a2m5 auditing ap and debt - allen pritchett & bassett, llp ap accrued... · auditing a/p,...

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Auditing A/P, Accrued Expenses, and Debt

A2M5/15/01


Learning Objectives

• Discuss typical audit risks and special considerations.

• Tailor audit plan to assessed audit risk.

• Evaluate results of the search for unrecorded liabilities.

• Assess the propriety of accrued estimates.

• Evaluate debt covenant compliance:

– Alter financial statement presentation and disclosure for noncompliance.

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Accounts Payables Defined

• Generally relates to purchases of goods or services.

• Created with passage of title or receipt of benefit in accounting period.

• Must recognize, even if no statement or invoice received.

• May be deposits received in advance of delivery of goods or services.

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Accrued Liabilities

• Incurred, but not yet paid, in current period.

• In accordance with matching principle.

• Based on operations:

– Sales tax, income tax, payroll, bonuses.

• Based on estimates:

– Property taxes, warranty obligations.

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Primary Assertions

1. Existence -- Obligations for benefits received in current period.

2. Completeness -- All authorized obligations.

3. Obligations -- Unpaid costs and expenses.

4. Valuation -- Computed and classified.

5. Accuracy or classification -- Related party.

6. Cut-off.

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Exhibit 1: Typical Accounts Payable and Accrued

Liability Audit Procedures

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Search for Unrecorded Liabilities

• Cut-off test of trade payables.

• Search for significant commitments and contingencies relating to current year.

• Disbursements, unpaid invoices, vendor statements, and entries to accounts payable.

• Staggered scope.

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Exhibit 2: Search for Unrecorded Liabilities Case Study

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Substantive Analyticals

• Accrued payroll:

– First payroll report of next year.

• Accrued payroll taxes/benefits:

– Percentage of total salaries.

• Accrued real estate taxes:

– Prior year, considering changes.

• Accrued interest:

– Percentage of total debt.

• Accrued commissions:

– Percentage of December sales.

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Loss Contingency

• Likelihood that future event(s) ranges from probable to remote.

• Term loss is used for convenience:

– Includes many charges against income commonly referred to as expenses, and others referred to as losses.

• Purpose is to require loss accrual when they are reasonably estimable and relate to the current or prior period.

• Disclosure is preferable to accrual when a reasonable estimate of loss cannot be made.

• Losses that are reasonably estimable are not accruable if it is not probable that asset impaired or liability incurred.

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Uncertainties That Could Result in Future Loss

• Collectibility of receivables.

• Obligations related to product warranties/defects.

• Loss from catastrophes assumed by property and casualty insurance entities, including reinsurance entities.

• Guarantees of indebtedness of others.

• Obligations of commercial banks under standby letters of credit.

• Agreements to repurchase receivables, or the related property, that have been sold.

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Substantive Audit Procedures to Test Contingencies

• Reviewing and testing the process used by management to develop the estimate.

• Developing an independent expectation of the estimate:

– May require the use of a specialist, including legal counsel.

• Reviewing subsequent events or transactions occurring prior to the date of the auditor’s report.

• Review minutes of meetings with those charged with governance.

• Review legal and professional expense accounts and invoices.

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Exhibit 3: Key Controls

Exhibit 4: EvaluatingAccrued Estimates

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Debt -- Typical Audit Procedures

• Reading terms and confirmation typical.

• Inquiry, representation, and review of minutes.

• Identify special terms and provisions.

• Roll-forward schedule.

• Analytically testing interest and accruals.

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Why Debt Classification Key?

• Debt covenants are often affected by current vs. concurrent classification (e.g., working capital).

• Potential lenders assess borrower’s liquidity and credit risk.

• Surety providing performance bond to assess service fees.

• Ratings agencies to determine credit ratings.

• Auditors to assess going concern uncertainty.

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Short-Term Debt

• Generally evidenced by promissory note.

• Recorded and presented at present value:

– Normally face value.

– Unless no stated interest rate or interest rate is unreasonable, then use effective interest rate implied in note.

• Trade notes payable -- Issued to trade creditors.

• Nontrade notes payable -- Issued to banks, officers, or similar.

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Due on Demand

• “Current” absent unconditional waiver in proper form.

• Assessment of likelihood of lender exercising right is not relevant in classification.

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Subjective Acceleration Clauses

• E.g., material adverse change in operations, significant decline in market value of collateral.

• If default probable and probable creditor will call debt – Current.

– If unconditional waiver in proper form -- Long-term.

• If likelihood is possible -- Long-term with disclosure that could be called sooner.

• If likelihood is remote -- Long-term with no special disclosure.

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Audit Procedures -- Subjective Acceleration

• Identify any events that would trigger subjective acceleration.

• Consider likelihood of occurrence within one year of the B/S date.

• Consider continuation of any existing deteriorating conditions, such as recurring operation losses.

• Consider likelihood that lender will call loan:

– Consistent with lender’s past practice.

– Borrower’s historic ability to predict lender’s past practice.

– Borrower’ ability to modify expectations for current conditions.

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S-T Obligations Expected to Refinance

• S-T obligations expected to be refinanced as L-T are not “current”:

– Assumes refinancing is probable, not just possible.

• Both conditions must be met in order to be classified as L-T:

1. Management must intend to refinance on a L-T Basis.

2. Management must demonstrate an ability to refinance.

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Intent to Refinance Considerations

• Agreement must not expire within one year from B/S date.

• Agreement cannot be cancellable by lender for subjective reasons:

– Even if grace period for curing subjective violations.

– May contain objective cancellable or callable provisions.

• No violation of any provisions can exist at B/S date or at F/S issuance date:

– Waiver may make the refinancing agreement still valid.

• Lender expected to be capable of honoring agreement.

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Demonstrating Ability to Refinance

• Actual L-T refinancing during the period between B/S date and date F/S issued.

• Equity securities issued for refinancing before F/S issued.

• Reaching a clear and firm agreement with lender that extends beyond one year.

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Refinancing Obtained BeforeB/S Date

• If borrower obtains funds from L-T financing before the B/S date, and those funds used as basis for reclassifying S-T debt as L-T:

– Related designated funds are also classified as L-T assets.

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Refinancing Obtained After B/S Date

• If borrower obtains L-T funds or agreement post-B/S date to refinance a S-T obligation:

– Only the amount of the S-T debt that is covered is noncurrent.

• If after B/S date, but before F/S available for issuance, borrower repays S-T obligation and then gets replacement L-T financing:

– S-T obligation classified as current.

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Efforts to Secure Alternative Financing

• Taints classification of S-T debt as L-T if no intent to use the “in place” agreement if alternative financing does not come through.

• May occur because “in place” agreement has unreasonable terms, like excessive interest rates or collateral requirement.

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Replacing S-T Debt with OtherS-T Debt

• Borrower must have option to renew, extend, or replace S-T debt for an uninterrupted period beyond one year from B/S date.

– E.g., revolving credit agreement or rollover of commercial paper accompanied by standby credit agreement.

• Current classification if borrowings are due when underlying S-T notes roll over (e.g. in 90 days).

• If subjective acceleration clause, classification depends on likelihood of lender exercising rights.

– Unless there is a lock-box arrangement controlled by the lender.

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Revolving Credit Agreements: L-T Classification

• Borrowings are due at a specified period that extends beyond one year from the F/S date.

– Principal does not roll over until MORE than one year past F/S date?

– Principal is only due at maturity that is MORE than one year from the F/S date?

• S-T notes are automatically replaced with other S-T notes that extends the process beyond one year.

– E.g., series of automatic renewals or replacements every 60 days.

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Lock-Box Arrangements

• If maintained at the borrower’s discretion, no impact on debt classification.

– If subjective acceleration clause (e.g., material adverse change in operations), classification depends on likelihood.

• If maintained at lender’s discretion, noncurrent if cash received is automatically and contractually used to repay borrowings.

– If subjective acceleration clause, automatically current.

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“Springing” Lock-Box Arrangement

• Existence alone does not impact debt classification.

• Lender may only use the cash to automatically repay the borrowings if another substantive event occurs (e.g., failure to maintain satisfactory operations):

– I.e., there is an event that “springs” the lender’s ability to contractually apply discretion on use of cash received into the lock-box.

• Classification depends on likelihood of lender exercising rights under the subjective acceleration clause.

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Lines of Credit

• Negotiated lending arrangement with terms agreed prior to the need for borrowing.

• NOT an actual liability until drawn.

• Disclose unused liquidity available.

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Secured Debt

• Mortgage:

– Backed by collateralized assets.

– Generally payable in equal installments.

– Report as cash amount that would satisfy the obligation.

• Secured loan:

– Similar to a mortgage, as backed by certain assets.

– Used to reduce interest cost to borrower and collectability risk to lender.

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Troubled Debt Restructuring

• Creditor makes concessions or revises original terms for economic or legal reasons:

– E.g., suspension of interest payments for a period of time, reduction in interest rates, extension of maturity date, exchange of assets to pay off debt, etc.

– A gain or loss may be recognized at time of restructuring.

• If no concessions, then report as an extinguishment of the debt prior to maturity.

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Transfer of Assets for Full Settlement

• Debtor transfers assets to creditor:

– E.g., real estate, inventory, receivables, investments, etc.

– Called an “Asset Swap”

• Debtor usually requires recognition of two gains or losses:

– Gain/Loss on asset disposal (MV Asset – Carrying Value Asset).

– Gain on concessions granted (MV of Asset – CV of Liquidated Debt).

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Modification of Debt Terms

• May involve modifications to interest or maturity date or both.

• Most modifications of debt are mere extensions of existing debt.

– Do not result in a significant economic transaction.

– Modifications are reflected in future periods.

• No journal entry in current period.

• New “implicit” interest rate is computed and used to compute interest expense in subsequent periods.

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General Exception to the Rule –Substantial Modification of Debt Terms

• Total payments under new debt structure (including future interest payments) < Carrying value of the debt at time of restructuring.

• Difference immediate gain on debtor’s books.

• New CV of loan = undiscounted future payments.

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Callable Obligation

• Lender has right to demand repayment or give notice to such intent.

• Callable due to borrower violation of provision and not expected to cure violation within any specified grace period:

– Significance of the violation is not considered.

– Judgment applied in likelihood of curing during grace period.

• Current, unless:

– Lender waives (or otherwise loses right to demand) repayment for more than one year from B/S date.

– Probable that will cure the violation during grace period.

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Examples of Common Debt Covenants

• Minimum current ratio.

• Maximum debt to equity ratio.

• Minimum level of stockholder’s equity.

• Minimum fixed charge coverage ratio.

• Prohibition from incurring or maintaining indebtedness in excess of specified amount.

• Prohibition from annual capital expenditures above certain amount.

• Maintenance of minimum earnings before interest, taxes, depreciation, and amortization (EBITDA).

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Common Waiver Letter Flaws

• Only waiving as of balance sheet date.

• Waiver date less than one year from B/S date.

• Vague wording leaving room for lender to change mind or interpretation.

• Not considering “trickle down” violations.

• Oral representations not adequate.

• Letter addressed to client.

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Debt Covenant Violation -- Audit Considerations

• Consult client’s legal counsel.

• Obtain relevant management representations.

• Analyze compliance after all adjusting entries, including passed adjustments.

• Going concern considerations.

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Exhibit 5: DebtClassification Exercise

Exhibit 6: Sample Debt WaiverRequest and Response

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Debt Covenant Disclosures

• Consider whether F/S users would be influenced by information:

– Extent should vary with circumstances.

• No requirement to disclose all waivers received for violations:

– May consider if significant and likely, or recurrence in future.

• Optional disclosures:

– Specific debt covenants.

– Degree of compliance.

– Expectations about future compliance.

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C O N N E C T W I T H U S

Surgent Professional Education

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a2m5 auditing ap and debt - allen pritchett & bassett, llp ap accrued... · auditing a/p,...

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