On 10th September, Melinda Johnson was auditing 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 during a leveraged buyout with long-term financing that includes several restrictive covenants.
In order to get debt financing, companies often have to agree to certain conditions, some of which can restrict the way in which they conduct their business. If the borrower fails to comply with the stated conditions, it can be considered in default, which, which would provide the lender the right to accelerate the due date of the debt, add other restrictions, waive the default for a stated period, or revise covenants. Generally there is a grace period during which the borrower can cure the default.
Johnson believes that it is possible that at 31st August Mother Earth was in violation of the debt covenant restrictions, which became effective on that date. The debt covenants need the company to maintain a certain receivable turnover rate. Johnson is not certain, thus, 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 can be able to get a waiver or modification of the covenant.
Required:
a. Show the audit procedures that Johnson would conduct to evaluate if Mother earth would violated the debt covenants. How would Johnson evaluate whether Mother Earth would be able to obtain a waiver, consider that the company was in violation of the debt covenants?
b. Based on case scenario and financial accounting pronouncements about the classification of obligations that are callable by creditor, should Mother Earth continue to classify this debt as noncurrent? Justify your answer.