auditing equity is easy, until it’s not. 

Auditing equity is usually one of the easiest parts of an audit. For some equity accounts, you agree the year-end balances to the prior year ending balance, and you’re done. For instance paid-in-capital seldom changes. Often, the only changes in equity are from current year profits and owner distributions. And testing those equity additions and reductions in equity takes only minutes.

Nevertheless, auditing equity can be challenging, especially for businesses that desire to attract investors. Such companies offer complicated equity instruments. Why? The desire to attract cash without giving away (too much) power. And this balancing act can lead to complex equity instruments.  

Regardless of whether a company’s equity is easy to audit or not, below I show you how to focus on important equity issues.

Auditing Equity

Auditing Equity — An Overview

In this post, we will cover the following:

  • Primary equity assertions
  • Equity walkthroughs
  • Equity-related fraud and errors
  • Directional risk for equity
  • Primary risks for equity
  • Common equity control deficiencies
  • Risk of material misstatement for equity
  • Substantive procedures for equity
  • Common equity work papers
Continue reading
Audit Lessons from a Brain Tumor
May 20

Audit Lessons from a Brain Tumor

By Charles Hall | Auditing

Did you know you can learn audit lessons from a brain tumor? Here’s my story.

One day while driving, I said to my wife, “Am I weaving?” I did not feel in control, and I was hearing clicking noises in my ears. My conditions worsened and the mystery grew over the next two years as I visited three doctors. They stuck, prodded, and probed me, but no solution.

Frustrating.

Audit Lessons from a Brain Tumor

As time passed, I felt a growing numbness on the right side of my face. So one night I started Googling health websites (the thing they tell you not to do) and came upon this link: Acoustic Neuroma Association. I clicked and read, having never heard of an acoustic neuroma. While reading about the symptoms, it was as though I was staring at my diary. My next thought was “it can’t be a brain tumor.” I turned to my wife behind me and said, “this is what I have.”

The next day I handed the acoustic neuroma information to my doctor, asking, “Would you please order a brain scan?”

Two days after the MRI, I received my doctor’s call while on a golf course. He said, “Mr. Hall, you were right. You have a 2.3-centimeter brain tumor.” (I sent him a bill for my diagnosis, but was never paid–just kidding.) My golfing buddies gathered around and prayed for me on the 17th green, and I went home to break the news to my wife. We had two children at the time, ages two and four. Having just started my own CPA business six years before, I was forty-one years old. So, as you can imagine, I was concerned about my family and business, but strangely, I was completely at peace.

Shortly after that, I was in a surgeon’s office in Atlanta. The doctor said they’d do a ten-hour operation; there was a 40% chance of paralysis and a 5% chance of death. The tumor was too large for radiation–or so I was told.

I didn’t like the odds, so I prayed more and went back to the Internet. There I located Dr. Jeffrey Williams at Johns Hopkins Hospital in Baltimore. I emailed the good doctor, telling him of the tumor’s size. His response: “I radiate tumors like yours every day.” He was a pioneer in fractionated stereotactic radiation, one of the few physicians in the world (at that time) using this procedure.

A few days later, I’m lying on an operating table in Baltimore with my head bolted down, ready for radiation. They bolt you down to ensure the cooking of the tumor (and not your brain). Fun, you should try it. Four more times I visited the table, and I kept noticing everyone left the room–a sure sign you should not try this at home.

Each day I laid there silently, talking to God and trusting in Him. And my wife sat outside, lifting me up in prayer.

Three weeks later I returned to work. Twenty-two years later, I have had two sick days.

I’ve watched my children grow up. They are twenty-six and twenty-eight now–both finished college at the University of Georgia (Go Dawgs!). And a year and a half ago, my daughter had our first grandchild. My wife is still by my side, and I’m thankful for each day. Here’s a recent picture of my family at one of our favorite places: Cades Cove, Tennessee.

So what does a brain tumor story tell us about audits? (You may, at this point, be thinking, “they did cook his brain.”)

Audit Lessons Learned from a Brain Tumor

1. Pay Attention to Signs

It’s easy to overlook the obvious. Maybe we don’t want to see a red flag (I didn’t want to believe I had a tumor). It might slow us down. But an audit is not purely about finishing and billing. It’s about gathering proper evidential matter to support the opinion. To do less is delinquent and dangerous.

2. Seek Alternatives

If you can’t gain appropriate audit evidence one way, seek another. Don’t simply push forward, using the same procedures year after year. The doctor in Atlanta was a surgeon, so his solution was surgery. His answer was based on his tools, his normal procedures. If you’ve always used a hammer, try a wrench.

3. Seek Counsel

If one answer doesn’t ring true, see what someone else thinks, maybe even someone outside your firm. Obviously, you need to make sure your engagement partner agrees (about seeking outside guidance), but if he or she does, go for it. I often contact the Center for Plain English AccountingI find them helpful and knowledgeable. I also have relationships with other professionals, so I call friends and ask their opinions–and they call me. Check your pride at the door. I’d rather look dumb and be right than to look smart and be wrong.

4. Embrace Change

Fractionated stereotactic radiation was new. Dr. Williams was a pioneer in the technique. The only way your audit processes will get better is to try new techniques: paperless software (we use CCH Prosystem Engagement), data mining (we use TeamMate Analytics), real fraud inquiries (I use ACFE techniques), electronic bank confirmations (I use Confirmation.com), project management software (I use Basecamp). If you are still pushing a Pentel on a four-column, it’s time to change.

Postscript

Finally, remember that work is important, but life itself is the best gift. Be thankful for each moment, each hour, each day. 

Auditing Debt
Apr 25

Auditing Debt: The Why and How Guide

By Charles Hall | Auditing

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.

Auditing 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
  • Debt-related fraud
  • Debt mistakes
  • 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 include:

  • Completeness
  • Classification
  • Obligation

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.

Debt 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.

Debt Walkthrough

As you perform your debt walkthrough ask or perform the following:

  • Are there any debt covenant violations?
  • If the company has violations, is the debt classified appropriately (usually current)?
  • Is someone reconciling the debt in the general ledger 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?
  • Who approves new leases? Who handles lease accounting and are they competent?
  • Does the company have any leases that should be recorded as debt?
  • Inspect new loan and lease approvals. 
  • How are debt service payments made (e.g., by check or wire)? Who makes those payments?
  • 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 loan proceeds,
    • Recording debt in the general ledger, and
    • Reconciling the debt in the general ledger to the loan amortization schedules
  • Is the company required to file periodic (e.g., quarterly) reports with the lender? Inspect sample debt-related reports, if applicable.
  • Does the company have any convertible debt or debt with detachable warrants? Are they properly recorded?
  • Is the company following reporting framework requirements (e.g., FASB Codification) for debt?
  • 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 accounted for properly based on the reporting framework requirements? (FASB requires the netting of such costs with debt.)
  • Has the company guaranteed the debt of another entity?

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.

Debt-Related Fraud

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.

Debt Mistakes

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 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?

Directional Risk for Debt

Auditing Debt

The directional risk for debt is an understatement. So, audit for completeness (and determine that all debt is recorded).

Primary Risks for Debt

Primary risks for debt include:

  1. Debt is intentionally understated (or omitted)
  2. Debt is recorded as noncurrent (due more than one year from the balance sheet date) though the amount is current (due within one year of the balance sheet date)

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.

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 debt issuance
  • Funds are borrowed without appropriate approval
  • Debt postings are not agreed to amortization schedules
  • Accounting personnel don’t understand the accounting standards for debt (including lease accounting)

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, completeness, and obligation. So my risk of material misstatement for these assertions is usually moderate to high. 

Auditing Debt

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.

Substantive Procedures for Debt

My customary tests for auditing debt are as follows:

  1. Summarize and test debt covenants
  2. Review new leases to determine if debt should be recorded
  3. Confirm all significant debt with lenders
  4. Determine if all debt is classified appropriately (as current or noncurrent)
  5. Agree the end-of-period balances in the general ledger to the amortization schedules
  6. Agree future debt service payment summaries to amortization schedules 
  7. Review accruals of any significant interest 
  8. Review interest expense (usually comparing current and prior year interest)

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 internal control deficiencies related to debt
  • Risk assessment of debt at the assertion level
  • Debt audit program
  • A copy of all significant debt agreements (including lease 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
  • Summary of all debt information for disclosure purposes (e.g., future debt service to be paid, interest rates, types of debt, collateral, etc.) 

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 Summary

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.

To understand the new lease standard (ASC 842) from the lessee’s perspective, see my lease article: Account for Finance and Operating Leases

Next we’ll look at how to audit equity.


>