Before your company’s public accounting audit, you must gather your essential documents, review your financial statements, and evaluate your internal controls with a SOX 404 compliance team as part of your public accounting audit. Common apprehensions before public company audits are often related to complex debt. These are some areas of debt to review with your team.
General Types of Debt Agreements
During PCAOB audits, your auditor will review financial records for debt agreements and liabilities. Three standard types of debt agreements for publicly traded companies are:
- Convertible debt: This debt can be converted into equity shares of the company.
- Non-convertible debt: This debt is a non-convertible security that requires the bondholder to be repaid in full with cash and not stock.
- Debt issued with warrants: This debt includes warrants, which are similar to stock options, and allows the holder to purchase a certain number of shares for a certain price over a defined period.
What Is Considered Complex Debt?
A debt is considered “complex” for many reasons and can affect the way they are accounted for. Such treatments include but are not limited to derivative accounting, the potential for a beneficial conversion feature, and allocation of the securities attached to the debt, include features that alter cash flows over the term of the security. These debt agreements feature multiple levels of review to determine the value of the debt during your public company audit.
1. Beneficial Conversion Feature
If a convertible debt provision creates a beneficial conversion feature (BCF), then accounting guidance requires that a debt discount be established equal to the relative value of the BCF. This is a complex area of GAAP, but if the lender can purchase shares at a price below fair market value, then BCF is present.
2. Derivative Liabilities
Derivatives are financial securities set between two or more parties and derive their value from another instrument. Derivatives are complex due to the nature of the value, which depends on the change in the prices of another underlying instrument. Derivatives are also sensitive to changes in the amount of time to expiration, the cost of holding the underlying instrument, interest rates, and stock price changes. These variables make it difficult to match the value of the derivative with the underlying asset. Complexities with derivative liabilities arise when:
- There are varying conversion prices of the derivatives that result in a variable number of shares.
- There is a fundamental clause in the convertible note. Depending on the obligations of the clause, the convertible debt will be considered equity or liability.
3. Allocation
Another area of debt complexity arises in the allocation of warrants and equity shares. GAAP requires that a debt discount be established based on the relative fair value of the warrants issued in connection with debt issuance. Various factors affect whether the fair value of the warrant is recorded as equity or liability, and each classification will lead to differences in the accounting.
Complex Debt Requires Expert Assistance
If your company is preparing for a public accounting audit, now is the time to assess not only your financial statements but also your internal controls. SOX 404 compliance is a key part of audit readiness, especially when your company has complex debt instruments on the books. A highly trained, certified public accounting firm with SOX 404 compliance experience can help ensure your internal control framework is robust and your audit is timely and compliant.
Does your company have complex debt? It’s essential to stay ahead of new accounting rules that may affect your next audit.
Our accounting team at Assurance Dimensions has a proven track record in supporting public companies with top SOX 404 compliance services. We can help your organization understand and navigate complex debt challenges. Contact us today to learn about our audit and assurance services.