Chapter 15
Debt

Introduction

15.01 Depository institutions use long and short term borrowings to provide funds that supplement deposits and to carry out their overall asset/liability management strategy. Finance and mortgage companies cannot accept deposits, and therefore, rely almost exclusively on borrowings to fund loans and operations.

15.02 Debt-to-equity ratios of finance companies generally are higher than those of manufacturing companies because finance company assets consist more of liquid assets, such as receivables, than of inventories and fixed assets. Debt-to-equity ratios of at least four- or five-to-one are not uncommon for finance companies. However, finance companies' leverage has traditionally been much lower than the leverage of depository institutions.

15.03 Debt may be classified as senior, senior subordinated, and junior subordinated. The classifications describe priorities of repayment, which become especially significant when solvency becomes questionable.

15.04 Internal policy and credit rating goals cause companies to establish diverse target amounts for each priority category of debt. Moreover, debt agreements usually contain restrictions on the amount of debt that may be incurred in each category. For example, a common restriction in debt securities issued to the general public prohibits pledging assets to secure new or existing debt. Other common restrictions may limit dividend payments and the amount of additional senior debt that can be incurred. If an issuer has other restrictions in its current typical public debt issue, lenders commonly demand the same restrictions in a private placement.

15.05 The creditworthiness of an institution’s debt may be assessed by a rating agency based on analysis of the issuer’s financial condition as measured by ratios and other factors.1 Ratings directly affect the institution’s cost of borrowing and, thus, its ability to borrow. Institutional investors, such as other financial institutions, insurance companies, trusts, mutual funds, and pension and profit-sharing plans, rely heavily on credit ratings when making investment decisions. Some institutions are prohibited by law or formal agreement from investing in debt below a specified minimum level. For example, some states prohibit licensed domestic insurance companies from investing in corporate obligations that do not meet specified fixed-charge coverage ratios. Similarly, many government agency pension funds are prohibited by law from investing in securities that do not have an investment grade2 rating.

Long Term Debt

15.06 The most common long term debt funding sources are debentures and notes. Institutions also may have long term mortgages, obligations and commitments under capital leases, and mandatorily redeemable preferred stock, that have many of the characteristics of debt. Such obligations are similar to those of other kinds of enterprises. Funds are also borrowed through Eurodollar certificates, collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs), mortgage-backed bonds (MBBs), mortgage-revenue bonds, and Federal Home Loan Bank (FHLB) advances.

15.07 The terms of an institution's long term debt obligations vary widely. They may be secured or unsecured. The debt may be senior or subordinated to other debt. The debt may be convertible into shares of preferred or common stock. Convertible debentures are convertible into stock at a specified price at the option of the holder. In most cases, convertible debt securities are also callable at the option of the issuer, generally beginning a few years after issuance. Interest rates may be fixed or floating.

15.08 Credit unions may borrow from individuals (whether or not they are members of the credit union) by issuing promissory notes or certificates of indebtedness. Certificates of indebtedness are generally uninsured. Their issuance is governed by Section 701.38 of the National Credit Union Administration (NCUA) regulations. Credit unions can have access to the NCUA maintained Central Liquidity Facility for short term borrowing by either being a member directly, or indirectly through an agent (usually a corporate credit union). Other notes issued by credit unions are generally payable to corporate credit unions or other financial institutions, or a Federal Reserve Bank.

15.09 Institutions and their subsidiaries sometimes finance expansion using traditional real estate mortgages.

Short Term Debt

15.10 Repurchase agreements. Repurchase agreements (repos) are discussed in chapter 14, “Federal Funds and Repurchase Agreements,” of this guide.

15.11 Federal funds purchased. Federal funds purchased are discussed in chapter 14 of this guide.

15.12 Commercial paper. Commercial paper is an unsecured promissory note that provides creditworthy institutions, typically, finance companies or holding companies of banks and savings institutions, with short term funds. Commercial paper is generally short term (at most 270 days, but usually much less) and negotiable.

15.13 Institutions that rely heavily on commercial paper generally sell and redeem it continuously. They may sell more commercial paper than needed on certain days simply to maintain a market for customers who wish to invest beyond the institution’s current needs. Sales of commercial paper may also increase when large amounts of commercial paper or long term debt mature. Proceeds in excess of current needs are often invested by entering into repos or by buying Eurodollar deposits, or commercial paper issued by others.

15.14 Lines of credit. Institutions often obtain funds through lines of credit from banks and savings institutions.

15.15 Institutions may obtain lines of credit as a source of funds or to provide creditors with assurance that commercial paper and other shorter term debt will be repaid. Further, rating agencies generally will not rate a finance company’s commercial paper if it is not supported by a line of credit.

15.16 Institutions may pay commitment fees, maintain compensating balances, or do both to have lines of credit available. Interest rates on borrowings under lines of credit are usually based on a spread over the lender’s prime rate based on the lender’s assessment of credit risk.

15.17 Borrowing from Federal Reserve discount windows and FHLB system. Member depository institutions may borrow from their regional Federal Reserve Bank in the form of discounts (often called rediscounts) and advances, which are primarily used to cover shortages in the required reserve account and also in times of liquidity needs. A discounting transaction is technically a note to the Federal Reserve Bank with recourse secured by a member institution's eligible loans. In an advancing transaction, a member institution executes a promissory note, which is collateralized generally by government securities to the Federal Reserve Bank. Most discount-window transactions are in the form of advances. Interest charged in those transactions is referred to as discount. The rates are set biweekly by the individual reserve banks. Such loans usually have short maturities. Members of the FHLB System can obtain callable and non-callable advances of varying maturities from their district FHLBs. FHLB advances often are secured through pledges of loans or securities. Paragraph 15.73 discusses the performance of agreed-upon procedures relating to collateral for FHLB advances.

15.18 Treasury tax and loan note accounts. Employers that withhold federal taxes from employees' pay are required to deposit those funds periodically with a bank or savings institution. Institutions record such deposits, which are noninterest-bearing, as treasury tax and loan accounts and include such accounts with their deposits. However, on the day after receipt, such funds must be remitted to the Federal Reserve Bank or converted into an open-ended, interest-bearing note, commonly referred to as a treasury tax and loan note account.

15.19 Banker’s acceptances. Paragraphs 24–26 of FASB Accounting Standards Codification (ASC) 860-10-05 state that banker's acceptances provide a way for a bank to finance a customer's purchase of goods from a vendor for periods usually not exceeding 6 months. Under an agreement among the bank, the customer, and the vendor, the bank agrees to pay the customer's liability to the vendor upon presentation of specified documents that provide evidence of delivery and acceptance of the purchased goods. The principal document is a draft or bill of exchange drawn by the customer that the bank stamps to signify its acceptance of the liability to make payment on the draft on its due date. Once the bank accepts a draft, the customer is liable to repay the bank at the time the draft matures. The bank recognizes a receivable from the customer and a liability for the acceptance it has issued to the vendor. The accepted draft becomes a negotiable financial instrument. The vendor typically sells the accepted draft at a discount either to the accepting bank or in the marketplace. A risk participation is a contract between the accepting bank and a participating bank that the participating bank agrees, in exchange for a fee, to reimburse the accepting bank in the event that the accepting bank's customer fails to honor its liability to the accepting bank in connection with the banker's acceptance. The participating bank becomes a guarantor of the credit of the accepting bank's customer.

15.20 Banker’s acceptances are similar to other short term borrowed funds in that they can be effectively used for short term liquidity needs by avoiding disbursing funds for short term loans to bank customers. Readers may also refer to FASB ASC 460, Guarantees, for guidance, because banker’s acceptances contain an obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur, which may require the recognition of an obligation at fair value.

15.21 MBBs. MBBs are any borrowings (other than those from an FHLB) collateralized in whole or in part by one or more real estate loans. MBBs typically have the following characteristics:

  1. a.  Fixed maturities or payments of principal and interest
  2. b.  The use of mortgage loans or mortgage-backed securities (MBSs) owned by the issuer as collateral
  3. c.  Stated or fixed interest rates with interest payable monthly or semiannually (there may also be call provisions)
  4. d.  Principal payments made through periodic sinking-fund payments or at final maturity
  5. e.  Mortgage collateral in which the purchaser does not have an ownership interest
  6. f.  Collateral values usually ranging from 110 percent to 200 percent of the amount of the debt issue, so that the collateral value exceeds the principal value throughout its term (overcollateralization)

15.22 Preferred stock and other securities of finance subsidiaries. Finance subsidiaries, as defined in federal banking regulations, are a means by which institutions can issue preferred stock and other securities at rates lower than those the institutions would otherwise have to pay if they issued the securities directly. Thus, finance subsidiaries afford banking institutions the opportunity to obtain less costly funds.

15.23 Finance subsidiaries, as defined in the FASB ASC glossary, are subsidiaries with no assets, operations, revenues, or cash flows other than those related to the issuance, administration, and repayment of the security being issued and any other securities guaranteed by its parent entity.

15.24 In a structured financing (the simplest form of a finance subsidiary), the parent entity transfers certain assets to a special-purpose finance subsidiary to collateralize or otherwise support the securities issued by the finance subsidiary. In return for the assets, the subsidiary remits the net proceeds of the offering to the parent for use in operations. Where debt is issued at the subsidiary level, the trustee for the debt perfects a security interest in the transferred collateral. If preferred stock is issued, no security interest is perfected. However, because the finance subsidiary is chartered for the limited purpose of issuing the securities and can neither incur debt nor engage in any other business (that is, a bankruptcy remote entity), the preferred stock is, in fact, insulated from other encumbrances and is, therefore, backed by the collateral in a manner approximating a security interest. The result is to provide greater protection for preferred stockholders than any of them would have had if the parent entity had been the issuer.

15.25 The economic value of this financing technique is made possible by a variety of factors. Because of the requirements established by the rating agencies, preferred stock offerings are significantly overcollateralized by a combination of mortgage securities, short term money-market instruments, treasuries, and other securities. This degree of collateralization, combined with the protection afforded by the structure, enables the rating agencies to issue triple-A ratings. Additionally, because qualified corporate taxpayers holding preferred stock are eligible for a deduction of a specified percentage of dividends received, the dividends paid by the issuer can be low by market standards, making the transaction a low-cost "borrowing" for the parent entity.

15.26 CMOs. As introduced in paragraph 7.31 of this guide, CMOs are multiclass, pay-through bonds collateralized by MBSs or mortgage loans and are generally structured so that all, or substantially all, of the collections of principal and interest from the underlying collateral are paid to the holders of the bonds. Typically, the bonds are issued with two or more maturity classes; the actual maturity of each bond class varies depending upon the timing of the cash receipts from the underlying collateral. CMOs are usually issued by a minimally capitalized special-purpose entity (issuer) established by one or more sponsors (frequently the original owners of the mortgages). The assets collateralizing the bonds are acquired by the special-purpose entity and then pledged to an independent trustee until the issuer's obligation under the bond indenture has been fully satisfied. The investor agrees to look solely to those trusteed assets and the issuer's initial capital (collectively referred to as segregated assets) for repayment of the obligations. Therefore, the sponsor and its other affiliates no longer have any financial obligations for the instrument, although one of those entities may retain the responsibility for servicing the underlying mortgage loans.

15.27 For the sponsor of the CMO, cash is immediately generated; there is no waiting for the collection of the amounts when the respective mortgage payments come due. Credit enhancement of CMOs is generally achieved by using collateral that carries a third-party guarantee; otherwise, CMOs are overcollateralized to mitigate the risk of default. The excess collateral generally reverts to the sponsor at the maturity of the CMOs. The sponsor of the CMO issuer may retain any residual (see chapter 7, “Investments in Debt and Equity Securities,” of this guide), or an unrelated third party may acquire the residual as an investment.

15.28 For both the issuer and investor, cash flows may not materialize as scheduled. For example, prepayments of the underlying mortgages at a greater-than-anticipated rate can reduce the yield to maturity expected by the investor.

15.29 REMICs. REMICs are vehicles for issuing multiclass mortgage-backed obligations that require compliance with a number of technical requirements of the IRC. REMICs refer to the taxable entity (rather than to the security structure like a CMO and other types of mortgage-backed borrowings). Failure to comply with the requirements could result in imposition of a corporate income tax on the gross income of the REMIC. REMIC certificates of ownership are qualifying real property loans and qualified assets under the IRC.

15.30 To qualify for REMIC status as defined by the IRC, all of the assets continuously held by the REMIC must consist of qualified mortgages and permitted investments. In general, the term, qualified mortgages refers to mortgages that are principally collateralized by an interest in real property and are transferred to the REMIC at the time of its formation or purchased by the REMIC within three months of its formation. Qualified mortgage also refers to a regular interest in another REMIC. The term permitted investments includes cash-flow investments, qualified reserve assets, and foreclosed property.

15.31 All of the interests in the REMIC normally consist of either regular interests or residual interests. A regular interest is an interest that unconditionally entitles the holder to receive specified principal and interest payments under terms that are fixed at the time of the REMIC's formation. A residual interest is any interest in a REMIC that is not a regular interest. Only one class of residual interest may exist with respect to a REMIC. In other words, the rights of all of the holders of an interest that does not qualify as a regular interest must be exactly the same.

Regulatory Matters

15.32 Federal savings institutions must notify the Office of the Comptroller of the Currency before borrowing money, unless the institution meets regulatory capital requirements and any applicable minimum capital directive. Regulations may also prohibit growth above a certain level without prior regulatory approval. Further, savings institutions generally must obtain written approval (prior to issuance) for subordinated debt to qualify as regulatory capital.

15.33 The Federal Reserve Act limits the availability of certain types of borrowings through the Federal Reserve discount window.

Accounting and Financial Reporting

15.34 Significant categories of borrowings should be presented as separate line items in the liability section of the balance sheet, or as a single line item with appropriate note disclosure of components as stated in FASB ASC 942-470-45-1. Institutions may, alternatively, present debt based on the debt’s priority (that is, senior or subordinated) if they also provide separate disclosure of significant categories of borrowings. FASB ASC 860-30-45-1 explains that if the secured party (transferee) has the right by contract or custom to sell or repledge the collateral, then the obligor (transferor) should reclassify that asset and report that asset in its statement of financial position separately (for example, as security pledged to creditors) from other assets not so encumbered.

15.35 FASB ASC 860-30-45-2 states that liabilities incurred by either the secured party or obligor in securities borrowings or resale transactions should be separately classified. However, FASB ASC 860-30-45 does not specify the classification or the terminology to be used to describe such liabilities, nor does it specify the classification or the terminology to be used for pledged assets reclassified by the transferor of securities loaned or transferred under a repo accounted for as a collateralized borrowing if the transferee is permitted to sell or repledge those securities.

15.36 FASB ASC 942-470-50-3 states that for debt, the notes to the financial statements should describe the principal terms of the respective agreements including, but not limited to, the title or nature of the agreement, or both; the interest rate (and whether it is fixed or floating); the payment terms and maturity date(s); collateral; conversion or redemption features; whether it is senior or subordinated; and restrictive covenants (such as dividend restrictions or earnings requirements), if any.

15.37 Accounting and reporting requirements for long term obligations are the same for financial institutions as for other entities, as stated in FASB ASC 942-470-50-2. If the financial institution has an unclassified balance sheet, there is no need to separate balances into current and long term portions. (See FASB ASC 440 for disclosure requirements of future payments on long term borrowings.)

15.38 In accordance with FASB ASC 470-10-50-1, institutions should disclose the combined aggregate amount of maturities and sinking-fund requirements for all long term borrowings for each of the five years following the date of the latest balance sheet presented.

15.39 According to “Pending Content” in FASB ASC 835-30-45-1A, debt issuance costs related to a note should be reported in the balance sheet as a direct deduction from that face amount of that note. The debt issuance costs should not be classified as a deferred charge or a deferred credit. “Pending Content” in FASB ASC 835-30-45-3 further states that the amortization of debt issuance costs should be reported as interest expense. FASB ASC 470-10-35-2 states that debt issue costs should be amortized over the same period used in the interest cost determination.

15.40 Debt instruments with redemption features should be carefully analyzed to determine the appropriate period over which these items should be amortized.

15.41 FASB ASC 480, Distinguishing Liabilities from Equity,3 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. “Pending Content” in paragraphs 4–5 of FASB ASC 480-10-25, as well as paragraphs 8 and 14 of FASB ASC 480-10-25, require an issuer to classify the following instruments as liabilities (or assets in some circumstances):

  1. a.  A mandatorily redeemable financial instrument, unless the redemption is required to occur only upon the liquidation or termination of the reporting entity. A financial instrument that embodies a conditional obligation to redeem the instrument by transferring assets upon an event not certain to occur becomes mandatorily redeemable if that event occurs, the condition is resolved, or the event becomes certain to occur.
  2. b.  Any financial instrument, other than an outstanding share, that, at inception, embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation, and that requires or may require the issuer to settle the obligation by transferring assets.
  3. c.  A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares if, at inception, the monetary value of the obligation is based solely or predominantly on any of the following:

i.  A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares),

ii.  Variations in something other than the fair value of the issuer’s equity shares (for example, a financial instrument indexed to the S&P 500 and settleable with a variable number of the issuer’s equity shares), and

iii.  Variations inversely related to changes in the fair value of the issuer’s equity shares (for example, a written put option that could be net share settled).

15.42 As stated in FASB ASC 480-10-25-10, examples of financial instruments that meet the criteria in FASB ASC 480-10-25-8 include forward purchase contracts or written put options on the issuer’s equity shares that are to be physically settled or net cash settled.

15.43 Convertible instruments. Accounting for debt obligations that are convertible into other instruments such as equity securities can be very complex. Such instruments may require bifurcation of embedded derivatives, bifurcation between liability and equity, calculation of any beneficial conversion feature, and impact earnings per share calculations.

15.44 Redeemable preferred stock. As noted in paragraph 15.41, “Pending Content” in FASB ASC 480-10-25-4 states that a mandatorily redeemable financial instrument should be classified as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity. “Pending Content” in FASB ASC 480-10-45-1 states that items within the scope of FASB ASC 480-10 should be presented as liabilities (or assets in some circumstances). Those items should not be presented between the liabilities section and equity section of the statement of financial position.4

15.45 Redeemable preferred stock that is conditionally redeemable (for example, stock that is puttable by the holder at a specified date) is not in the scope of FASB ASC 480. For SEC registrants, according to SEC Accounting Series Release No. 268, Presentation in Financial Statements of “Redeemable Preferred Stocks” (codified in the SEC Codification of Financial Reporting Policies), mezzanine presentation applies for conditionally redeemable stock that is not in the scope of FASB ASC 480. (Also see paragraphs 17.17–.26 of this guide for a discussion of preferred stock and regulatory capital).

15.46 Banker’s acceptances. FASB ASC 860-10-55-65 addresses banker's acceptances and risk participations in them. An accepting bank that obtains a risk participation should not derecognize the liability for the banker's acceptance because the accepting bank is still primarily liable to the holder of the banker's acceptance even though it benefits from a guarantee of reimbursement by a participating bank. The accepting bank should not derecognize the receivable from the customer because it has not transferred the receivable. The accepting bank should, however, record the guarantee purchased, and the participating bank should record a liability for the guarantee issued. FASB ASC 460-10-05-2 explains that certain disclosures are required to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. The “General” subsections of FASB ASC 460 also address the recognition of a liability by a guarantor at the inception of a guarantee for the obligations the guarantor has undertaken in issuing that guarantee.

15.47 MBBs. FASB ASC 942-470-45-2 states that transfers of mortgages accounted for under FASB ASC 860, Transfers and Servicing, as secured borrowings of the issuing institution should be classified as debt on the institution's balance sheet. Such MBBs should be classified separately from advances, other notes payable, and subordinated debt.

15.48 Any discounts or premiums associated with the issuance of MBBs ordinarily should be reported in a contra liability (debit) or liability (credit) account, consistent with “Pending Content” in FASB ASC 835-30-45-1A and FASB Concept No. 6, Elements of Financial Statements (paragraphs 235–239). Similarly, related bond issuance costs should be reported in the balance sheet as a direct deduction from the face amount of that bond.

15.49 Extinguishments of liabilities. FASB ASC 405-20 provides accounting and reporting standards for extinguishments of liabilities. FASB ASC 405-20-40-1 states that a debtor should derecognize a liability if and only if it has been extinguished. A liability has been extinguished if either of the following conditions is met:

  1. a.  The debtor pays the creditor and is relieved of its obligation for the liability. Paying the creditor includes delivery of cash, other financial assets, goods or services, or reacquisition by the debtor of its outstanding debt securities whether the securities are canceled or held as so-called treasury bonds.
  2. b.  The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor. FASB ASC 405-20-40-2 provides related guidance.

15.50 Gain or loss on extinguishments. Most gains or losses on extinguishments are recorded as ordinary items. However, in accordance with FASB ASC 225-20-45-16, gains or losses from extinguishment of debt that an entity considers to be a material event or transaction of an unusual nature and of a type that indicates infrequency of occurrence should be reported as a separate component of income from continuing operations. The nature and financial effects of each event or transaction should be presented as a separate component of income from continuing operations, or, alternatively disclosed in notes to financial statements. Gains or losses of a similar nature that are not individually material should be aggregated and such items should not be reported on the face of the income statement net of income taxes. Similarly, the earnings per share effects of those items should not be presented on the face of the income statement.

15.51 Modifications or exchanges of debt. FASB ASC 470-50 provides accounting and reporting standards for assessing modification or exchanges of debt arrangements in determining whether or not the modifications or exchanges will result in extinguishment or modification accounting. FASB ASC 470-60 provides accounting and reporting guidance for determining when a modification is considered a troubled debt restructuring.

15.52 Foreign currency debt. Entities with debt payable in a foreign currency may experience fluctuations in the reporting currency value of the debt due to changes in exchange rates. In some instances, entities enter into a currency swap contract to receive a foreign currency and pay the reporting currency. FASB ASC 815-10-45-2 states that none of the provisions in FASB ASC 815-10 support netting a hedging derivative's asset (or liability) position against the hedged liability (or asset) position in the balance sheet. Readers may refer to FASB ASC 815, Derivatives and Hedging, for further guidance.

15.53 Dual currency bonds. The guidance in paragraphs 35–36 of FASB ASC 815-20-55 related to foreign-currency-denominated interest payments also applies to dual-currency bonds that provide for repayment of principal in the functional currency and periodic fixed-rate interest payments denominated in a foreign currency, as stated in FASB ASC 815-20-55-37. FASB ASC 830-20 applies to dual-currency bonds and requires the present value of the interest payments denominated in a foreign currency to be remeasured and the transaction gain or loss recognized in earnings.

15.54 REMICs. As discussed, REMIC is simply a label that covers various forms of underlying securities. These securities may resemble either CMOs or pass-through certificates that represent a transfer of the underlying receivables. Institutions may enter into REMIC transactions to raise immediate cash utilizing mortgage agreements as collateral. FASB ASC 860 provides accounting and reporting standards for transfers of financial assets, including transfers associated with REMICs and CMOs. FASB ASC 810, Consolidation, provides guidance on the consolidation of these entities which are typically variable interest entities.

15.55 Lease financing. Accounting for leases by lessees and lessors is established in FASB ASC 840, Leases.

15.56 Lending of customers' securities. Banks and savings institutions sometimes lend customers’ securities. FASB ASC 860-30 discusses application of the guidance to securities lending transactions. Any contingencies related to the lending of securities normally should be accounted for in conformity with FASB ASC 450, Contingencies.

15.57 Fair value measurements. FASB ASC 820, Fair Value Measurement, defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. See chapter 20, “Fair Value,” of this guide for a summary of FASB ASC 820. Some institutions have elected to apply fair value accounting to financing agreements under FASB ASC 825, Financial Instruments.

Auditing5

Objectives

15.58 The primary audit objectives in this area are to obtain sufficient appropriate evidence that

  1. a.  short and long term borrowings recorded as of the date of the financial statements, including embedded derivatives that are required to be accounted for in accordance with FASB ASC 815 and debt issuance costs, include all such liabilities of the institution and that they have been properly valued, classified, described and disclosed, and reflect all transactions for the period;
  2. b.  financing subsidiaries are consolidated with the parent institution as required by FASB ASC 810;
  3. c.  interest expense and the related balance sheet accounts (accrued interest payable, unamortized premiums or discounts, and issuance costs) are properly measured and recorded, and amortization has been properly computed;
  4. d.  collateral for borrowings is properly identified and disclosed;
  5. e.  borrowings have been authorized in accordance with management's written policies and are obligations of the institution; and
  6. f.  the effects on reported amounts and disclosures of any noncompliance with debt covenants are properly identified, described, and disclosed.
  7. g.  the potential impact of failed covenants, debt maturing within 1 year or other related events that are considered in the auditor’s going concern analysis.

Planning

15.59 In accordance with AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (AICPA, Professional Standards), the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement (as described in chapter 5, “Audit Considerations and Certain Financial Reporting Matters,” of this guide). Factors related to debt that could influence the risks of material misstatement may include accounting for borrowings, regulatory considerations, the existence of restrictive covenants, the existence of conversion features, and the existence and adequacy of collateral, if applicable. The auditor might also review board of directors' reports, the current year's interim financial statements, and other documents that may include information about whether any significant new debt has been incurred or issued and whether any significant debt has been repaid or refinanced. The auditor may also inquire as a means to obtain audit evidence about the nature of the entity, for example, the existence of financing subsidiaries.

Internal Control Over Financial Reporting and Possible Tests of Controls

15.60 AU-C section 315 addresses the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements through understanding the entity and its environment, including the entity’s internal control. Paragraphs .13–.14 of AU-C section 315 state that the auditor should obtain an understanding of internal control relevant to the audit, and, in doing so, should evaluate the design of those controls and determine whether they have been implemented by performing procedures in addition to inquiry of the entity’s personnel. (See chapter 5 of this guide for further discussion of the components of internal control.) To provide a basis for designing and performing further audit procedures, paragraph .26 of AU-C section 315 states that the auditor should identify and assess the risks of material misstatement at the financial statement level and the relevant assertion level for classes of transactions, account balances, and disclosures.

15.61 AU-C section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained (AICPA, Professional Standards), addresses the auditor’s responsibility to design and implement responses to the risks of material misstatement identified and assessed by the auditor in accordance with AU-C section 315 and to evaluate the audit evidence obtained in an audit of financial statements.

15.62 In accordance with paragraph .08 of AU-C section 330, the auditor should design and perform tests of controls to obtain sufficient appropriate audit evidence about the operating effectiveness of relevant controls if (a) the auditor’s assessment of risks of material misstatement at the relevant assertion level includes an expectation that the controls are operating effectively or (b) substantive procedures alone do not provide sufficient appropriate audit evidence at the relevant assertion level. Controls relating to the financial reporting of debt include, but are not limited to, the following:

  • Debt transactions are reviewed and approved by the board of directors or its designated committee and documented in the minutes.
  • Debt agreements are reviewed by the appropriate accounting and legal personnel to ensure that borrowings meet U.S generally accepted accounting principles (GAAP) criteria for classification as a liability, debt agreements are evaluated for derivative accounting in accordance with FASB ASC 815 and debt issuance costs are appropriately identified and accounted for.
  • Adjustments to liability accounts are reviewed and approved by responsible personnel.
  • The subsidiary ledgers for long and short term borrowings and collateral are periodically reconciled with the general ledger. Reconciliations are regularly reviewed and approved by supervisory personnel.
  • Reports or statements from outside trustees or transfer agents are periodically reconciled to the institution's records. Reconciliations are regularly reviewed and approved by supervisory personnel.
  • Through periodic confirmation with the trustee or transfer agent, the institution ascertains that collateral on borrowings remains sufficient.
  • Borrowings (such as CMOs and REMICs) are reviewed to ensure that they meet the GAAP criteria for treatment as financing transactions and consolidation.
  • Periodic tests of covenant compliance are performed and reviewed by responsible personnel.

15.63 AU-C section 402, Audit Considerations Relating to an Entity Using a Service Organization (AICPA, Professional Standards), addresses the user auditor’s responsibility for obtaining sufficient appropriate audit evidence in an audit of the financial statements of a user entity that uses one or more service organizations (for example, processing CMO or REMIC cash flows by a trustee). Specifically, it expands on how the user auditor applies AU-C sections 315 and 330 in obtaining an understanding of the user entity, including internal control relevant to the audit, sufficient to identify and assess the risks of material misstatement and in designing and performing further audit procedures responsive to those risks. If, in accordance with paragraph .16a of AU-C section 402, the user auditor plans to use a type 2 report as audit evidence that controls at the service organization are operating effectively, paragraph .17 of AU-C section 402 states that the user auditor should determine whether the service auditor’s report provides sufficient appropriate audit evidence about the effectiveness of the controls to support the user auditor’s risk assessment by

  1. a.  evaluating whether the type 2 report is for a period that is appropriate for the user auditor’s purposes;
  2. b.  determining whether complementary user entity controls identified by the service organization are relevant in addressing the risks of material misstatement relating to the relevant assertions in the user entity’s financial statements and, if so, obtaining an understanding of whether the user entity has designed and implemented such controls and, if so, testing their operating effectiveness;
  3. c.  evaluating the adequacy of the time period covered by the tests of controls and the time elapsed since the performance of the tests of controls; and
  4. d.  evaluating whether the tests of controls performed by the service auditor and the results thereof, as described in the service auditor's report, are relevant to the assertions in the user entity's financial statements and provide sufficient appropriate audit evidence to support the user auditor's risk assessment.

Substantive Tests

15.64 Irrespective of the assessed risks of material misstatement, paragraph .18 of AU-C section 330 states that the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balance, and disclosure. In accordance with paragraph .A45 of AU-C section 330, this requirement reflects the facts that (a) the auditor’s assessment of risk is judgmental and may not identify all risks of material misstatement and (b) inherent limitations to internal control exist, including management override.

15.65 Review of documentation. The auditor might review documentation such as legal agreements and signed notes supporting long term debt and agree pertinent information to subsidiary ledgers. The auditor might review the following information:

  1. a.  Type of debt
  2. b.  Interest rate and dates interest is payable
  3. c.  Maturity of the debt
  4. d.  Underlying collateral of the debt, if any
  5. e.  Subordination of the debt
  6. f.  Evidence of regulatory approval
  7. g.  Presence of restrictive covenants
  8. h.  Unusual features
  9. i.  Embedded derivatives

15.66 Confirmation. Paragraph .A8 of AU-C section 500, Audit Evidence (AICPA, Professional Standards), states that corroborating information obtained from a source independent of the entity may increase the assurance that the auditor obtains from audit evidence that is generated internally, such as evidence existing within the accounting records, minutes of meetings, or a management representation. AU-C section 505, External Confirmations (AICPA, Professional Standards), addresses the auditor’s use of external confirmation procedures to obtain audit evidence, in accordance with the requirements of AU-C sections 330 and 500.

15.67 The auditor should consider confirming pertinent information with the trustee or transfer agent, including all terms, unpaid balance, accrued interest payable, principal and interest payments made during the year, collateral description, annual trust accounts activity, and the occurrence of any violations of the terms of the agreement. If collateral is not under the control of the institution and is held by a trustee or transfer agent, the auditor should consider confirming its existence, completeness, and valuation with the trustee or transfer agent. If collateral is deemed deficient with respect to the terms of the debt agreement or is not under the control of the institution, the auditor might consider the need for disclosure.

15.68 Tests of premiums, discounts, and issuance costs. The auditor may consider testing borrowings that were issued at a premium or discount to determine whether amortization has been properly computed and recorded. The auditor may also evaluate the propriety of amortization of costs incurred in connection with a debt issuance. The auditor may also consider the appropriateness of debt issuance costs recorded and test the classification and account of the costs.

15.69 Analytical procedures. Paragraph .05 of AU-C section 520, Analytical Procedures (AICPA, Professional Standards), states that when designing and performing analytical procedures, either alone or in combination with tests of details, as substantive procedures in accordance with AU-C section 330,6 the auditor should

  1. a.  determine the suitability of particular substantive analytical procedures for given assertions, taking into account the assessed risks of material misstatement and tests of details, if any, for these assertions. (For example, analytical procedures can provide substantive evidence about the completeness of debt-related financial statement amounts and disclosures; however, such procedures in tests of debt expense are often less precise than substantive tests such as recalculations. Because institutions generally issue a wide variety of debt with rates that vary with each issuance, it is normally difficult to develop expectations to be used in analyzing yields on debt.)
  2. b.  evaluate the reliability of data from which the auditor’s expectation of recorded amounts or ratios is developed, taking into account the source, comparability, and nature and relevance of information available and controls over preparation.
  3. c.  develop an expectation of recorded amounts or ratios and evaluate whether the expectation is sufficiently precise (taking into account whether substantive analytical procedures are to be performed alone or in combination with tests of details) to identify a misstatement that, individually or when aggregated with other misstatements, may cause the financial statements to be materially misstated.
  4. d.  determine the amount of any difference of recorded amounts from expected values that is acceptable without further investigation as required by paragraph .07 of AU-C section 520 and compare the recorded amounts, or ratios developed from recorded amounts, with the expectations.

15.70 As discussed in paragraph 15.69a, it is normally difficult to develop sufficiently precise expectations to be used in analyzing yields on debt. Accordingly, analytical procedures in this area might be considered only as a supplement to other substantive procedures, except where an expected yield can be known with some precision (using computer-assisted audit techniques). Analytical review procedures that the auditor may apply in the debt area include analysis and evaluation of the following:

  • Comparison of interest expense by major category of debt as a percentage of the average amount of the respective debt outstanding during the year with stated rates on the debt instruments (yield test)
  • Reasonableness of balance sheet accruals and other related balance sheet accounts (accrued interest payable, deferred issuance costs, and premiums and discounts) by comparison to prior-year balances

15.71 Paragraph .A7 of AU-C section 520 states that the auditor’s substantive procedures to address the assessed risk of material misstatement for relevant assertions may be tests of details, substantive analytical procedures, or a combination of both. The decision about which audit procedures to perform, including whether to use substantive analytical procedures, is based on the auditor's judgment about the expected effectiveness and efficiency of the available audit procedures to reduce the assessed risk of material misstatement to an acceptably low level. Further guidance on the auditor’s use of analytical procedures as substantive procedures is provided in AU-C section 520. AU-C section 315 addresses the use of analytical procedures as risk assessment procedures, and AU-C section 330 addresses the nature, timing, and extent of audit procedures in response to assessed risks; these audit procedures may include substantive analytical procedures.

15.72 Other procedures. Other audit procedures the auditor may consider, related to debt and the extinguishment of debt, are as follows:

  • Review debt covenants and test whether the institution has complied with such covenants. Determine whether disclosures are appropriate.
  • Read minutes of meetings of the board of directors to determine whether financing transactions have been authorized in accordance with the institution's written policies.
  • Compare recorded interest expense and accrued interest payable to recorded debt for completeness of debt liabilities.
  • Obtain a detailed supporting schedule of prior-year and current-year account balances. Agree the prior-year balance to prior-year working papers and the current-year balance to the general ledger. Review activity for reasonableness.
  • For CMOs and REMICs, obtain and review compliance and verification letters prepared by the trustee's auditors. (Such letters are prepared on an annual basis and provide for the verification of the principal balance of the collateral and bonds, the cash flows associated with the issue, and compliance with the respective terms of the underlying agreements.)
  • Examine canceled notes for borrowings that have been paid in full or consider confirmation procedures to validate that borrowings have been paid in full.
  • Read lease agreements, identifying those that should be capitalized, and determine whether they were recorded using effective rates of interest.
  • For financing transactions resulting from failed sales under FASB ASC 860, revisit agreement terms to validate that financing treatment is still appropriate (that is, a call option may have expired resulting in a reconsideration event under FASB ASC 860 that may change the nature of the transfer from a financing to a true sale).
  • Assess the sufficiency of the value of assets collateralizing any borrowings to determine whether the entity has posted and recorded sufficient collateral for its borrowings.

15.73 If applicable, the auditor may be engaged to perform agreed-upon procedures relating to collateral for FHLB advances by reference to the security agreement signed by the institution's management that indicates compliance. The procedures depend upon the nature of the agreement (blanket lien, specific lien without delivery, or specific lien with delivery of the collateral). The respective district FHLB provides guidance on procedures to be performed. In light of the professional standards, the auditor considers whether and how to perform all that is requested by the FHLB.

15.74 The terms of some debt agreements may mandate companies to have their independent auditors issue compliance reports on various restrictive covenants involving matters such as restrictions on assets, payments of interest, and dividend payments. Such reports, which normally are in the form of negative assurance, are discussed in AU-C section 806, Reporting on Compliance With Aspects of Contractual Agreements or Regulatory Requirements in Connection With Audited Financial Statements (AICPA, Professional Standards).

15.75 Finance company credit questionnaires. Finance companies provide creditors with financial and operating information through standard credit questionnaires developed jointly by industry participants and the Risk Management Association (an association of lending officers). Some finance companies include credit questionnaires as information in addition to the finance company’s basic financial statements. The auditor’s responsibility depends on the services requested by the finance company.

15.76 Paragraph .03 of AU-C section 725, Supplementary Information in Relation to the Financial Statements as a Whole (AICPA, Professional Standards), states that the objective of the auditor, when engaged to report on supplementary information in relation to the basic financial statements as a whole, is to evaluate the presentation of the supplementary information in relation to the basic financial statements as a whole and to report on whether the supplementary information (such as a credit questionnaire) is fairly stated, in all material respects, in relation to the financial statements as whole. Supplementary information (for purposes of generally accepted auditing standards) is defined as information presented outside the basic financial statements, excluding required supplementary information that is not considered necessary for the financial statements to be fairly presented in accordance with the applicable financial reporting framework. Paragraphs .A7–.A8 of AU-C section 725 explain that supplementary information includes additional details or explanations of items in or related to the basic financial statements, consolidating information, historical summaries of items extracted from the basic financial statements, statistical data, and other material, some of which may be from sources outside the accounting system or outside the entity. Supplementary information may be prepared in accordance with an applicable financial reporting framework, by regulatory or contractual requirements, in accordance with management’s criteria or in accordance with other requirements. The auditor may report on such information using the guidance in paragraphs .09–.13 of AU-C section 725.

15.77 However, paragraphs .A1–.A2 of AU-C section 725 state that the auditor’s responsibility for information that a designated accounting standard setter7 requires to accompany an entity’s basic financial statements is addressed in AU-C section 730, Required Supplementary Information (AICPA, Professional Standards). The auditor’s responsibility for financial and nonfinancial information (other than the financial statements and the auditor’s report thereon) that is included in a document containing audited financial statements and the auditor’s report thereon, excluding required supplementary information, is addressed in AU-C section 720, Other Information in Documents Containing Audited Financial Statements (AICPA, Professional Standards).

Notes

__________________________

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
18.227.111.33