Erik Rekdahl, senior-in-charge, is auditing Koonce Katfood, Inc.'s, long-term debt for the year ended December 31. Long-term debt is composed of two bond issues, which are due in 10 and 15 years, respectively. The debt is held by two insurance companies. Rekdahl has examined the bond agreements for each issue. The agreements provide that if Koonce fails to comply with the covenants of the contract, the debt becomes payable immediately. Rekdahl identified the following covenants when reviewing the bond agreements: "The debtor company shall endeavor to maintain a working capital ratio of 2 to 1 at all times, and in any fiscal year following a failure to maintain said ratio, the company shall restrict compensation of officers to a total of $650,000. Officers include the chairperson of the
board and the president." "The debtor company shall keep all property that is security for these debt agreements insured against loss by fire to the extent of 100 percent of its actual value. Policies of insurance comprising this protection shall be filed with the trustee." "The company is required to restrict 40 percent of retained earnings from availability for paying dividends." "A sinking fund shall be established with the First Morgan Bank of Austin, and semiannual payments of $500,000 shall be deposited in the fund. The bank may, at its discretion, purchase bonds from either issue."
a. Provide any audit steps that Rekdahl should conduct to determine if the company is in compliance with the bond indentures.
b. List any reporting requirements that the financial statements or footnotes should include.
a. Rekdahl should perform the following audit steps to determine if the company is in compliance with the bond indentures:
• Calculate the working capital ratio to ensure that it is 2 to 1 at the end of each month during the fiscal year.
• If the working capital ratio is less than 2 to 1, verify that the total compensation of the chairperson and president is not more than $650,000.
• Confirm with the trustee that insurance policies protecting against fire loss to the extent of 100 percent of value have been filed.
• Test retained earnings to ensure that 40 percent has been restricted from dividend payments.
• Confirm with the First Morgan Bank of Austin that a sinking fund has been established and that the required semiannual payments have been made.
• Confirm whether any bonds have been repurchased.
b. The following disclosures should be included in the footnotes of the financial statements:
• The amount, interest rate, and due date of each bond issue.
• The covenant restrictions on the bond indentures.
• The amount of debt due over each of the next five years.
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