Before your company’s public accounting audit, you must gather your essential documents, review your financial statements, and discuss any concerns with your audit team. Common apprehensions before a public accounting audit are often related to complex debt. These are some areas of debt to review and discuss with your auditor.

 

General Types of Debt Agreements

During a public accounting audit, your auditor will review financial records for debt agreements and liabilities. Three standard types of debt agreements for publicly traded companies are:

  1. Convertible debt: This debt can be converted into equity shares of the company.
  2. Non-convertible debt: This debt is a non-convertible security that requires the bondholder to be repaid in full with cash and not stock.
  3. 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 the 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 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 debt falls into one of these categories, it is critical that you evaluate it before your company’s public accounting audit. These types of debt can be challenging, and it is critical that you work with the audit team familiar with public company regulations and accounting standards and provide analysis of these types of instruments in advance. A highly trained PCAOB auditor can help ensure that your audit is timely and you are in compliance.

Does your company have complex debt? It’s essential to stay ahead of new accounting rules that may affect your next audit. Learn more about recent accounting updates regarding debt in our next blog article. 

Our accounting team at Assurance Dimensions has a proven track record in public company audits. We can help your organization understand and navigate complex debt challenges. Contact us today.