Companies, like individuals, have long-term debt. To perform an audit, you need to understand the forms a company’s long-term debt can take and the debt-related issues you need to consider when conducting your audit. Your audit clients use three debt vehicles — mortgages, notes, and bonds — to finance the acquisition of their assets. Depending on the client, bonds may not be as common as mortgages and notes.
Mortgages: Mortgages are used to finance the purchase of real property tangible assets. The property collateralizes the mortgage, which means the property is held as security on the mortgage. If the company defaults on the mortgage, the lending institution seizes the property and sells it in an attempt to pay off the loan.
Notes: Notes are formal written documents that spell out how money is being borrowed. This type of agreement between a lender and a borrower specifies principal, rate, and time. For a business, loans for assets such as autos, equipment, and machinery are classified on the balance sheet as notes payable.
Accounts payable is not considered to be one of the common long-term debt accounts. There are two reasons for this: Per generally accepted accounting principles, or GAAP, accounts payable is always a short-term liability. Also, no formal written agreement exists in the accounts payable process. Money that a company owes its vendors may eventually become long-term debt depending on arrangements your client makes with the vendor. However, if this transition happens, that portion of accounts payable is reclassified to a note.
If your audit client shows figures in accounts payable that are similar to figures from a prior year, check to make sure that its arrangements with the vendor haven’t changed. Reflecting long-term debt as short-term debt affects financial statement ratio analysis, which is one way the users of financial statements evaluate a company’s performance.
Bonds: Bonds are long-term lending agreements between a borrower and lender. An example of a bond is when a municipality (such as a city or village) needs to build new roads or a hospital and issues bonds to finance the project. Corporations generally issue bonds to raise money for capital expenditures, operations, and acquisitions.
The people who purchase a bond receive interest payments during the bond’s term (or for as long as they hold the bond) at the bond’s stated interest rate. When the bond matures (the term of the bond expires), the company pays the bondholder back the bond’s face value.
Usually, bonds are traded in highly-regulated public security markets such as the New York Bond Exchange. So you may not see bonds payable on the balance sheets of the audit clients you’re assigned to as a newbie auditor. However, your client may hold bonds that it has purchased as investments.