Illustruative Case: Violations of Debt Covenants In the audit of a large constru
ID: 2486282 • Letter: I
Question
Illustruative Case: Violations of Debt Covenants
In the audit of a large construction company, the auditors found the client's working capital to be far below the minimum level stipulated in the indenture of long-term secured bonds payable. In addition, the client had allowed the required insurance coverage of pledged assets to lapse. These violations of the indenture were sufficient to cause the bond issue to become payable on demand.
Although the client agreed to reclassify the bond issue as a current liability and disclose the problem in the financial statements, the auditors were unable to satisfy themselves that the client could meet the obligation if the bondholders demanded payment. Also, if the bondholders foreclosed on the pledged assets, the ability of the client to continue as a going concern would be questionable. Thus, even after the liability was reclassified as current, the auditors added an explanatory paragraph to their report referring to the uncertainty regarding the company's ability to meet its obligations and remain a going concern.
In the audit of a large construction company, the auditors found the client's working capital to be far below the minimum level stipulated in the indenture of long-term secured bonds payable. In addition, the client had allowed the required insurance coverage of pledged assets to lapse. These violations of the indenture were sufficient to cause the bond issue to become payable on demand.
Although the client agreed to reclassify the bond issue as a current liability and disclose the problem in the financial statements, the auditors were unable to satisfy themselves that the client could meet the obligation if the bondholders demanded payment. Also, if the bondholders foreclosed on the pledged assets, the ability of the client to continue as a going concern would be questionable. Thus, even after the liability was reclassified as current, the auditors added an explanatory paragraph to their report referring to the uncertainty regarding the company's ability to meet its obligations and remain a going concern.
Required: Explain the case and the key points about it
Explanation / Answer
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. The auditors should be familiar, however, with the principal provisions of the Federal Securities Act of 1933 and the corporate blue sky laws of the client's state of incorporation. 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.