Debt Audit Procedures: Confirmation, Agreement Review and Interest Recompute

Debt is a small number of large transactions with strong external evidence. Misstatements concentrate in four places: unrecorded borrowings, wrong current versus long-term classification, interest and fee accounting, and disclosure. This post runs a debt program from the lender list to the footnote. Covenant testing has its own treatment in loan covenant compliance testing, and the accounting for modifications is in ASC 470 debt classification and covenants.

Step 1: Establish completeness of lenders

The main assertion for liabilities is completeness. The risk is a borrowing the client has not recorded or disclosed. Build the list of lenders from several sources, not from the debt schedule alone.

• Prior-year debt schedule and confirmations.
• Bank confirmations, which include loans and guarantees.
• Interest expense analysis: every payee of interest is a lender or a counterparty.
• Board and shareholder minutes approving financing.
• Loan agreement files, legal letters and lien searches (UCC filings).
• Related party schedules, where shareholders and officers lend to the entity.
• Cash receipts around year end that look like loan proceeds.

If a UCC lien search shows a filing by a lender who is not on the schedule, follow it up.

Step 2: Confirm balances and terms

Send confirmations to lenders for the balance, interest rate, maturity, payment terms, collateral, covenants and any defaults or waivers. Control the request as described in bank confirmations step by step. For private lenders or shareholder loans that will not respond, perform alternative procedures: inspect the agreement, trace payments to bank statements, and obtain a signed statement of balance and terms from the counterparty, evaluating its reliability.

Step 3: Read the agreements and abstract them

For every material agreement, prepare an abstract on one page:

The abstract feeds the interest recompute, the classification and the disclosures, so it is worth doing once and cross-referencing.

Step 4: Roll forward the balance

Reconcile opening balance plus proceeds minus repayments plus or minus noncash items to the closing balance.

Vouch each proceeds and repayment line to bank statements and lender statements. Agree the closing balance to confirmations. Where debt issuance costs are recorded for term debt, present them as a direct deduction from the debt (ASC 835-30-45-1A) and test amortization.

Step 5: Recompute interest

Interest is an analytical and recompute test. For each loan, recalculate interest using the rate, the average balance and the days outstanding, and compare to expense and accrued interest.

Worked recompute for the equipment note: opening $410,000, repayments of $20,500 each quarter, rate 6.25 percent. Average balance is the simple average of opening and closing balances, ($410,000 + $328,000) ÷ 2 = $369,000. Interest = $369,000 × 6.25% = $23,063. Recorded interest $23,400. The difference of $337 is 1.4 percent of recorded interest and consistent with payment timing within the quarters, so no further work is needed beyond confirming the payment dates.

For the variable-rate revolver, build the rate by month from the index and spread, apply to monthly average balances and sum. A difference larger than the firm's threshold requires investigation: unrecorded fees, capitalized interest, or interest recorded in the wrong account.

Test accrued interest at year end: days since last payment times daily interest, using the day count in the agreement. For Term loan A ($2,100,000 at 6.50 percent, interest paid through December 15), 16 days accrued is $6,067 on an actual/360 basis and $5,984 on actual/365. The $83 gap is small here and large on a bigger facility, so confirm the basis in the abstract. Test whether interest is capitalized on qualifying construction. Compare interest expense to debt over the year as a reasonableness check; expense that implies a rate well above the stated rate points to a lender or borrowing not on the schedule, and a rate well below it points to capitalized or unrecorded interest.

Step 6: Test classification

Split each loan between current and long-term. The current portion includes principal due within one year or the operating cycle, and the entire balance if a covenant violation at the balance sheet date makes the debt callable and the lender has not waived or lost the right to demand repayment for more than one year (or the operating cycle) from the balance sheet date. A probable violation at a later test date within the year can also require current classification even with a waiver; the callable-debt and covenant guidance in ASC 470-10-45 and the sibling ASC 470 guide set out the criteria. Debt that matures within twelve months but is refinanced after year end on a long-term basis qualifies for noncurrent classification only if the accounting criteria are met. See covenant compliance testing.

Step 7: Test related party debt

Shareholder and officer loans carry special risk of terms that are not arm's length. Read the note, test interest accrued and paid, confirm balances directly with the lender and verify disclosure. See related party procedures.

Step 8: Test disclosures

The note shows, at minimum, the nature of each facility, interest rates, maturities by year for the next five years, collateral, covenants and any violations, unused commitments, and related party terms. Agree amounts to the roll-forward and the abstract.

Worked example summary

The auditor finds the revolver confirmation shows $1,200,000 but the unadjusted ledger showed $1,150,000, a December 30 draw booked on January 2. The adjustment increases debt and cash by $50,000, and the roll-forward above is shown after that entry. The interest recompute is within tolerance. The UCC search turned up a filing by an equipment lessor not on the schedule. Inspection of the agreement showed a $64,000 lease that met the finance lease criteria and had been expensed as rent. The auditor records both on the adjusting entry log and updates the lease analysis under ASC 842.

Documentation checklist

• Lender completeness list with sources.
• Confirmations and follow-up.
• Agreement abstracts.
• Roll-forward with vouching tick marks.
• Interest recompute and accrued interest test.
• Classification workpaper.
• Related party debt memo.
• Disclosure tie-out.

CORAA prepares ready-to-review audit files for US CPA firms; the firm keeps the client, the review and the signature. See /us.

Sources

• AICPA, AU-C Section 505, External Confirmations; AU-C Section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained
• FASB, ASC 835-30, Interest: Imputation of Interest
• FASB, Accounting Standards Codification Topic 470, Debt

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error