Following Long-Term Debt Audit Procedures

By Maire Loughran from Auditing For Dummies

As an auditor, your primary objective is to make sure all your client’s legitimate obligations are properly recognized on its financial statements. Here are three tasks auditors must perform when examining long-term debt.

Review the board of directors meeting minutes: During your review, make sure that any new loan agreements or bond issuances are authorized. This varies client by client, but normally you look for a motion and vote to approve taking on new debt.
Look at client agreements: The second area you need to look at is any agreements your client has entered. Check out the loan documents to make sure they reconcile with information in the minutes of the board meeting. Note the principal, rate, and length for loans. You need this information to make sure the balance sheet shows the correct outstanding balance for each loan.

Here’s an example of how to take this step: say FPD (a fictitious company for this example) owes $250,000 on the mortgage for the beachside shop and $10,000 on the fixtures loan. The real estate loan rate is 5.75 percent, and the fixtures loan rate is 8.25 percent. The average debt is $130,000 [($250,000 + 10,000)/2], and the average interest rate is 7 percent [(5.75 percent + 8.25 percent)/2].

Average debt multiplied by average interest rate equals $9,100, which is a good estimate as to what FPD’s interest expense should be. If FPD’s interest expense is more than your ballpark estimate, check to see whether FPD has any loans that aren’t reflected on the balance sheet. Also, check to see whether the principal portion of the loan payment is mistakenly being taken to interest expense.
Examine cash transactions: The last place you should look when reviewing your client’s long-term debt is cash transactions. You should trace any large cash disbursements made by your client or cash receipts hitting its bank statements to the appropriate source documents. The company may be trying to artificially inflate sales by recording a loan as sales revenue. The source document in this case would be the customer invoice. Follow it through by checking the shipping documents to make sure the order was indeed shipped to a customer.

Unscrupulous shareholders may try to increase their amount of ownership in the company by recording debt as equity. The way this works is that the loan proceeds are deposited in the bank, but the journal entry is made to increase an equity account beneficial to the shareholder, such as stock or additional paid-in-capital. Additional paid-in capital is money paid to purchase shares of stock that’s in excess of the stock’s par value — the dollar amount written on the stock certificate.