Auditing Long-Term Debt: Mortgages, Notes, and Bonds

• Companies use mortgages, notes, and bonds to finance asset acquisition, which results in long-term debt.
• Auditors focus on potential understatements of debt obligations and completeness assertions in long-term debt audits.
• Long-term debt is a key funding source, typically material in balance.
• Long-term debt repayment is due more than one year out, with the portion due within a year classified as short-term borrowing.
• Audits aim to ensure proper recording, classification, and disclosure of debt balances and related transactions.
• Auditors verify that financial statement amounts for long-term debt are not materially misstated.
• This verification extends to the recognition of interest expense, tested using substantive procedures.
• Notes and bonds payable audits should be paired with interest expense and payable audits.
• This reduces verification time and minimizes misstatement risk.
• Accuracy of accrued interest is tested after verifying notes, bonds, and related interest details.
• Testing interest expense alongside notes payable reduces the risk of omitting notes with paid interest.
• Exhaustively tying out interest expense for numerous notes/bonds or transactions can be time-prohibitive.

Audit Controls for Notes and Bonds Payable

• Proper authorization is key when issuing new or renewing existing notes/bonds.
• This ensures debt arrangements are authorized.
• Controls over principal and interest repayment make sure proper amounts are paid.
• Ensure proper record-keeping and procedures so all amounts are recorded in all transactions.
• Periodic verification ensures all controls over notes payable are functional.
• Internal controls over notes/bonds payable must be adequate.
• Transactions involving principal and interest must be properly authorized and recorded per standards.
• Liabilities, interest expense, and accrued liabilities should be accurately reported in financial statements.
• Related disclosures must be properly disclosed in financial statements.

Key Controls for Notes and Bonds

• Issuance must be properly authorized via board of directors or high-level management.
• Loan agreements require multiple authorized signatures, stipulating loan amount, interest rate, payment terms, and pledges.
• Renewed instruments must undergo the same authorization as new issuances.
• Accounting departments should receive a copy of the note/bond at the time of issuance.
• Accounting should provide documents and issue checks when notes/bonds are due.
• Subsidiary records are needed, plus control over blank and paid notes/bonds by authorized personnel.
• Paid notes/bonds should be cancelled and retained under authorized personnel's custody.
• Detailed records should be periodically reconciled with the general ledger.
• Comparison to holder's records is to be done by an employee separate from detailed record maintenance.
• An independent person should recalculate interest expense.
• Test of controls and substantive tests of transactions are needed for liability accounts in the capital acquisition and repayment cycle.
• Control and substantive tests are neded over the payment of principal and interest and the issuance of new notes or other liabilities.
• Tests of balances ensure accuracy of liabilities, interest payable, and interest expense.
• Auditors verify capital acquisition and repayment cycle transactions and balances.

Loan Controls: Oversight and Prevention

• To ensure the amount of note liabilities, there should be an examination of note request forms for proper authorization.
• Terms of notes were discussed with appropriate management personnel.
• Records reconciled to control account.

Inherent Risk for Long-Term Debt

• Notes and bonds are generally assessed low to moderate because transaction volume is low, accounting not complex, and third-party statements are common.
• However, the amounts involved are large, and sophisticated instruments may increase the inherent risk.

Control Risk for Long-Term Debt

• Auditors often set control risk high and skip control tests, performing substantive procedures due to the lack of financing transactions.

Notes Payable: Nature and Characteristics

• Notes payable are written agreements (promissory notes) where one party agrees to pay cash to another.
• A note is a formal document detailing the terms of debt.
• Long-term notes payable mature beyond one year after the company's reporting period/operating cycle.
• Common transactions: borrowing money from a bank with a promissory note or issuing a note for non-cash assets.
• Typical note payable information includes the amount to be paid, interest rate, maturity dates, maker's name, payee's name, and signature.
• Notes are either interest-bearing or non-interest-bearing.
• Interest-bearing notes involve funds loaned with accrued interest as per the agreement.
• Mortgages are an example of interest-bearing notes because they include principal and interest repayment.
• Long-term loans support a company's funding needs over multiple years.
• Interest-bearing note terms require borrower to repay principal at the end of the term or in installments.
• Auditor focuses on the amount of accrued interest at year-end and the interest expense recognized based on effective interest for interest-bearing notes.
• Accrued interest is recognized only when interest was incurred on a note payable but unpaid as of year-end.
• Interest accrued at year-end is based on the nominal interest, but the amount of interest expense is generally based on the effective interest when the note was issued.
• Non-interest-bearing notes lack a documented interest rate requirement so if the debt were sold the amount would be at a discount to ts face value.
• A non-interest-bearing note includes unspecified principal and interest amount.

Bonds Payable: Nature and Characteristics

• Bonds are debt instruments that are issued to get a large amount of capital on a long-term amount.
• A bond issuer must repay the principal on a definite maturity date and make all of the cash payments of interest.
• Bond indenture is a formal agreement which specifies things like terms, restrictions, peso amount, rate and date, and maturity.

Bonds: Issuance and Characteristics

• Bonds enable firms to borrows large sums of money and repay loans over a long time.
• Bonds are sold or issued to investors.
• Borrowers pay interest on specific dates, semiannually or annually, and repay the principal at maturity.
• The bond certificate sets obligations, usually in denominations, and are traded like stocks.

Types of Bonds

• Collateral: Assets that secure bonds.
• Debenture: Bonds with no specific collateral.
• Term: Principal due on a specific date.
• Serial: Bonds with differing due dates.
• Convertible: Exchangeable for ordinary shares.
• Callable: May be retired or redeemed by the issuer.
• Callable bonds have a stated redemption or re-acquisition price.
• Redeemable: Gives the investor the right to retire or sell back to the issuer before the due date.

Audit Assertions for Long-term Liabilities

• Existence/Occurrence: Verify long-term liabilities exist and occurred as of year-end.
• Completeness: Ensure all payable transactions are included in long-term liability balances.
• Valuation: Confirm long-term liabilities are recorded at their actual economic value.
• Rights and Obligations: Verify the company's liability at the reporting date.
• Presentation and Disclosure: Ensure liabilities are properly classified, described, and disclosed per accounting principles.

Substantive Analytical Procedures for Debt

• Auditors test interest expenses using substantive analytical procedures.
• They build expectations based on effective interest rates and average outstanding debt.
• Further tests are needed if recalculation differs significantly from the client's records.
• Additional tests are required to investigate the difference.
• The auditors objective is to see that al client's obligations are properly recognized.

Examination of Long-Term Debts

• Review board of directors to ensure approval of loan agreements or bond issuances and check documents.
• Examine cash transactions by tracing disbursements or cash receipts to source documents.

Substantive Tests of Debt Details

• Obtain a schedule of borrowings and interest, including lender name, dates, interest rate, and balance.
• Reconcile the schedule balance to the general ledger and compare opening balances to previous figures.
• Obtain and examine board minutes relating to new borrowings or repayments.
• Trace debt additions to cash receipts and deductions/repayments to disbursement records.
• Review debt agreements for restrictive covenants and their disclosures.
• Perform lender confirmation to verify outstanding amounts, accrued interest, and security held.
• Understand client procedures for debt covenant compliance to determine compliance.

Valuation of Long-Term Notes Payable

• Long-term notes are recorded at the fair value of goods/services or loan proceeds.
• Periodic interest expense is based on market interest at the issuance date and the note balance.
• The carrying value of long-term notes payable is the present value of remaining cash flows, discounted at the market rate at issuance.