Debt: confirmations, interest, covenants and current vs noncurrent classification

• Confirm debt balances and terms and agree them to the loan agreement
• Recompute interest expense and accrued interest
• Recalculate covenant ratios from audited figures using the agreement’s definitions
• Classify debt after a covenant violation using the ASC 470-10-45-11 waiver test

What can go wrong with debt

Borrowings are usually easy to prove exist. The risks sit elsewhere: completeness (a line of credit or guarantee left off), accuracy of interest, classification between current and noncurrent, and disclosure of terms, maturities and covenants. A covenant breach can also move the audit into going concern territory. AU-C 330.18 requires substantive procedures for each relevant assertion of significant accounts, and for debt classification and presentation are usually relevant assertions.

Core procedures

1. Confirm balances, interest rates, maturity, collateral, guarantees and unused lines with each lender. The standard bank confirmation request covers deposits and loans; send a separate request for loan terms when you need more detail. A debt confirmation letter helps.
2. Read the agreements and amendments. Note the rate, payment schedule, prepayment terms, collateral, financial covenants, reporting covenants (such as delivering audited statements within a set number of days), and acceleration clauses.
3. Roll forward each facility: opening balance, borrowings, repayments, closing balance. Agree borrowings and repayments to bank activity. The debt and interest rollforward has the layout.
4. Recompute interest expense and accrued interest using the rate, day count and balances outstanding. For a variable rate, use the reset dates and index from the agreement.
5. Check debt issuance costs on term debt are presented as a deduction from the debt and amortized, and look for modifications during the year that need extinguishment analysis.
6. Look for unrecorded debt in board minutes, the bank confirmation, interest payments with no matching loan, and lease or guarantee arrangements.

Covenant compliance

Recalculate each financial covenant using the definitions in the agreement, not the client's spreadsheet and not GAAP labels. "EBITDA" in a credit agreement often adds back items GAAP does not, and "debt service" may include lease payments. Use the audited numbers after proposed adjustments, because an adjustment can tip a ratio. Check reporting covenants too: late delivery of statements is a violation in many agreements.

Classification when a covenant is breached

ASC 470-10-45-11 requires a long-term obligation to be classified as current if a violation of the debt agreement at the balance sheet date makes it callable by the creditor, or will make it callable if not cured within a grace period. There are two ways to keep it noncurrent:

• The creditor has waived or subsequently lost the right to demand repayment for more than one year (or the operating cycle, if longer) from the balance sheet date.
• For an obligation that becomes callable if not cured within a grace period, it is probable the violation will be cured within that grace period.

Read every waiver. The waiver must cover the right to demand repayment for more than one year, and only for the violations it names. Even then, ASC 470-10-45-1 requires current classification when the lender keeps the future covenant tests and it is probable the borrower will fail them within the next 12 months. A waiver of the year-end violation, with the same covenant measured again next quarter and the client expecting to fail it, therefore leaves the debt current. The guide on debt classification and covenants covers the related ASC 470-10 rules, and the covenant memo template documents the conclusion.

Disclosures and going concern

Disclose maturities for each of the five years after the balance sheet date, collateral, significant terms and any covenant violation and its resolution. A breach with no waiver, or a waiver the client expects to need again, is a condition you evaluate under AU-C 570 and ASC 205-40 alongside forecasts and liquidity.

Common file findings

• Covenant compliance taken from the client's certificate without recalculation.
• Waiver in the file with no read of its period or conditions.
• Interest expense "reasonable" with no expectation.
• Unused lines of credit and guarantees not confirmed or disclosed.

Covenant breach and waiver at Lakeshore Fabrication, Inc.