The following covenants are extracted from the indenture for McMorris Industries' 20 year-bond. The indenture provides that failure to comply with its terms in any respect automatically advances the due date of the loan to the date of noncompliance. REQUIRED: Assume that each of these is an independent scenario and identify the audit steps that should be taken or reporting requirements necessary

Question

in connection with (a) through (d).
a. The debtor company shall endeavor to maintain a working capital ratio of 2.5 to 1 at all times, and, in any fiscal year following a failure to maintain this ratio, the company shall restrict compensation of the CEO and executive officers to a total of no more than $1,000,000 . Executive officers for this purpose shall include the chairman of the board of directors, the president, all vice presidents, the secretary, and the treasurer.

b. The debtor company shall insure all property that is security for this debt against loss by hurricane to the extent of 90% of its actual value. Insurance policies securing this protection shall be filed with the trustee.

c. The debtor company shall pay all taxes legally assessed against the property that serves as security for this debt within the time provided by law for payment without penalty and shall deposit receipted tax bills or equally acceptable evidence of payment of same with the trustee.

d. A sinking fund shall be established and deposited with the trustee by semiannual payments of $450,000, from which the trustee shall, at his/her discretion, purchase bonds of this issue.

Answer 1

Any failure, or likely failure, of McMorris Industries to comply with the covenants should be reported in a note to the financial statements.
Audit steps for each independent scenario follow:
a . The balance sheets should be reviewed for each applicable period to determine compliance with the covenant. If the company is below the stated ratio, the auditor should review officer compensation to determine if it is in compliance with the covenant.
b. Examine client copies of insurance policies or certificates of insurance to determine compliance with the covenant. The auditor should prepare a summary of all the scheduled information contained in the policies. In addition, the auditor should confirm the existence of the policies with the trustee.
c. Examine vouchers supporting tax payments on all property covered by the indenture. If vouchers are questionable, confirm tax payments with the trustee who holds the tax receipts.
d. Vouch the payments to the sinking fund. Confirm bond purchases and the sinking fund balance with trustee. Confirm any cancellation of bonds with the trustee or observe the canceled bond.