AP-10: Audit Program for Notes

Payable and Long-term Debt

Company Balance Sheet Date

The company has the following general ledger accounts that will be classified in the
notes payable and long-term debt captions of the balance sheet:

Description or
General Ledger Number Brief Purpose of the Account

Audit Program for Notes

Payable and Long-term Debt

Company Balance Sheet Date

Audit N/A Workpaper
Objectives Performed Index
Audit Procedures for Consideration by
FINANCIAL STATEMENT ASSERTIONS

E/O Existence or occurrence. V/A Valuation or

allocation.
C Completeness. P/D Presentation
and disclosure.
R/O Rights and obligations.

AUDIT OBJECTIVES
A. Notes payable, long-term debt, and debt equivalents
represent a complete listing of authorized debt (assertions E/O, C,
R/O, and V/A).

B. Such debt is properly classified between current and long-

term portions, and required disclosures have been made (assertions
V/A and P/D).
IDENTIFICATION CODES

The letters preceding each of the above audit objectives, i.e., A, B,

etc., serve as identification codes. These codes are presented in the
left column labeled Audit Objectives when a procedure
accomplishes an objective. If the alpha code appears in a bracket,
e.g., [A], [B], etc., the audit procedure only secondarily
accomplishes the objective. If an asterisk precedes a procedure, it is
a preliminary step or a follow up step that does not accomplish an
objective.

BASIC PROCEDURES

A, B 1. Obtain or prepare an analysis of notes payable, long-term

debt, capitalized lease obligations, and other financing transactions
or arrangements, such as lines of credit.

a. For significant notes or financing arrangements that will

not be confirmed on the standard bank confirmation, have the client
prepare separate confirmation letters. (See examples at CL-20, CL-
21, CL-22, and CL-31.)

(1) Address the letter to an official at the financial institution

who is responsible for the clients account or is knowledgeable
about such transactions or arrangements.

(2) Be sure that the confirmations are to be returned directly

to the auditor and contain a return envelope for this purpose.

(3) Control the mailing of the letters.

(4) Send a second request approximately 10 days after the

first mailing. Determine the cause for confirmation requests
returned as undeliverable. If possible, obtain new addresses and
remail.

(5) Retain copies of all confirmations in the workpapers.

b. Compare debt terms and debt balances as of the balance

sheet date to amounts confirmed on the standard bank
confirmations or other confirmations. Investigate any differences.

c. Test the reasonableness of interest expense and accrued

interest payable for the year.

d. Consider the need to impute interest on noninterest-bearing

notes.
Practical Considerations:

Ordinarily, confirmation requests are mailed to all recorded

holders of debt securities or parties to financing arrangements as
well as to all banks with which the company has accounts (standard
bank confirmation). However, alternative procedures are
sometimes applied when there are numerous long-term note
obligations that were confirmed in prior years.

Copies of debt and lease agreements should be maintained in

the auditors permanent file. See Step 2 of the program for other
general procedures to update the permanent file. Also, CL-34,
Confirmation of Lease Agreement, can be used to confirm
significant lease obligations and related lease provisions.

An overall calculation, based on the average principal amounts

outstanding during the period and contractual interest rates, is
 usually an effective overall test of the interest expense for the
period. If this computation results in a reasonable expense when
related to interest expense recorded in the general ledger expense
account, the adequacy of accrued interest payable is also tested. A
significant difference between the auditors computation and
recorded interest expense could indicate the existence of a
derivative. See Step 3 of the audit program for investments at AP-
8.

When an analytical procedure is used as the principal

substantive test of a significant financial statement assertion, SAS
No. 56, Analytical Procedures, as amended by SAS No. 96, Audit
Documentation, requires the auditor to document (1) the
expectation and the factors considered in its development (unless
readily determinable from the work performed), (2) the results of
the comparison between the expectation and recorded amounts, and
(3) any additional procedures performed in response to significant
unexpected differences and the results of those procedures. SAS
No. 96 is effective for audits of financial statements for periods
beginning on or after May 15, 2002, with early application
permitted.

The Confirmation and Correspondence Control at CX-24 can

be used to monitor the status of confirmations.

B 2. Summarize in the workpapers the information needed to

prepare any required financial statement disclosures.

a. Review loan and debt agreements and determine if assets

are pledged and if there are any restrictive covenants. Make
financial statement disclosure points for pledged assets and loan
restrictions. Determine if the company is in compliance with
restrictive covenants.

b. Examine lease agreements and determine if any leases

should be capitalized. Summarize in the workpapers the financial
statement disclosures for both capital and operating leases.

c. Determine the current portion of long-term debt.

Summarize in the workpapers the disclosures for note terms,
interest rates, and maturities over the next five years.
Practical Considerations:
 Auditors should be alert for due on demand clauses that many
banks include in standard commercial note agreements. Unless
waived in writing by the bank, the clauses result in classifying the
related debt as current. (See paragraph 1102.15.)

If a loan agreement has numerous restrictive covenants, the

auditor should consider photocopying the restrictive covenants and
pasting them on a multi-column spreadsheet included in the
permanent file workpapers. The spreadsheet columns can then be
used in each audit period to indicate compliance or noncompliance
with each covenant.

Auditors should be alert for cross default provisions where a

violation of one loan covenant affects other loan covenants.

The company should request a waiver from the creditor if it is

not in compliance with restrictive covenants. Creditor waivers
should be documented by formal waiver letters or creditor
confirmations. If covenant violations are not waived by the creditor
for a period of more than one year following the balance sheet date,
the related debt may need to be classified as current.

If the company has short-term debt and has obtained a

financing agreement which allows the obligation to be refinanced
on a long-term basis, the debt can only be excluded from current
liabilities if the financing agreement does not contain a subjective
acceleration clause.

If the company has a long-term debt agreement, the existence

of a subjective acceleration clause does not require that the debt be
classified as current if the likelihood of acceleration of the due date
is remote. See paragraph 1102.15.

Auditors should consider whether the company has the ability

to pay current debt maturities or to refinance the debt if necessary.

* 3. Consider the need to apply one or more additional

procedures. The decision to apply additional procedures should be
based on a consideration of whether information obtained or
misstatements detected by performing substantive tests or from
other sources during the audit alter your judgment about the need to
 obtain a further understanding of control activities, the assessed
level of risk of material misstatements (whether caused by error or
fraud), and on an evaluation of whether the basic procedures have
been sufficient to achieve the audit objectives. Attach audit
program sheets to document additional procedures.
Practical Considerations:

Certain common additional procedures relating to the

following topic are illustrated following this program:

Fair value disclosures.

Practitioners may refer to PPCs Guide to Fraud Investigations

for more extensive fraud detection procedures if it is suspected that
the financial statements are materially misstated due to fraud.

* 4. Consider whether procedures performed are adequate to

respond to identified fraud risk factors. If fraud risk factors or other
conditions are identified that require an additional audit response,
consider those risk factors or conditions and the auditors response
in connection with the performance of Step 11 in AP-1b.
Practical Consideration:

Specific responses to identified fraud risk factors are addressed

in individual audit programs. In connection with evaluation and
other completion procedures in AP-1b, the auditor considers the
need to perform additional procedures based on the results of
procedures performed in the individual audit programs and the
cumulative knowledge gained from performing those procedures.

* 5. Consider whether the results of audit procedures indicate

reportable conditions in internal control and, if so, add to the memo
of points for the communication of reportable conditions. (See
section 1504 for examples of reportable conditions, and see CX-18
for a worksheet that can be used to document the points as they are
encountered during the audit.)
CONCLUSION
.
We have performed procedures sufficient to achieve the audit
objectives for notes payable and long-term debt, and the results of
these procedures are adequately documented in the accompanying
workpapers. (If you are unable to conclude on any objective,
 prepare a memo documenting your reason.)

Additional Audit Procedures for Notes

Payable and Long-term Debt
Instructions: Additional procedures will occasionally be necessary on some small
business engagements. The following listing, although not all-inclusive, represents
common additional procedures and their related objectives.

Fair Value Disclosures

B Obtain information about the fair values of financial instruments

(for example, notes payable and long-term debt) for disclosure in
the financial statements.

Practical Considerations:

SFAS No. 126, Exemption from Certain Required Disclosures

about Financial Instruments for Certain Nonpublic Entities: An
Amendment of SFAS No. 107, makes SFAS No. 107s disclosures
about the fair value of financial instruments optional for companies
that meet the following criteria:

The company is a nonpublic company.

The companys total assets are less than $100 million on the
date of the financial statements.

The company has no instrument that, in whole or in part, is

accounted for as a derivative instrument under SFAS No. 133
during the reporting period.

The carrying amount of floating rate notes payable, mortgages

payable and long-term debt will ordinarily approximate fair value.
However, if the interest rate on the debt is significantly more or less
than current market rates, fair value can be estimated based on
quoted market prices for same or similar issues, current debt of the
same remaining maturities, or by discounted future cash flows at a
current interest rate. SFAS No. 107 indicates that one option is for
the company to use its incremental borrowing rate on similar debt.
For interest rate swaps, fair value can be estimated by comparing
the swap with a similar swap entered into recently.

Interpretation No. 1 of SAS No. 57, Auditing Accounting

Estimates (AU 9342), addresses auditing the clients fair value
estimates for disclosures required by SFAS No. 107. The
Interpretation requires that the auditor obtain sufficient competent
evidence to provide reasonable assurance that:

Valuation principles are in accordance with SFAS No. 107,

consistently applied, and supported by underlying documentation.

The method of estimation and significant assumptions used

are properly disclosed.

Paragraph 60 of SFAS No. 107 allows companies to use

simplified assumptions to estimate fair value of financial
instruments. Consequently, it is important that the methods and
significant assumptions used in the estimates are disclosed.

SFAS No. 107 does not require that fair values of financial
instruments be estimated if it is not practicable, or cost effective, to
develop the estimates. The decision of whether it is practicable
should consider such things as the importance of the financial
instrument to the clients business activities and the materiality of
the carrying amount of the financial instrument to the financial
statements.

When it is not practicable to estimate the fair value of a

financial instrument, disclosure must be made of:

Information pertinent to estimating the fair value of the

financial instrument.
 The reasons why it is not practicable to estimate fair value.

AU 9342 provides additional guidance for situations in which

the client chooses to provide voluntary fair value information in
addition to that required by SFAS No. 107.

If a fair value estimate is based on the work of an outside

specialist (e.g., an appraiser), the requirements of SAS No. 73,
Using the Work of a Specialist, should be followed. The additional
procedures to AP-1 contain audit procedures regarding using the
work of a specialist.

Additional Audit Procedures for Notes

Payable and Long-term Debt
Beginning Balance in Initial Audit
Company Balance Sheet Date

Audit N/A Workpaper

Objectives Performed Index
Audit Procedures for Consideration by

Instructions: Additional procedures will be necessary in an

initial audit. These procedures are applied to opening balances and
differ depending whether you are relying on your review of a
predecessors work or placing no reliance on a predecessors audit.
(Section 1803 discusses considerations when replacing a
predecessor auditor, including a discussion of what the term
reliance means when used in this program.) These procedures may
be applied in conjunction with the basic procedures applied to the
ending balance. The asterisks preceding the procedures indicate
that they are an intermediate step in achieving audit objectives for
the ending balance.

* 1. If a predecessors audit of the prior periods financial

statements is to be relied on:

a. Scan the predecessors workpaper analyses of notes

payable, long-term debt, and capitalized lease obligations, trace
 amounts to opening balances and compare to similar analyses for
the current period.

b. Compare interest expense and accrued interest payable for

the current period to the prior periods amounts and consider
reasonableness.

c. Vouch significant payments during the current period to

cash disbursements. Document the items tested.
Practical Consideration:

Since the basic procedures for the current period normally

include confirmation requests mailed to all recorded holders of debt
securities, and debt turnover is usually not significant, audit
objectives are substantially achieved by current basic procedures.

* 2. If no reliance on a predecessor is planned or possible:

a. Obtain or prepare analyses of notes payable, long-term

debt, capitalized lease obligations, and other financing transactions
or arrangements, e.g., lines of credit, at the close of the prior
period, trace amounts to opening balances, and compare to similar
analyses for the current period.

b. Compare interest expense and accrued interest payable for

the current period to the prior periods amounts and consider
reasonableness.

c. Vouch significant payments during the current period to

cash disbursements. Document the items tested.
Practical Consideration:

Since the basic procedures for the current period normally

include confirmation requests mailed to all recorded holders of debt
securities or parties to financing arrangements and debt turnover is
usually not significant, audit objectives are substantially achieved
by current basic procedures.