Audit Procedure for Borrowing

What is Borrowing?

In the dynamic landscape of business, growth is a constant pursuit, and for many companies, the path to expansion often involves strategic borrowing. This delicate dance with corporate borrowing can be a game-changer when executed skillfully, propelling a company to new heights. However, mishandling this financial tool can lead to a distressing tango of financial troubles.

Companies resort to borrowing for various strategic reasons, each serving as a stepping stone toward achieving their growth objectives:

1. Fueling Expansion: Ambitious plans such as building a new factory, entering a new market, or acquiring a competitor may outstrip available cash reserves. Borrowing becomes the bridge between aspiration and reality.
2. Investing in Innovation: Research and development, being a costly endeavor, can be made possible through borrowing. This financial resource provides the necessary runway to bring groundbreaking technologies to the market.
3. Managing Cash Flow: Seasonal businesses or those with substantial upfront costs often turn to borrowing to smooth out their cash flow. This proactive measure helps them avoid debilitating shortfalls during lean periods.
4. Capitalizing on Opportunities: In the business world, opportunities don’t wait. Borrowing enables companies to swiftly seize once-in-a-lifetime deals, providing a competitive edge over rivals.

The options available for corporate borrowing are as diverse as the businesses themselves. Some popular choices include:

1. Bank Loans: Traditional loans from financial institutions provide secure financing, often used for specific projects or acquisitions.
2. Bonds: Issuing debt instruments to investors opens access to a broader pool of capital. However, this comes with fixed interest payments and the potential for market fluctuations.
3. Lines of Credit: Similar to a corporate credit card, lines of credit offer a flexible source of funding with quick access to cash. However, responsible management is essential to avoid spiraling debt.

Accounting for Borrowing

Type of borrowing:

• Loan: When a company takes out a loan, it’s recorded as an increase in the cash account and a credit to a notes payable account (or a similar liability account). As the company makes payments, the cash account decreases and the notes payable account balance decreases.
• Bond issuance: When a company issues bonds, it’s recorded as an increase in the cash account and a credit to a bonds payable account. Interest payments are recorded as interest expense, and the principal amount is repaid when the bonds mature.
• Line of credit: A line of credit is a revolving source of borrowing. When the company draws on the line of credit, it’s recorded as an increase in the cash account and a credit to the line of credit account. As the company makes payments, the cash account decreases and the line of credit balance decreases.

When a company borrows cash from a bank, pays interest, and eventually settles the borrowing, several journal entries are made to reflect these transactions. Let’s go through the journal entries step by step:

1. Borrowing Cash from the Bank:
   • Assuming the company borrows $100,000 from the bank.

   Account	Debit	Credit
   Cash	100,000
   Loan Payable		100,000

   This entry reflects the increase in the company’s cash (an asset) and the recognition of a loan payable (a liability).

2. Paying Interest on the Loan:
   • Let’s assume the company pays $5,000 in interest.
     

     Account	Debit	Credit
     Interest Expense	5,000
     Cash		5,000

   
This entry recognizes the interest expense and reduces the company’s cash.

3. Settling the Borrowing:
   • Let’s assume the company repays the loan principal along with the interest. The total repayment is $105,000 ($100,000 principal + $5,000 interest).

    

This entry reflects the reduction in the loan payable, the recognition of interest expense, and the decrease in cash to settle the borrowing.

Audit Risk for Borrowing

Certainly, let’s discuss audit risks related to borrowing without including mitigation strategies:

1. Existence and Completeness:
   • Risk: Failure to record all borrowings, including unrecorded loans, lines of credit, or off-balance sheet financing arrangements.
2. Accuracy:
   • Risk: Incorrect recording of the amount borrowed, interest rate, or maturity date.
3. Classification:
   • Risk: Improper classification of borrowings as current or non-current liabilities.
4. Loan Covenant Compliance:
   • Risk: Failure to comply with loan covenants, such as maintaining minimum working capital or debt-to-equity ratios, which could trigger loan defaults and penalties.
5. Inadequate Disclosure:
   • Risk: Inadequate disclosure of potential breaches of covenants in the financial statements.
6. Unauthorized Purposes:
   • Risk: Borrowing funds for unauthorized purposes that violate loan agreements or internal controls.
7. Diverting Borrowed Funds:
   • Risk: Diverting borrowed funds for personal gain or unrelated business activities.

Internal Control

Internal control over borrowing is essential for ensuring that a company’s borrowing activities are conducted in a controlled and orderly manner, with adherence to established policies and compliance with relevant laws and regulations. Here are key aspects of internal control over borrowing:

1. Authorization and Approval:
   • Internal controls should specify the individuals or positions responsible for authorizing and approving borrowing transactions. This helps prevent unauthorized borrowing and ensures that only valid and approved transactions are undertaken.
2. Clear Policies and Procedures:
   • Establishing clear policies and procedures for borrowing activities is crucial. These documents should outline the process for requesting, approving, and recording borrowings. They should also define the criteria for selecting appropriate financing options and the necessary documentation required.
3. Segregation of Duties:
   • To mitigate the risk of fraud or errors, responsibilities related to borrowing should be segregated among different individuals or departments. For example, the person authorizing a borrowing transaction should be different from the person responsible for recording it in the accounting system.
4. Documentation and Recordkeeping:
   • Robust recordkeeping is vital for internal control over borrowing. All relevant documents, such as loan agreements, covenants, and communications with lenders, should be properly maintained. This ensures that there is a clear trail of evidence supporting borrowing transactions.
5. Review and Reconciliation:
   • Regular reviews and reconciliations of borrowing-related accounts and activities should be performed. This includes comparing loan balances and interest payments with the terms outlined in loan agreements. Any discrepancies or unusual transactions should be promptly investigated.
6. Compliance with Loan Covenants:
   • Internal controls should monitor compliance with loan covenants, such as financial ratios and other requirements specified in loan agreements. Early detection of potential covenant breaches allows for proactive measures to address the issues before they escalate.
7. Monitoring of Interest Rates and Terms:
   • Regular monitoring of interest rates, maturity dates, and other key terms of borrowings is necessary. This ensures that the company is aware of upcoming obligations and can plan for repayment or refinancing as needed.
8. Training and Communication:
   • Adequate training should be provided to employees involved in the borrowing process to ensure they understand the company’s policies and procedures. Effective communication channels should be in place to disseminate information about changes in borrowing policies or practices.
9. Internal Audit and Evaluation:
   • The internal audit function should periodically evaluate the effectiveness of internal controls over borrowing. This involves conducting audits, reviews, or assessments to identify any weaknesses or areas for improvement.
10. Management Oversight:
    • Senior management should provide oversight of the borrowing process. This includes reviewing reports on borrowing activities, understanding the implications of borrowing decisions, and ensuring that the company’s overall financial strategy aligns with its borrowing practices.

Audit Assertion

In an audit, several key assertions are tested for different aspects of a company’s borrowings. Here are some of the most important:

Existence and completeness:

• This assertion ensures that all existing borrowings, including loans, lines of credit, and off-balance sheet financing, are recorded in the financial statements.
• Auditors will perform procedures such as reconciling loan agreements with accounting records, reviewing bank statements, and inquiring with management.

Accuracy:

• This assertion verifies that the amounts borrowed, interest rates, and maturity dates are accurately recorded in the accounting records.
• Auditors will review loan agreements, perform calculations to confirm interest expense, and test the timing of principal repayments.

Classification:

• This assertion confirms that borrowings are correctly classified as current or non-current liabilities based on their maturity date and the company’s intention to repay them.
• Auditors will analyze loan terms and assess the company’s liquidity to determine the appropriate classification.

Obligation:

• This assertion ensures that the company is legally obligated to repay the borrowings and that the lenders have enforceable claims.
• Auditors will review loan agreements and legal documents to assess the validity of the borrowing obligations.

Rights and obligations:

• This assertion focuses on the specific rights and obligations associated with the borrowings, such as restrictions on dividend payments or asset sales.
• Auditors will review loan covenants and assess the company’s compliance with these terms.

Disclosure:

• This assertion verifies that all relevant information about borrowings, including loan terms, covenants, and potential risks, is adequately disclosed in the financial statements and notes.
• Auditors will review the financial statements and related disclosures to ensure compliance with accounting standards and regulatory requirements.

Audit Procedure

audit procedures that auditors may perform when examining borrowing activities:

1. Review Loan Agreements:
   • Examine the terms and conditions of loan agreements to ensure they align with the recorded amounts in the financial statements.
2. Confirm Borrowings:
   • Obtain confirmations directly from lenders to verify the existence, terms, and balances of borrowings.
3. Inspect Supporting Documentation:
   • Examine supporting documents such as promissory notes, loan agreements, and communication with lenders to verify the accuracy of recorded borrowings.
4. Reconcile Borrowing Balances:
   • Reconcile recorded borrowing balances with lender statements, ensuring consistency and accuracy.
5. Verify Interest Accruals:
   • Confirm the accuracy of interest accruals by recalculating interest based on the terms of the loan agreements.
6. Assess Classification:
   • Evaluate the classification of borrowings as current or non-current liabilities based on the terms and conditions specified in loan agreements.
7. Evaluate Compliance with Loan Covenants:
   • Review the company’s compliance with loan covenants specified in loan agreements. This includes financial ratios, minimum working capital requirements, and other relevant conditions.
8. Assess Rights and Obligations:
   • Confirm the entity’s legal right to borrow and assess whether borrowings represent valid obligations.
9. Check Cutoff Procedures:
   • Review cutoff procedures to ensure that borrowing transactions are recorded in the correct accounting period.
10. Inspect Disclosures:
    • Examine disclosures related to borrowings in the financial statements, ensuring completeness and accuracy.
11. Analyze Repayment Terms:
    • Evaluate the terms of repayment for borrowings and assess the company’s ability to meet its debt obligations.
12. Review Board Resolutions:
    • If applicable, review board resolutions or minutes to confirm proper authorization for borrowing activities.