Mother Earth Foods On October 11, Linda John was auditing the financial statemen

Question

Mother Earth Foods On October 11, Linda John 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 inchudes 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 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 turmover rate. John is not certain, however, because the accounting records, including period-end cutoffs for sales and purchases, have not been well maintained. 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. Required A. Discuss the audit procedures that John would conduct to determine if Mother Earth violated the debt covenants. How would John 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 DO

Explanation / Answer

Ans A. The normal audit procedure in this case is to reconstruct the set of financial statements after obtaining such information and explanations from the management so as to make up for the poor quality of maintenance of financial records by the client. The financial and other records should then be checked for any possible instances of violations of the restrictive covenants.

Regarding waiver of restrictive covenants the auditor should ask for a written approval from the lenders that in case of a violation in the restrictive covenants the terms and conditions of the covenants will be waived. The auditor can also ask for an undertaking directly from the lenders.

Ans B. The debt should be classified as non current unless there is reasonable certainty backed by convincing evidence that the restrictive covenants are being violated and the due date of repayment of debt may be modified.  

Related Questions

Navigate

• Browse (All)
• Browse M
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.