Module 2

AUDIT OF NON-CURRENT LIABILITIES

Learning Objectives
At the end of this module, the following learning objectives will be attained by the students:
1. Describe the nature of debt.
2. Describe the auditors’ objectives in auditing debt.
3. Use the understanding of the client and its environment to consider inherent risks (including fraud risks)
related to debt.
4. Obtain an understanding of internal control over the financing cycle.
5. Assess the risks of material misstatement of debt and design further audit procedures to address the risks.

Source and Nature of Debt

Long-term debt usually is substantial in amount and often extends for periods of 20 years or more.
Debentures, secured bonds, and notes payable (sometimes secured by mortgages or trust deeds) are the
principal types of long-term debt. Debenture bonds are backed only by the general credit of the issuing
corporation and not by liens on specific assets. Since in most respects debentures have the characteristics of
other corporate bonds, we shall use the term bonds to include both debentures and secured bonds payable.
The formal document creating bond indebtedness is called the indenture or trust indenture. When
creditors supply capital on a long-term basis, they often insist upon placing certain restrictions on the
borrowing company. For example, the indenture often includes a restrictive covenant that prohibits the
company from declaring dividends unless the amount of working capital is maintained above a specified
amount. The acquisition of plant and equipment, or the increasing of managerial salaries, may be permitted
only if the current ratio is maintained at a specified level and if net income reaches a designated amount.
Another device for protecting the long-term creditor is the requirement of a sinking fund or redemption fund
to be held by a trustee. If these restrictions are violated, the indenture may provide that the entire debt is due
on demand.

The Auditors’ Objectives in Auditing Debt

The auditors’ objectives in the audit of debt are to:
a. Use the understanding of the client and its environment to consider inherent risks, including fraud
risks, related to debt.
b. Obtain an understanding of internal control over debt.
c. Assess the risks of material misstatement and design tests of controls and substantive procedures
that:
a. Substantiate the existence of debt and the occurrence of the related transactions.
b. Establish the completeness of recorded debt.
c. Verify the cut-off of transactions affecting debt.
d. Determine that the client has obligations to pay the recorded debt.
e. Establish the proper valuation of debt and the accuracy of transactions affecting debt.
f. Determine that the presentation and disclosure of information about debt are appropriate,
including disclosure of major provisions of loan agreements.

In conjunction with the audit of debt, the auditors will also obtain evidence about interest expense,
interest payable, and bond discount and premium. Many of the principles related to accounts payable also
apply to the audit of other forms of debt. As is the case for accounts payable, the understatement of debt is
considered to be a major potential audit problem. Related to disclosure of debt, the auditors should
determine whether the company has met all requirements and restrictions imposed upon it by debt
agreements.

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Assessment of the Inherent Risks Related to Debt
A major business risk related to debt is ensuring that the client obtains capital in an effective and
efficient manner. This risk is not indicative of a risk of material misstatement of the financial statements
and, therefore, is not of primary concern to the auditors. However, other business risks do equate to risks of
material misstatement. As an example, management must be concerned with the business risk of
noncompliance with debt covenants. This is also a concern of the auditors because noncompliance may
affect the classification of debt and related disclosures. Many of the principles related to accounts payable
also apply to the audit of debt. As is the case for accounts payable, the understatement of debt, whether due
to error or fraud, is considered to be a major potential inherent risk.

Internal Control over Debt

Authorization by the Board of Directors

Effective internal control over debt begins with the authorization to incur the debt. The bylaws of a
corporation usually require that the board of directors approve borrowing. The treasurer of the corporation
will prepare a report on any proposed financing, explaining the need for funds, the estimated effect of
borrowing upon future earnings, the estimated financial position of the company in comparison with others
in the industry both before and after the borrowing, and alternative methods of raising the funds.
Authorization by the board of directors will include review and approval of such matters as the choice of a
bank or trustee, the type of security, registration with the SEC, agreements with investment bankers, and
listing of bonds on a securities exchange. After the issuance of long-term debt, the board of directors should
receive a report stating the net amount received and its disposition as, for example, acquisition of plant
assets, addition to working capital, or other purposes.

Use of an Independent Trustee

Bond issues are always for large amounts—usually many millions of pesos. Therefore, only relatively large
companies issue bonds; small companies obtain long-term capital through mortgage loans or other sources.
Any company large enough to issue bonds and able to find a ready market for the securities will almost
always utilize the services of a large bank as an independent trustee. The trustee is charged with the
protection of the creditors’ interests and with monitoring the issuing company’s compliance with the
provisions of the indenture. The trustee also maintains detailed records of the names and addresses of the
registered owners of the bonds, cancels old bond certificates and issues new ones when bonds change
ownership, follows procedures to prevent over issuance of bond certificates, distributes interest payments,
and distributes principal payments when the bonds mature. Use of an independent trustee largely solves the
problem of internal control over bonds payable. Internal control is strengthened by the fact that the trustee
does not have access to the issuing company’s assets or accounting records and the fact that the trustee is a
large financial institution with legal responsibility for its actions.

Interest Payments on Bonds and Notes Payable

Many corporations assign the entire task of paying interest to the trustee for either bearer bonds or registered
bonds. Highly effective control is then achieved, since the company will issue a single check for the full
amount of the semi-annual interest payment on the entire bond issue. In the case of bearer bonds (coupon
bonds), the trustee upon receipt of this check will make payment for coupons presented, cancel the coupons,
and file them numerically. A second count of the coupons is made at a later date; the coupons then are
destroyed and a cremation certificate is delivered to the issuing company. The trustee does not attempt to
maintain a list of the holders of coupon bonds, since these securities are transferable by the mere act of
delivery. If certain coupons are not presented for payment, the trustee will hold the funds corresponding to
such coupons for the length of time prescribed by statute. In the case of registered bonds, the trustee will
maintain a current list of holders and will remit interest checks to them in the same manner as dividend
checks are distributed to stockholders. For a note payable, there generally is only one recipient of interest.
Companies control that disbursement in the same manner as other cash disbursements, without using a
trustee.
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Audit Documentation
A copy of the loan agreement or the indenture relating to a bond issue should be placed in the
auditors’ permanent file. A listing of the restrictions placed on the company is extracted from these
documents to facilitate the auditors’ tests of compliance with the debt provisions. Analyses of ledger
accounts for notes and bonds payable, and the related accounts for interest and discount or premium, should
be obtained for the current working papers file or the permanent file. In addition, the auditors should include
documentation of internal control and risk assessment for debt. A lead schedule is often not required for
short-term notes payable or for long-term debt.

Audit of Debt
After obtaining an understanding of the client and its environment, including internal control, the
auditors will assess the risks of material misstatement and design further audit procedures for debt. This
audit plan does not provide for the usual distinction between tests of controls and substantive procedures.
This is because individual transactions will generally be examined for all large debt agreements. To
document internal control, the auditors will usually prepare a written description, as well as an internal
control questionnaire. Questions included on a typical questionnaire are the following: (1) Are amounts of
new debt authorized by appropriate management? (2) Is an independent trustee used for all bond issues? (3)
Does a company official monitor compliance with debt provisions?
Because transactions are few in number but large in peso amount, the auditors are generally able to
substantiate the individual transactions. Therefore, testing of controls occurs through what actually amounts
to dual-purpose transaction testing.

Audit procedures appropriate for the verification of debt include the following:
1. Obtain or prepare analyses of debt accounts and related interest, premium, and discount accounts.
2. Examine copies of notes payable and supporting documents.
3. Confirm debt with payees or appropriate third parties.
4. Vouch borrowing and repayment transactions to supporting documents.
5. Perform analytical procedures to test the overall reasonableness of interest-bearing debt and interest
expense.
6. Test the valuation of debt, computation of interest expense, interest payable, and amortization of
discount or premium.
7. Evaluate whether debt provisions have been met.
8. Trace authority for issuance of debt to the corporate minutes.
9. Review notes payable paid or renewed after the balance sheet date.
10. Perform procedures to identify notes payable to related parties.
11. Send confirmation letters to financial institutions to obtain information about financing
arrangements.
12. Evaluate proper financial statement presentation and disclosure of debt and related transactions.

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Figure 2.1 relates these substantive procedures to their primary audit objectives.

1. Obtain or Prepare Analyses of Debt Accounts and Related Interest, Premium, and Discount
Accounts.
A notes payable analysis shows the beginning balance of each individual note, additional notes issued
and payments on notes during the year, and the ending balance of each note. In addition, the beginning
balances of interest payable or prepaid interest, interest expense, and interest paid and the ending balances of
interest payable or prepaid interest may be presented in the analysis working paper.
An analysis of the Notes Payable account will serve a number of purposes: (a) The payment or other
disposition of notes listed as outstanding in the previous year’s audit can be verified, (b) the propriety of
individual debits and credits can be established, and (c) the amount of the year-end balance of the account is
proved through the step-by-step examination of all changes in the account during the year.
In the first audit of a client, the auditors will analyze the ledger accounts for Bonds Payable, Bond Issue
Costs, and Bond Discount (or Bond Premium) for the years since the bonds were issued. The working paper
is placed in the auditors’ permanent file; in later audits, any further entries in these accounts may be added to
the analysis.
The accounts of the financing cycle are often relatively free of material misstatement. When
misstatements occur, they may be due to improper reporting of debt (e.g., a loan is recorded with a debit to
cash and a credit to a revenue account), incomplete recording of debt (e.g., a loan is not recorded and the
proceeds are maintained “off the books”), or improper amortization of loan-related discount and premium
accounts. In some situations, note disclosures related to debt are incomplete.
The auditors should also understand the risks involved when clients have complex organizational
structures involving numerous or unusual legal entities or contractual arrangements and transactions
involving related parties. In these cases, questions arise as to proper recording of the transactions. Also, the
auditors should realize that a lack of compliance with the provisions of a debt agreement usually makes the
debt involved entirely due and payable on demand.

2. Examine Copies of Notes Payable and Supporting Documents.

The auditors should examine the client’s copies of notes payable and supporting documents such as
mortgages and trust deeds. The original documents will be in the possession of the payees, but the auditors
should make certain that the client has retained copies of the debt instruments and that their details
correspond to the analyses described in the first procedure of this audit plan.

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3. Confirm Debt with Payees or Appropriate Third Parties.
Notes payable to financial institutions are confirmed as part of the confirmation of cash deposit balances.
The standard confirmation form includes a request that the financial institution confirm all borrowings by
the depositor.
Confirmation requests for notes payable to payees other than financial institutions should be drafted on
the client’s letterhead stationery, signed by the controller or other appropriate executive, and mailed by the
auditors. Payees should be requested to confirm dates of origin, due dates, unpaid balances of notes, interest
rates, dates to which interest has been paid, and collateral for the notes.
The auditors may also substantiate the existence and amount of a mortgage liability outstanding by direct
confirmation with the mortgagee. The information received should be compared with the client’s records
and the audit working papers. When no change in the liability account has occurred in the period under
audit, the only major procedure necessary will be this confirmation with the creditor. At the same time that
the mortgagee is asked to confirm the debt, it may be asked for an indication of the company’s compliance
with the mortgage or trust deed agreement.
Bond transactions usually can be confirmed directly with the trustee. The trustee’s reply should include
an exact description of the bonds, including maturity dates and interest rates; bonds retired, purchased for
the treasury, or converted into stock during the year; bonds outstanding at the balance sheet date; and
sinking fund transactions and balances.

4. Vouch Borrowing and Repayment Transactions to Supporting Documents.

The auditors should obtain evidence that transactions in debt accounts were valid. To accomplish this
objective, the auditors vouch the cash recorded as received from the issuance of notes, bonds, or mortgages
to the validated copy of the bank deposit slip and to the bank statement. Any remittance advices supporting
these cash receipts are also examined. The auditors can find further support for the net proceeds of a public
issue by referring to the underwriting contract and to the prospectus filed with the SEC.
Debits to a Notes Payable or a Mortgages Payable account generally represent payments in full or in
installments. The auditors should examine these payments; in so doing, they also will account for payments
of accrued interest. The propriety of installment payments should be verified by reference to the repayment
schedule set forth in the note or mortgage copy in the client’s possession.
A comparison of canceled notes payable with the debit entries in the Notes Payable account provides
further assurance that notes indicated as paid during the year have, in fact, been retired. The auditors’
inspection of these notes should include a comparison of the maturity date of the note with the date of cash
disbursement. Failure to pay notes promptly at maturity is suggestive of financial weakness.
There is seldom any justification for a paid note to be missing from the files; a receipt for payment from
the payee of the note is not a satisfactory substitute. If, for any reason, a paid note is not available for
inspection, the auditors should review the request for a check or other vouchers supporting the disbursement
and should discuss the transaction with an appropriate official.
In examining the canceled notes, the auditors should also trace the disposition of any collateral used to
secure these notes. A convenient opportunity for diversion of pledged securities or other assets to an
unauthorized user might be created at the time these assets are returned by a secured creditor.

5. Perform Analytical Procedures to Test the Overall Reasonableness of Interest-Bearing Debt and
Interest Expense.
One of the most effective ways to determine the overall reasonableness of interest-bearing debt is to
examine the relationship between recorded interest expense and the average principal amount of debt
outstanding during the year. If the client is paying interest on debt that is not recorded, this relationship will
not be in line with the interest rate at which the client company should be able to borrow. Therefore, the
auditors can use these procedures as a test of the completeness of recorded interest-bearing debt.
The auditors also compare the year-end amount of interest-bearing debt with the amount in the prior
year’s balance sheet. A similar comparison is made of interest expense for the current year and the preceding
year.

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6. Test the Valuation of Debt, Computations of Interest Expense, Interest Payable, and Amortization
of Discount or Premium.
Unless management elects the fair value option, debt is valued at its outstanding face value plus or minus
any unamortized premium or discount. To test valuation, the auditors test the amounts of amortization of
debt premiums or discounts. In addition, the auditors test the accuracy of the client’s computations of
interest expense and interest payable, including examining paid checks supporting interest payments. An
analysis of interest payments is another means of bringing to light any unrecorded interest-bearing liabilities.
The fair value option is available for companies that wish to value these financial liabilities at market
value. Depending upon the circumstances involved, valuation may be with observable inputs (e.g., market
prices) or unobservable inputs (discounted cash flows). When the fair value option has been selected, the
auditors should evaluate the propriety of the valuation techniques and the inputs.

7. Evaluate Whether Debt Provisions Have Been Met.

In the first audit of a client or upon the issuance of a new bond issue, the auditors will obtain a copy of
the bond indenture for the permanent file. The indenture should be carefully studied, with particular
attention to such points as the amount of bonds authorized, interest rates and dates, maturity dates,
descriptions of property pledged as collateral, provisions for retirement or conversion, duties and
responsibilities of the trustee, and any restrictions imposed on the borrowing company.
The indenture provisions may require maintenance of a sinking fund, maintenance of stipulated
minimum levels of working capital, and insurance of pledged property. The indenture also may restrict
dividends to a specified proportion of earnings, limit management compensation, and prohibit additional
long-term borrowing, except under stipulated conditions. The auditors will perform tests to evaluate whether
the company is in compliance with these provisions. For example, the auditors will examine evidence of
insurance
coverage, vouch payments to the sinking fund, and compare the amounts of management compensation and
dividends paid to amounts allowed by the agreements.
If the company has not complied fully with the requirements, the auditors should inform both the
client and the client’s legal counsel of the violation. In some cases of violation, the entire bond issue may
become due and payable on demand, and hence a current liability. When the client is in violation of an
indenture provision and the penalty is to make the debt become payable upon demand, the client usually will
be able to obtain a waiver of compliance with the provision. In other words, creditors often choose not to
enforce contract terms fully. To enable the liability to be presented as long term, the waiver must waive
compliance for a period of one year from the balance sheet date. Even if an appropriate waiver of
compliance is obtained, the matter should be disclosed in the notes to the client’s financial statements.
Auditors do not judge the legality of a bond issue; this is a problem for the client’s attorneys. They
should determine that the client has obtained an attorney’s opinion on the legality of the bond issuance. In
doubtful cases, they should obtain representations from the client’s legal counsel.

8. Trace Authority for Issuance of Debt to the Corporate Minutes.

The authority to issue debt generally lies with the board of directors. To determine that the bonds
outstanding were properly authorized, the auditors should read the passages in the minutes of directors’ (and
stockholders’) meetings concerning the issuance of debt. The minutes usually will cite the applicable
sections of the corporate bylaws permitting the issuance of debt instruments and may also contain reference
to the opinion of the company’s counsel concerning the legality of the issue.

9. Review Notes Payable Paid or Renewed after the Balance Sheet Date.
If any of the notes payable outstanding at the balance sheet date are paid before completion of the audit
engagement, such cash payments provide the auditors with additional evidence on the liability. Renewal of
notes maturing shortly after the balance sheet date may alter the auditors’ thinking as to the proper
classification of these liabilities.
In the audit of notes receivable, emphasis was placed on the necessity of close scrutiny of loans to
officers, directors, and affiliates because of the absence of arm’s-length bargaining in these related party
transactions. Similar emphasis should be placed on the examination of notes payable to insiders or affiliates,

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although the opportunities for self-dealing are more limited than with receivables. The auditors should scan
the notes payable records for the period between the balance sheet date and the completion of the audit so
that they may be aware of any unusual transactions, such as the reestablishment of an insider note that had
been paid just prior to the balance sheet date.

10. Perform Procedures to Identify Notes Payable to Related Parties.

As has been the case in other portions of the audit, the auditors should perform procedures to determine
that any related party debt is properly disclosed. Note here that the lower number of transactions makes
discovery of such transactions less difficult than in accounts with a large number of transactions such as
accounts payable.

11. Send Confirmation Letters to Financial Institutions to Obtain Information about Financing
Arrangements.
Financing arrangements and transactions can be very complex, and the details of these arrangements and
transactions must be adequately disclosed in the notes to the financial statements. If the auditors determine
that additional evidence is needed to verify these details, they will send a separate confirmation letter to the
financial institution. For example, confirmation letters may be used to obtain information about lines of
credit, contingent liabilities, compensating balance arrangements, letters of credit, or futures contracts.
These letters are signed by the client and specifically addressed to the client’s loan officer or another official
at the financial institution that is knowledgeable about the information. This expedites a response to the
confirmation and enhances the quality
of the evidence received.

Figure 2.2 provides an example of a

letter to confirm information about
lines of credit.

12. Evaluate Proper Financial

Statement Presentation and
Disclosure of Debt and Related
Transactions.
Because of the interest of creditors
in the current liability section of the
balance sheet and the inferences that
may be drawn from various uses of
notes payable, adequate informative
disclosure is extremely important.
Classification of notes by types of
payees, as well as by current or long-
term maturity, is necessary. Notes
payable to banks, notes payable to
trade creditors, and notes payable to
officers, directors, stockholders, and
affiliates should be listed separately.
Secured liabilities and pledged
assets should be cross-referenced to
one another with an explanation in the
notes to the financial statements. In the
event of financial difficulties and
dissolution, creditors expect to share in
the assets in proportion to their
respective claims; if certain assets,
such as current receivables, have been

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pledged to one creditor, the risk to unsecured creditors is increased. Current liabilities should include not
only
those notes maturing within a period of 12 months (or a longer operating cycle) but also any installments
currently payable on long-term obligations such as mortgages.
The essential point in balance sheet presentation of long-term liabilities is that they be adequately
described, including details about the types of debt, amounts authorized and issued, interest rates, maturity
dates, and any conversion or subordination features.

Long-Term Debt Payable in the Current Period

Long-term liabilities include all debts that will not be liquidated with the use of current assets. In other
words, any bonds or notes falling due in the coming operating cycle that are to be paid from special funds or
refinanced will be classified as long-term obligations regardless of maturity date. Before accepting a long-
term classification for maturing obligations, auditors should satisfy themselves that the client has both the
intent and the ability to refinance the obligation on a long-term basis. Intent and ability to refinance are
demonstrated by the client through either (1) refinancing the obligation on a long-term basis before the
issuance of the financial statements, or (2) entering into a financing agreement by that date, which clearly
permits such refinancing. Any debt maturing currently and payable from current assets should be classified
as a current liability.

Restrictions Imposed by Long-Term Debt Agreements

The major restrictions imposed on the company by long-term loan agreements are significant to the
company’s investors and creditors. Consequently, the nature of the restrictions should be clearly set forth in
a note to the financial statements.

Unamortized Bond Premium or Discount

Unamortized premium should be added to the face amount of the bonds or debentures in the liability section
of the balance sheet. Similarly, unamortized discount should be deducted from the face amount of the debt.

Time of Examination—Debt
Analysis of the ledger accounts for debt and interest expense takes very little time in most audits
because of the small number of entries. Consequently, most auditors prefer to wait until the end of the year
before analyzing these accounts.
Audit procedures intended to reveal any unrecorded liabilities cannot ordinarily be performed in
advance of the balance sheet date. Such steps as the evaluation of compliance with debt provisions, tests of
interest expense, and the investigation of notes paid or renewed shortly after the balance sheet date must
necessarily await the close of the period being audited. The opportunities for performing audit work in
advance of the balance sheet date are thus much more limited in the case of debt than for most of the asset
groups
previously discussed.

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APPENDIX

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Multiple-Choice Questions for Practice and Review

1. Loan covenants are used for which of the following reasons?

a. To protect the lender from the borrower’s substantially weakening of the latter’s financial
position.
b. To protect the borrower from the lender’s calling the loan early.
c. To protect the auditors from false information by the borrower.
d. To protect shareholders from management taking on too much debt.
2. In connection with the audit of an issue of long-term bonds payable, the audit team should
a. Determine whether bondholders are persons other than owners, directors, or officers of the
company issuing the bond.
b. Calculate the effective interest rate to see whether it is substantially the same as the rates charged
for similar issues.
c. Decide whether the bond issue was made without violating laws or regulations.
d. Ascertain that the client has obtained the opinion of counsel on the legality of the issue.
3. The primary reason for preparing a reconciliation between interest-bearing obligations outstanding
during the year and interest expense in the financial statements is to
a. Evaluate internal control over securities.
b. Determine the validity of prepaid interest expense.
c. Ascertain the reasonableness of imputed interest.
d. Detect unrecorded liabilities.
4. An audit team would most likely verify the interest earned on bond investments by
a. Vouching the receipt and deposit of interest checks.
b. Confirming the bond interest rate with the issuer of the bonds.
c. Recomputing the interest earned on the basis of face amount, interest rate, and period held.
d. Testing internal controls relevant to cash receipts.
5. In connection with the examination of bonds payable, the auditors would expect to find in a trust
indenture:
a. the yield to maturity of the bonds issued.
b. the names of the original subscribers to the bond issue.
c. the issue date and maturity date of the bond.
d. the company's debt to equity ratio at the time of issuance.
6. An audit plan to examine long-term debt most likely would include steps that require
a. Comparing the carrying amount of held-to-maturity securities with their year-end market values.
b. Correlating interest expense recorded for the period with outstanding debt.
c. Verifying the existence of the holders of the debt by direct confirmation.
d. Inspecting the accounts payable subsidiary ledger for unrecorded long-term debt.
7. Which of the following questions would auditors most likely include on an internal control questionnaire
for notes payable?
a. Are assets that collateralize notes payable critically needed for the entity’s continued existence?
b. Are two or more authorized signatures required on checks that repay notes payable?
c. Are the proceeds from notes payable used to purchase noncurrent assets?
d. Are direct borrowings on notes payable authorized by the board of directors?
8. An audit team’s purpose in reviewing the documentation concerning the renewal of a note payable
shortly after the balance-sheet date most likely is to obtain evidence concerning management’s
assertions about
a. Existence.
b. Valuation.
c. Completeness.
d. Classification.

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9. Which of the following is least likely to be an audit objective for debt?
a. Determine the existence of recorded debt.
b. Establish the completeness of recorded debt.
c. Determine that the client has rights to receive proceeds relating to the redemption of debt.
d. Determine that the valuation of debt is in accordance with generally accepted accounting
principles.
10. During the year being audited a company guaranteed the debt of an affiliate. Which of the following best
describes the audit procedure that would make the auditor aware of the guarantee?
a. Review the legal letter returned by the company's outside legal counsel.
b. Review the possibility of such guarantees with the chief accountant.
c. Review minutes and resolutions of the board of directors.
d. Review prior year's working papers with respect to such guarantees.
11. A likely reason that consideration of client compliance with debt provisions is important to an audit is
that violation of such debt provisions may affect the total recorded:
a. Number of debt restrictions.
b. Current liabilities.
c. Long-term assets.
d. Capital stock.
12. The audit procedure of confirmation is least appropriate with respect to:
a. The trustee of an issue of bonds payable.
b. Holders of common stock.
c. Holders of notes receivable.
d. Holders of notes payable.
13. The auditors can best verify a client’s bond sinking fund transactions and year-end balance by:
a. Recomputation of interest expense, interest payable, and amortization of bond discount premium.
b. Confirmation with individual holders of retired bonds.
c. Confirmation with the bond trustee.
d. Examination and count of the bonds retired during the year.
14. The auditors’ plan for the examination of long-term debt should include steps that require the:
a. Verification of the existence of the bondholders.
b. Examination of copies of debt agreements.
c. Inspection of the accounts payable subsidiary ledger.
d. Investigation of credits to the bond interest income account.
15. During the course of an audit, a CPA observes that the recorded interest expense seems to be excessive
in relation to the balance in the long-term debt account. This observation could lead the auditors to
suspect that:
a. premium on bonds payable is understated.
b. long-term debt is overstated.
c. long-term debt is understated.
d. discount on bonds payable is overstated.
16. Statement 1: Debentures are liabilities that are backed only by the general credit of the issuing
company.
Statement 2: The auditors should personally evaluate the legality of all new issues of debt by the client.
a. Both statements are True
b. Both statements are False
c. True, False
d. False, True

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17. Statement 1: The auditors have no responsibility to determine compliance with restrictions imposed by
borrowing agreements since these restrictions do not affect accounting principles.
Statement 2: The audit procedure of confirmation by direct communication with a creditor is more
likely to be applied to a note holder than to a bondholder.
a. Both statements are True
b. Both statements are False
c. True, False
d. False, True
18. Statement 1: The authority to issue interest-bearing debt generally lies with the stockholders of the
corporation.
Statement 2: The audit of interest expense may reveal the existence of unrecorded debt.
a. Both statements are True
b. Both statements are False
c. True, False
d. False, True
19. Statement 1: When a "sinking fund" exists, the auditors should be able to identify cash or other assets
set aside for the retirement of a debt.
Statement 2: Notes payable to financial institutions are confirmed as a part of the confirmation of cash
deposit balances.
a. Both statements are True
b. Both statements are False
c. True, False
d. False, True
20. Statement 1: The discovery of related-party transactions is generally easier in the area of notes payable
than in accounts payable.
Statement 2: Actual signed copies of the notes are often put in the auditors' permanent file.
a. Both statements are True
b. Both statements are False
c. True, False
d. False, True

ILLUSTRATIVE PROBLEMS
Problem 1
Identify by letter the assertions addressed in each of the following substantive procedures relating to audit of
liabilities:

Assertions:
A. Existence
B. Rights and Obligations
C. Completeness
D. Valuation and Allocation
E. Presentation and Disclosure

Substantive Procedures:
1. Confirm bond balances with trustee A
2. Recompute interest expense D
3. Confirm with banks and other financial institutions A

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 4. Examine documents, contracts, statements of account that provide basis for
A, B, C, D
accrual

5. Conduct cutoff test of purchases and accruals of interest B, C

6. Examine the reasonableness and adequacy of the amounts recognized as

C, D
provisions

7. Make appropriate inquiries of management, review minutes of meetings of the

B, C, E
board of directors and correspondence with the client’s lawyers

8. Review disclosures made in the prior period financial statements relating to

C, E
contingencies

9. Review unusual payments made during the reporting period C, D

10. Confirm status of pending litigation B, C, E
11. Reconcile beginning balance with ending balance of the obligation D, E
12. Compare closing balances with the corresponding figures for the previous year D, E

Problem 2
In your initial audit of Glorietta Company, you find the following ledger account balances.

12% Bonds Payable - Due 10 years from 01/01/2018

: 01/02/2018 CR P 5,000,000.00

Bonds Payable Redeemed

10/1/2021 CD P 1,110,000.00 :

Discount on Bonds Payable

1/2/2018 CR P 529,697.00 :

Bond Interest Expense

1/1/2021 CD P 300,000.00 :
7/1/2021 CD P 300,000.00 :

The bonds were redeemed for permanent cancellation on October 1, 2021 at 108 plus accrued interest. Based
on your computation, the bonds were originally issued to yield 14%.

Required:
a) Compute the following:
1. The adjusted balance of bonds payable as of December 31, 2021. 4,000,000
2. The adjusted balance of the bond discount on December 31, 2021. 317,702
3. The bond interest expense for the year 2018, 2019 and 2020.
4. The loss on bond redemption. 161,500
5. The balance of interest payable on December 31, 2021. 240,000

b) Prepare audit adjusting entry as of December 31, 2021.

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Problem 3
The noncurrent liabilities of PBB Company at December 31, 2020 included the following:

Note payable - bank P3,600,000

Liability under finance lease 2,623,200
Note payable - supplies 1,500,000

Transactions during 2021 and other information relating to PBB’s liabilities were as follows:
a. The note payable to the bank bears interest at 20% and is dated May 1, 2020. The principal amount
of P3,600,000 is payable in four equal annual installments of P900,000 beginning May 1, 2021. The
first principal and interest payment was made on May 1, 2021.
b. The finance lease is for a ten-year period. Equal annual payments of P750,000 are due on December
31, of each year. The interest rate implicit in the lease is 18%. The amount of P2,623,200 represents
the present value of the six remaining lease payments (due December 31, 2021 through December
31, 2026) discounted at 18%.
c. The note payable to supplier bears interest at 19% and matures on September 30, 2022. On February
25, 2022, after the December 31, 2021 balance sheet date, but before the 2021 statements were
authorized for issue, PBB Company consummated a noncancelable agreement with a lender to
refinance the 19%, P1,500,000 on a long-term basis, on readily determinable terms that have not yet
been implemented. Both parties are financially capable of honoring the agreement, and there have
been no violations of the agreement's provisions.
d. On April 1, 2021, PBB issued for P7,005,675, P6,000,000 face amount of its 20%, P100,000 bonds.
The bonds were issued to yield 15%. The bonds are dated April 1, 2021 and mature on April 1, 2026.
Interest is payable annually on April 1.

Based on the above and the result of your audit, determine the following:

1. Carrying amount of bonds payable as of December 31, 2021 6,893,813

2. Total noncurrent liabilities as of December 31, 2021 10,711,357
3. Current portion of long-term liabilities as of December 31, 2021 2,727,832
4. Total interest expense for 2021 2,145,314

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Problem 4
Your company has been engaged to examine the financial statements of Kryz Company for the years ended
December 31, 2021 and December 31, 2020. You have been assigned to review the liabilities and
shareholder’s equity balances. You have learned that on January 1, 2019, Kryz Company issued a five-year,
8% bonds P5,000,000 for P5,500,000. Each P1,000 bond is convertible into 8 shares of P100 par ordinary
share of Kryz Company, at the option of the bondholder. Interest on the bonds is payable annually on
December 31. Without the conversion feature, the bonds would have sold to yield 10% to the holders.
(Round present value factors to four decimal places.)

Required:
1. Compute the issue price that was attributable to the debt. 4,620,820
2. What was the correct carrying value of the bonds on December 31, 2019? 4,682,902
3. What is the interest expense on these bonds for the year ending December 31, 2020? 468,290
4. P2,000,000 of the bonds were converted into ordinary shares on January 1, 2021. What amount
should have been credited to share premium, upon conversion? 652,149
5. Disregard the information given in item no. 4. Assume, instead, that on January 1, 2021, P2,000,000
of the bonds were retired @ 109. The bonds without the conversion feature would have sold @ 105
on this date. What amount of gain (loss) should be recognized on the retirement of the bonds?
(199,523)
6. Disregard the assumption in item 4. Assume that on January 1, 2021, P2,000,000 of the bonds were
retired @ 109. The bonds without the conversion feature would have sold @ 105 on this date. What
should be the interest expense for the year ended December 31, 2021? 285,072

Problem 5
In the course of your examination of the liabilities accounts of April Company, you found that the entity on
January 2, 2021 issued at a premium bonds payable with a face value of P500,000. The premium was
erroneously credited by the company to Interest Income. The bonds are payable on December 31, 2028 and
pay interest semi-annually on June 30 and December 31. You instructed your audit staff to compute the
premium amortization using the interest method and he provided you with the following:

Premium amortization from January 2, 2021 to June 30, 2021 P 1,562

Bond carrying value as of June 30, 2021 555,738
Total interest paid on bonds for the year 2021 (payments made on
June 30 and December 31) 70,000

Required:
1. The annual stated interest rate on the bonds is 14%
2. The effective annual interest rate on the bond is 12%
3. The premium amortization on the bonds payable for 2021 is 3,218
4. Interest expense on the bonds for 2021 is 66,782

Problem 6
You are reviewing the Notes Payable and Interest Expense accounts of La Mere Fashion Boutique as of
December 31, 2021. You noted that the company regularly borrows from the bank in order to finance
working capital. The following schedule shows loans with 12% interest rate, with interest payable at
maturity. All loans are repaid on their scheduled maturity dates, and interest expense is recorded when the
loans are repaid, with no adjustments taken up at year-end:

Date of Loan Amount Maturity Date Term of Loan

November 1, 2020 P1,500,000 October 31, 2021 one year
February 1, 2021 2,500,000 July 31, 2021 six months
May 1, 2021 1,000,000 January 31, 2022 nine months

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Required:
1. How much did La Mere Fashion Boutique record as interest expense during the year 2021? 330,000
2. What is the correct interest expense during the year 2021 as a result of the above loans? 380,000
3. How much Notes Payable, inclusive of Interest Payable should be shown in the current liabilities
section of the statement of financial position on December 31, 2021 as a result of the foregoing
loans? 1,080,000

Problem 7
In your initial audit of JF Corporation, you find the following ledger account balances:

12% Bonds Payable, due March 31, 2024

10/1/2021 P 3,060,000 3/31/2019 P 10,000,000

Premium on Bonds Payable

3/31/2019 772,144

Bond Interest Expense

3/31/2021 P 600,000
9/30/2021 600,000

The bonds pay interest semiannually on March 31 and September 30. The bonds were issued on March 31 at
a price to yield 10%.

On October 1, 2021, P3,000,000 of the bonds were redeemed for permanent cancellation at 102.

For your convenience, fill up the following columns in the amortization table.

Interest Date Interest Paid Effective Interest Premium Amortization Amortized Cost,
End
March 31, 2019 P 10,772,144
Sept. 30, 2019 600,000 538,607 61,393 10,710,751
March 31, 2020 600,000 535,538 64,462 10,646,289
Sept. 30, 2020 600,000 532,314 67,686 10,578,603
March 31, 2021 600,000 528,930 71,070 10,507,533
Sept. 30, 2021 600,000 525,377 74,623 10,432,910
March 31, 2022 600,000 521,646 78,354 10,354,556

The company adopts calendar year as its reporting period.

Required:
1. The adjusted ledger balance of Bonds Payable account at December 31, 2021 is 7,000,000
2. The adjusted ledger balance of Premium on Bonds Payable at December 31, 2021 is 275,613
3. Interest Payable at December 31, 2021 is 210,000
4. Interest Expense for the year 2021 is 972,418
5. The gain (loss) on bond redemption is 69,873

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