Audit Debt
Introduction
In the audit of debt, our primary concern is usually the misstatement due to the understatement of the debt obligations. Likewise, we usually focus our attention more on the test of the completeness assertion.
Debt is usually considered as one of the main sources of funds for the company besides equity. In this case, its balance is usually material in which we need to design appropriate audit procedures for the audit of debt.
Usually, debt is the liability in which its repayment obligations are due more than one year in the future. However, the current portion of it which is required to pay in one year will need to be recognized as short term borrowing.
Hence, debt usually has two portions that are required to present on the balance sheet. One is the short term borrowing which is on current liabilities side while another one is the long term borrowing which is on non-current liabilities side.
The main objective of the audit of debt is to determine whether all the debt balances and their related transactions have been properly recorded, classified and disclosed.
Audit Assertions for Debt
Audit assertions for debt are included in the table below:
| Audit assertions for debt | |
|---|---|
| Completeness | All debt obligations that should have been recorded have been recorded. |
| Existence | Debt obligations reported on the balance sheet actually exist at the reporting date. |
| Valuation | All debt obligations have been recorded in the correct amount and their balances reflect the actual economic value. |
| Rights and obligation | The company actually owes a liability for the debt obligations as at reporting date. |
| Presentation and disclosure | Debt obligations are properly classified between current and non-current liabilities, and appropriately disclosed in accordance with applicable accounting standards. |
In the audit of debt, the completeness is the most relevant audit assertion which we have more concern comparing to other audit assertions. This is due to the material misstatement that usually happens on debt account tend to related to understatement which is the issue of completeness in the debt balances.
Risk of Material Misstatement in Audit of Debt
In the audit of debt, risk of material misstatement is the combination of inherent risk and control risk in the debt account. Inherent risk here is the susceptibility of the debt account to misstatement while control risk is the risk that the client’s internal controls fail to prevent or detect material misstatement in the debt account.
The common risks related to the debt include unauthorized transactions, improper recording of debt transactions and noncompliance of debt covenants.
Unauthorized transactions concern the risk of whether new debts that the client borrows or the payment on the existing debts have been properly authorized. The unauthorized transactions could lead to the fraud risk which is usually material in the audit of debt.
The risk regarding the recording of debt transactions involves whether the client has properly recorded in accordance with applicable accounting standards. The major concern here is whether the client has properly classified the interest expenses, interest accrued, and current portion and non-current portion of debts.
Meanwhile, the debts that the client obtained usually comes with several conditions that the company must comply with. They may include the restrictions on the company’s total borrowings and adherence to specific borrowing ratios.
This is where the risk of noncompliance of debt covenants arises. The breach of debt covenants can lead to the going concern issue. Hence, we may need to pay more attention to the borrowing agreements to verify the compliance of debt covenants.
Test of Controls in Audit of Debt
As auditors, we usually perform the test of control when we want to place reliance on the client’s internal control to reduce some of our works in the substantive audit procedures. However, this is usually in a situation where the client has a lot of transactions.
In this case, we would perform the test of control to evaluate whether the client’s control adequately addresses the risk of material misstatement for the relevant debts and their related accounts.
The typical tests of controls include:
- Inquiry: inquire the personnel that perform the controls
- Observation: observe the controls being performed by the client’s staff
- Inspection: inspect the supporting documents to ensure that the control has really been performed by the client
- Reperformance: we reperform the controls that have been performed by the client’s staff
However, in the audit of debt, we most likely set the control risk as high and do not perform the test of control in this area at all. In this case, we tend to go directly to perform substantive audit procedures on the debt obligations to gather audit evidence for our audit opinion.
This is due do most clients do not have many financing transactions, so going directly to the substantive audit procedures is more efficient.
Substantive Audit Procedures in Audit of Debt
Substantive Analytical Procedures for Debt
In the audit of debt, we usually perform substantive analytical procedures to test interest expenses. In doing so, we usually build our expectations based on the interest expenses by using the average interest rates and average outstanding of the debts.
As a result, we usually get our expected interest expenses by multiply the average interest rate with the average outstanding balance of the debts. However, we usually breakdown the debts by type in order to make our expectation our accurate.
If our result is similar to those recorded by the client, we won’t need to perform further tests on the interest expenses and interest accrued. Otherwise, if our estimate is significantly different from the client’s record, we need to investigate further in order to determine the reason of the difference. Likewise, additional substantive tests of details will be required for the investigation of the difference.
For example, if our result is much lower than the client’s record, it may be due to the client didn’t properly record the interest payment or the client wrongly recorded interest payment to the debt principal. In this case, the test of details on the interest payment may help to clarify the reason for the difference.
Substantive Test of Details for Debt
An example of the test of details in the audit of debt include as below:
- Obtain the schedule of borrowings and interest at the year-end that includes the name of the lender, borrowing date, maturity date, interest date, interest rate, and balance at the end of the reporting date
- Reconcile the balance on the schedule to the general ledger
- Compare the opening balance of the debts to the previous audited figures
- Obtain and examine the board minutes relating to new borrowings or repayments.
- Trace the proceed of the additions of debts to cash receipt and bank statement
- Trace the debt deductions and repayments to cash disbursement record
- Review debt agreements for the restrictive covenants and consider any effect on disclosures in the financial statements
- Perform debt confirmation with the lenders by indicating the amounts outstanding, accrued interest and what security they hold.
In regards to debt covenants, we need to have a good understanding of the procedures that the client used to determine whether they are in compliance with their debt covenants. It is important that we need to determine whether the client is in compliance with the debt covenants or not.
If the client is not in compliance, we might need to obtain direct confirmation on the matter from the lender to see their response. For example, if the lender does not intend to waive the violation in the non-compliance of the client, the lender may declare the outstanding debt immediately.
In this case, we would need to classify the debt to the current liabilities and sufficient disclosure will be required in this matter. The test for going concern may also be required here.