Debt is simply liabilities, the amount the company owes to someone. Auditing of debt requires an understanding of complex debt instruments, classification of debt as per covenants, and characteristics of debt.
In the financial statements, the debit balance at the reporting date is reporting the balance sheet under current or non-current liabilities depending on the maturity of the debt.
The debts such as detachable warrants have equity features that can lead to various complications. Some transactions like a lease end up creating debt even if the intention is completely different.
Organizations all big or small deal in debts in some form or other. Debt forms a major part of total liabilities.
The balances of debt need checks of rigid internal control systems employed by the company’s management, extensive substantive procedures wherever necessary, and since it is related to an outside party, balance confirmation through books and from the party.
This article will discuss certain areas related to the auditing of debt, including the general risks of material misstatements related to the debt, assets assertion to test the existence and valuation of debt, and interest calculation.
We will also discuss the substantive procedures that auditors normally perform to test or audit debt in the financial statements.
The relevant debt assertions related to debt are completeness, classification, and obligation. Auditors in general prioritize completeness and classification.
The balances of debt on the balance sheet would mean that the requirements related to debt are complete and it is being classified correctly.
Classification of debt would mean the differentiation between long- and short-term debt. Further, the transaction also needs assurance regarding whether the debt is involved and not equity through the features. Debt is the obligation of the entity that is being audited.
|Completeness||This states that all the debt obligations have been recorded properly.|
|Existence||On the date of the balance sheet, all the company obligations have been reported.|
|Valuation||The balances of the debt accounts correctly reflect the actual economic value.|
|Rights and obligation||The company owes a sum of money on the date of reporting of the balance sheet.|
|Presentation and disclosure||Debts are correctly classified into current and non-current liabilities as per applicable accounting standards.|
Visualization of debt is necessary to understand the assertions that need to be checked. The visualization of debt also checks if any internal control weakness exists. The following are the questions to be asked while visualizing the debt:
- Documents to inspect
- Existence of debt covenants and violations, if any
- Nature of violations
- Preparation of amortization schedules.
- Line of credit available to the company
- Inspection of loan documents.
- Refinancing debt
- Existence of sinking funds
- Reconciliation of debt in the general ledger to the loan amortization schedule
Further, in case of the existence of weakness in control, the auditors must create substantive audit procedures to address the issue. Take, for instance, the person who has been made responsible is the same for loan documentation and reconciliation.
There is no scope for verification and double-checking. In this case, the auditors shall perform substantive audit procedures related to fraud.
Major debt risks
This would include the following:
- Understatement or omitting of debt
- Wrong classification of debt i.e. non-current liabilities recorded as current as on the balance sheet date.
The company will always want to understate its risk if it’s unethical. It can wrongly classify current debt as non-current debt to make the balance sheets look healthier on the outside.
The company’s working capital ratio in such a scenario improves and then the company can get an additional loan on this basis.
Risk of Material Misstatement in Audit of Debt
The inherent risk and control risk in the obligations from the risk of material misstatement in debt. The inherent risk of being susceptible to misstatement due to the nature of the debt is the inherent risk.
Control risk occurs when the internal control system of the auditee fails to prevent or detect material misstatement in debt.
To name some risks, unauthorized transactions, wrong recording of debt, and non-confirmation of debt accounting standards are material misstatements.
An unauthorized transaction is a case where someone other than the person authorized and responsible for debt-related affairs deals with the debt matters either within the entity or with outsiders.
Such risks generally create the risk of fraud which is itself a material misstatement. The audit client shall correctly record debt as per applicable accounting standards.
The proper classification shall be done. Further, the breach of debt covenants also leads to material misstatements. Hence, the auditor needs to clearly understand the borrowing arrangements and check if they are complied in time and in full.
Substantive Procedures for Debt:
The general substantive procedures are followed if the auditor decides based on his professional judgment and experience. These are the general procedures:
- Summarizing and reviewing the various debt covenants from the clients and then testing the completeness testing of the debt covenants
- Perform the positive confirmation on the selected sample size to confirm the existence of debts and their accuracy.
- Reviewing all the terms and conditions of debt and checking the level of compliance
- Process of preparation and maintenance of amortization schedules.
- Obtain the schedule of debt or borrowing including the interest calculation at the end of the period or year-end. Ensure that the listing has certain important information including the name of the lender, maturity date, borrowing date, interest rate, interest date, and balance at the end of the reporting date
- Obtaining the board minutes concerning new debts or borrowings