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
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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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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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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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