On September 10, Melinda Johnson was auditing the financial statements of a new audit client, Mother Earth Foods, a health-food chain that has a June 30 year-end. The company is privately held and has just gone through a leveraged buyout with long-term financing that includes various restrictive covenants.
In order to obtain debt financing, companies often have to agree to certain conditions, some of which may restrict the way in which they conduct their business. If the borrower fails to comply with the stated conditions, it may be considered in default, which, which would give the lender the right to accelerate the due date of the debt, add other restrictions, waive the default for a stated period, or revise the covenants. Usually there is a grace period during which the borrower can cure the default.
Johnson believes that it is possible that at August 31 Mother Earth was in violation of the debt covenant restrictions, which became effective on that date. The debt covenants require the company to maintain a certain receivable turnover rate. Johnson is not certain, however, because the accounting records, including period-end cutoffs for sales and purchases, have not been well maintain. Nevertheless, Mother Earth's executives assure Johnson that if they were in violation, the company will be able to obtain a waiver or modification of the covenant.
a. Discuss the audit procedures that Johnson would conduct to determine if Mother earth would violated the debt covenants. How would Johnson determine whether Mother Earth would be able to obtain a waiver, assuming that the company was in violation of the debt covenants?
b. Based on the case scenario and financial accounting pronouncements about the classification of obligations that are callable by the creditor, should Mother Earth continue to classify this debt as noncurrent? Justify your answer.