Question

it is Principles of Auditing 330-01 class

a. What is the most effective substantive procedure to verify the amount of a Long-Term Debt balance included on the client’s year-end trial balance?

b. Why do banks include loan covenants in formal loan agreements with borrowers?   

c. At a client’s year-end, what is the significance of the company being in violation of one or more loan covenants under its long-term debt agreement?   

d. If the client you are auditing is in violation of one or more loan covenants at its year-end, what would you suggest that your client do?

Answer 1

a) The most effective method to verify the account balance of a long term debt is to roll out independent balance confirmation (ISA i.e.. obtaining external confirmation) to the lender. This will cover existence as well as valuation assertion for the account balance.

b) Banks faces credit risk (i.e.. risk of default) upon advances of loan. To cover this banks adds debt covenants so that their loans should not come in the default category. Additionally it also helps them in monitoring the performance of the borrower. Typical example of debt covenants includes maintenance of debt equity ratio, current ratio etc.

c) While auditing this account cycle, it's very important for the auditor to check each debt covenants. Failure of meeting the debt covenant may lead to forfeiture of loan. On that case, auditor must show the loan balance as current liability even if it is a long term debt. This reclassification will have a adverse effect on current ratio of the company.

d) As explained above, the client show the loan balance as current liability rather than non-current liability. Further we may insist the client obtain waiver letter from the bank to avoid this reclassification. If waiver letter is not obtained before the authorization of financial statements then the loan must be categorized under current liability.