Auditing Debt or Loan auditing are not two different aspects. They are the same. That’s all about auditing the financial obligation and obtaining audit evidence to confirm that the Debt GL balance is complete and accurate. Lets understand the basic concepts in this context first.
Meaning of Debt/Loan
Debt/Loan is a financial obligation which has the interest element. Debt can be secured or unsecured. Secure means loans given on security which minimizes the risk for Lender. For example, a banker lends loan for purchase of Car. Loan has Car as security and is under mortgage to the Lender. These loans are more favorable to Lenders as they have the right to sell the security and receive the loan amount in case of default by the borrower.
Unsecured debt is a debt sanctioned solely depending on the borrower’s repayment capacity and creditworthiness. The best example, in this case, would be personal loans. As the Lender risk is higher for unsecured debts, the interest percentage will be higher.
Before moving into the concept of auditing debt or loan auditing, lets have a look into the different types of debt
Table of contents
Types of Debt
Debts are classified depending on its tenure of loan. The Classification is for presentation purpose and those forms basis for calculating the ratios. For example, short term debt is a major input for the current ratio. If there is lack of understanding of classification then calculating such ratios is not possible.
- Short term Borrowings
- Long term Borrowings
Short term Borrowings
Short Term Borrowings are the debts or financial obligations which are repayable within one year. These forms part of current liabilities in the balance sheet and do not include trade payable.
Trade payables are the obligation to pay the Creditor for the purchase of goods or services received. These borrowings are to facilitate operating activities. Here the goods are brought on credit. So, the credit is not in terms of money. These trade payables exist due to operating expenses, tax liabilities, or even for the creditors.
Is there any interest charged for trade payables?
Further, there is no interest for the credit period. The credit period is depends on the relationship between buyer and seller of goods (or) receiver and seller of services. However there is one exception to this. If there are any delays then Supplier might charge penalty or interest.
Is any Security involved?
Trade payable does not depend on any security. The seller delivers the goods (or) services to the buyer and allows time to clear the liability. So, this scenario is quite different from that of borrowings.
Unlike Trade payables, the purpose of obtaining these borrowings is not specific but general in nature. So, debts are for any business purpose.
How about an Short term Borrowings example?
Credit Cards, Cash Credit, Overdraft Loans from Banks or financial institutions. Nowadays, many online platforms provide short-term credit facilities such as Amazon Pay later, Flipkart Pay Later, Ola Postpaid, and the list goes on. These all fall under the short term borrowings
Long Term Borrowings
Long term borrowing is a financial obligation which is not payable on demand or within the next 12 months from the reporting date. These funds are sourced for requirements such as expanding business, starting a new venture and purchasing fixed assets, which helps in the primary business activity. In other words, the monetary requirement and payment terms are more than that of short-term borrowings.
These are classified under Non-Current Liabilities. For example, Debentures or Treasury bonds issued fall under the category of long-term borrowings.
Now that we’ve learned of different types of debt and their meanings, we’ll move on to the concept of “auditing debt or Loan auditing.”
First and foremost, step in debt testing is performing risk assessment procedures, then comes the following steps:
– Ascertaining the operating effectiveness of the controls around the debt and
– Establish the assertions that need to be tested.
Debt Risk Assessment
Before testing any account balance, we need to assess the risk associated with the account balance. If risk is lower, then the samples that needs to be tested is lower and vice -versa. So, risk assessment drives the testing. The auditor shall perform the initial risk assessment procedures in the planning phase.
So, before auditing debt or loan auditing, we need perform the risk assessment. Therefore, consider the following aspects for risk assessment:
- Understanding of the Entity and its industry
- Knowledge obtained from the prior year audits
- Preliminary Analytical Procedures performed for the current year
- Audit Results of testing procedures performed over the debt account balance from previous years
- History of Misstatements in this account balance
- Control Deficiencies identified in the previous year if any
Consider the following point for risk assessment as well,
“Understand the terms of contracts entered in the current year and see if any risks are arising of unfavorable requirements as per the loan agreements“
For example, the Entity shall maintain a current ratio of 3 each year. If the company fails to maintain this ratio, then the loan becomes payable in the current year. However, the the current ratio is 2.5 for the current year. In this case, the auditor shall consider this as an additional risk and assess the substantive procedures to address this risk.
What are the responsive steps in this scenario?
The auditor shall perform inquires with the management and how the Entity addresses this requirement. If the response is not satisfactory, the audit team shall decide the requirement of further audit procedures and decide if the risk for this account balance shall be classified as higher or significant.
Ascertain how the Controls are operating in the Entity:
The audit team performs the design and operating effectiveness of all the debt-related controls. The testing results help the auditor in deciding whether reliance can be placed on internal controls of the Entity. If the audit team decides to place reliance on controls, then the extent of substantive procedures will not be high.
Assertions for Auditing Debt/Loan auditing:
Balance sheet GL Assertions are Existence, Completeness, Rights and Obligations, Accuracy, and valuation. However, all these assertions are not applicable for debt. Assertions that need to be tested for debt are listed below:
- Completeness: Auditor requests for debt listing, which contains the loan amount available under contract, interest amount and outstanding principal balances. The completeness of debt under audit is tested by agreeing the debt balance as per listing to the general ledger.
Refer below in the following procedures section for testing of the last three assertions .
Auditing Debt (or) Loan Auditing Procedures
Audit team tests the the debt or loan balance either any one or both of the below procedures:
– Sending confirmations or
– Tracing the amounts to the entity bank statements.
Confirmation response is provided by the third party and the bank statements could not be modified. So, testing the obligation assertion gives more comfort because of external audit evidence.