9.1 Auditing Long-Term Debt and Leases
3 min read•august 13, 2024
Auditing long-term debt and leases is crucial for ensuring financial statement accuracy. This topic covers key components of debt agreements, risks associated with long-term debt, and the complexities of lease accounting. Understanding these elements is essential for auditors to effectively assess and test a company's financial obligations.
The audit procedures for long-term debt and leases involve verifying existence, completeness, and proper valuation. Auditors must confirm debt terms with lenders, evaluate covenant compliance, and assess lease classifications. These steps help ensure that financial statements accurately reflect a company's debt and lease obligations.
Long-term debt components
Key terms and characteristics
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- Long-term debt financial obligations due beyond one year or current operating cycle, whichever is longer
- Common types include bonds, , and mortgages
- Key components of long-term debt agreements
- Principal amount
- Interest rate (fixed or variable)
- Maturity date
- Repayment terms
- Collateral or security pledged
- Convertible debt includes option for holder to convert debt into specified number of shares of issuer's common stock at predetermined price
- Embedded conversion feature requires separate accounting treatment
Debt covenants and issuance costs
- restrictions or requirements imposed by lender that borrower must adhere to
- Examples: maintaining certain financial ratios (debt-to-equity, interest coverage), obtaining lender approval for significant transactions (acquisitions, asset sales)
- Debt issuance costs expenses incurred in connection with issuance of debt
- Examples: legal fees, underwriting costs, registration fees
- Typically amortized over life of debt using effective interest method
Risks in long-term debt
Audit risk assessment
- Auditors should assess risk of material misstatement related to long-term debt considering factors such as
- Complexity of debt agreements
- Company's compliance with debt covenants
- Accuracy of debt-related account balances and disclosures
- Auditors should obtain and review debt agreements to understand terms, conditions, and covenants
Audit procedures for long-term debt
- Verify existence and completeness of long-term debt
- Obtain confirmations from lenders
- Perform procedures (tracing debt transactions to supporting documentation, recalculating )
- Evaluate company's compliance with debt covenants
- Review financial ratios and other relevant metrics
- Inquire with management about instances of non-compliance or waivers obtained from lenders
- Assess appropriateness of classification of long-term debt as current or non-current
- Based on maturity dates and violations of debt covenants that may accelerate repayment
Accounting for leases
Lease classification and treatment
- Leases classified as finance leases (previously capital leases) or operating leases based on terms of lease agreement and transfer of risks and rewards of ownership
- Finance leases treated as purchase of asset and corresponding liability
- Asset depreciated over useful life
- Liability reduced through lease payments
- Operating leases treated as rental expenses, with no asset or liability recognized on balance sheet (prior to or )
- Finance leases treated as purchase of asset and corresponding liability
- Under ASC 842 and IFRS 16, lessees required to recognize right-of-use asset and for most leases, including operating leases, on balance sheet
Lessor accounting and disclosures
- Lessors classify leases as sales-type, direct financing, or operating leases based on terms of lease agreement and transfer of risks and rewards of ownership
- Key disclosures for leases include
- Description of significant leasing arrangements
- Nature and amount of lease assets and liabilities
- Future minimum lease payments
- Restrictions or covenants imposed by lease agreements
Auditing long-term debt and leases
Audit procedures for leases
- Obtain schedule of long-term debt and leases, including key terms (principal amounts, interest rates, maturity dates, payment schedules)
- Confirm existence and terms of long-term debt and leases directly with lenders and lessors
- Reconcile confirmation responses to company's records
- Test completeness of long-term debt and leases
- Review board minutes, loan agreements, and lease contracts to identify unrecorded obligations
- Recalculate interest expense and lease expense to verify accuracy of recorded amounts and proper application of effective interest method or straight-line method
Valuation and subsequent events
- Evaluate reasonableness of company's incremental borrowing rate used to measure lease liabilities by comparing to market rates for similar borrowings
- Test valuation of right-of-use assets and lease liabilities by recalculating present value of future lease payments using appropriate discount rate
- Review subsequent events and transactions to identify new or modified debt or lease agreements that may require adjustment to financial statements
Key Terms to Review (18)
Amortized cost: Amortized cost refers to the gradual reduction of an asset's value over time, typically applied to long-term debts and leases. This accounting method helps spread the expense of an asset over its useful life, ensuring that financial statements reflect a more accurate financial position. It involves allocating the cost of the asset against its revenues, which is crucial for understanding the overall financial impact of long-term financing arrangements.
ASC 842: ASC 842 is the Accounting Standards Codification Topic 842 that establishes the guidelines for accounting and reporting of leases. This standard significantly changes how lessees account for leases, requiring them to recognize lease liabilities and right-of-use assets on their balance sheets, which enhances transparency and comparability in financial reporting.
Bonds payable: Bonds payable are long-term debt instruments that companies issue to raise capital, promising to pay back the principal amount along with interest at specified intervals. They represent a formal agreement between the issuer and bondholders, often used for financing projects or expanding operations. This type of debt is crucial for companies as it allows them to leverage funds while providing investors a fixed income over time.
Capital lease: A capital lease, also known as a finance lease, is a long-term lease that effectively transfers ownership of the asset to the lessee at the end of the lease term. This type of lease must be accounted for on the lessee's balance sheet, reflecting both an asset and a liability, which aligns with the principles of financial reporting. Recognizing capital leases in this way ensures that the financial statements accurately represent the lessee’s obligations and resources.
Carrying Value: Carrying value is the value at which an asset is recognized on the balance sheet, after deducting any accumulated depreciation, amortization, or impairment costs. It reflects the book value of an asset and plays a significant role in the assessment of long-term debt and leases, as it affects financial ratios and the overall financial health of an organization.
Confirmation Procedures: Confirmation procedures are audit techniques used to obtain independent verification of account balances and transactions from third parties. This process is vital in ensuring the accuracy and completeness of financial information, as it helps auditors validate the existence and ownership of assets and liabilities reported by an entity.
Debt covenants: Debt covenants are legally binding agreements or conditions set by lenders to protect their interests when extending credit. These covenants can impose certain restrictions or requirements on the borrower, such as maintaining specific financial ratios, limiting additional debt, or ensuring timely financial reporting. They play a crucial role in the management of long-term debt, helping lenders assess the risk associated with a borrower’s financial health and ensuring compliance with agreed-upon terms.
Default risk: Default risk refers to the possibility that a borrower will fail to meet their debt obligations, which can lead to financial losses for lenders and investors. This risk is particularly important when auditing long-term debt and leases, as it directly affects the assessment of a company's creditworthiness and financial stability. Evaluating default risk helps auditors determine whether the reported liabilities accurately reflect the potential risks associated with the borrowing entity.
Effective Interest Rate: The effective interest rate is the actual rate of interest earned or paid on a financial product, taking into account the effects of compounding over a specific period. This rate reflects the true cost of borrowing or the true return on investment, making it crucial in evaluating long-term debt and lease agreements, as it influences both the financial statements and the decision-making process of entities.
Financial Accounting Standards Board (FASB): The Financial Accounting Standards Board (FASB) is an independent organization responsible for establishing and improving financial accounting and reporting standards in the United States. FASB plays a crucial role in ensuring transparency and consistency in financial statements, which is vital for stakeholders such as investors and creditors. Their standards guide how organizations report long-term debt and leases, as well as revenue recognition, influencing how these elements are understood and evaluated by auditors and financial analysts.
IFRS 16: IFRS 16 is an International Financial Reporting Standard that prescribes the accounting treatment for leases, effective from January 1, 2019. This standard requires lessees to recognize almost all leases on their balance sheets as assets and liabilities, fundamentally changing how leases are reported and perceived in financial statements.
Interest expense: Interest expense is the cost incurred by an entity for borrowed funds, typically calculated as a percentage of the outstanding debt. This expense is crucial for understanding an entity's financial obligations, as it directly impacts profitability and cash flow. Interest expense arises from loans, bonds, or any other forms of debt financing, making it a key component in evaluating long-term financial sustainability.
Lease liability: Lease liability is the present value of future lease payments that a lessee is obligated to make over the term of a lease. This term is crucial in accounting as it reflects the financial responsibility of the lessee for lease agreements, affecting both the balance sheet and income statement. Understanding lease liability is essential for assessing a company’s long-term obligations and overall financial health.
Liquidity risk: Liquidity risk is the risk that an entity will not be able to meet its short-term financial obligations due to an inability to convert assets into cash without a significant loss in value. This risk is crucial for financial instruments and obligations, as it impacts an entity's ability to finance its operations and service its debts, making it essential for auditors to assess liquidity conditions during financial reporting and analysis.
Notes payable: Notes payable are written promises to pay a specified amount of money to a creditor at a future date, typically used as a form of borrowing for businesses. These notes can be short-term or long-term obligations and may carry interest, making them an essential part of a company's financial management. Understanding notes payable is crucial for assessing a company's overall debt position and cash flow.
Operating Lease: An operating lease is a rental agreement that allows a lessee to use an asset without transferring ownership, typically for a shorter duration than the asset's useful life. This type of lease is treated as a rental expense on the income statement, rather than being capitalized on the balance sheet as a long-term asset. This has implications for financial reporting and analysis, affecting how companies present their liabilities and assets.
Securities and Exchange Commission (SEC): The Securities and Exchange Commission (SEC) is a U.S. government agency responsible for regulating the securities industry, enforcing federal securities laws, and protecting investors. The SEC's primary role is to ensure transparency and fairness in the financial markets, which is crucial when auditing long-term debt and leases as these financial instruments must adhere to strict reporting standards.
Substantive Testing: Substantive testing refers to audit procedures designed to detect material misstatements in financial statements, focusing on the accuracy and validity of transactions and account balances. This type of testing plays a vital role in assessing the completeness and accuracy of financial information, helping auditors form an opinion on the financial statements.