Efficient Tests of Balances Series—No. 31: Auditing Notes Payable, Long-Term Debt, Commitments and Contingencies

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Auditing procedures in this section are focused primarily on long-term obligations and agreements, various commitments and contingencies and related party relationships and transactions. While notes payable, long-term debt, and lease obligations ordinarily don’t present significant auditing issues or problems, except perhaps for loan covenant compliance, determining the existence of commitments and contingencies and related party relationships is usually more difficult. Obtaining and examining agreements, reading minutes from board and committee meetings and making inquiries of management are among the procedures necessary to verify financial statement assertions for these classifications. 

For most small to medium-size entities, there are usually only limited internal controls or policies regarding these audit areas.  Some auditing procedures will be performed during planning, while most will occur during yearend fieldwork (some may be accomplished during interim work).  While the assessed level of risk of material misstatement at the financial statements level may affect the auditor’s professional skepticism, substantive auditing procedures for small to medium-size entities will ordinarily be extensive for contracts, commitments, contingencies and related party transactions.

Analytical Procedures

As for other major audit areas, reading the general ledger in notes payable, long-term debt and related interest expense accounts is the most pervasive analytical procedures, particularly on small to medium-size audits.  Focusing on payment amounts, their frequency and their timeliness enable the auditor to determine if the terms of these obligations are being met.

For contracts, commitments and contingencies and related party transactions, reading the general ledger may disclose unusual circumstances or matters that should be discussed with management.  Because reading the general ledger should be performed early in the engagement planning and risk assessment procedures, resolution of such unusual matters can be the first matters of attention during fieldwork.

Other analytical procedures, such as comparing account balances with prior periods, may reveal other undisclosed affiliated relationships, new investments or undisclosed contracts or contingencies. Performing these comparisons using interim information (if an adjusted trial balance is not available) during planning can also enable the auditor to inquire about these circumstances early during engagement performance.  If this information requires additional auditing procedures, they can be planned and performed during fieldwork simultaneously with other auditing procedures to minimize time charges.

Tests of balances procedures will be illustrated in the next blog.

Efficient substantive procedures for notes payable, long-term debt and other account classifications resulting from cost-beneficial audit strategies are discussed in my live and on-demand webcasts which can be accessed by clicking the applicable box on the left side of my home page, www.cpafirmsupport.com.

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Is reading of the original documents discussed in another segment in your Efficient Tests series? I find this is where the most information is contained regarding third party requirements that can restrict access to otherwise unrestricted net assets crucial for normal operating liquidity as well as operating reserves. Terms have become even more onerous during these difficult economic times.