An audit engagement team is planning for the upcoming audit of a client who recently underwent a significant restructuring of its debt. The restructuring was necessary as economic conditions hampered the client’s ability to make scheduled re-payments of its debt obligations. The restructured debt agreements included new debt covenants. In auditing the debt obligation in the prior year (before

Question

the restructuring), the team established materiality specific to the financial statement debt account (account level materiality) at a lower amount than overall financial statement materiality. In planning the audit for the current year, the team plans to use a similar materiality level. While such a conclusion might be appropriate, what judgment trap(s) might the team fall into and which step(s) in the judgment process are most likely affected?

What will be an ideal response?

Answer 1

The team needs to understand the terms of the debt restructuring. If the covenants in the new debt
agreements require the company to maintain certain financial ratios (for example, ratio of assets to
liabilities greater than 1.5 to 1), the appropriate account level materiality threshold may be lower than the
threshold used in the prior year when the debt agreement in place only required the client to meet certain
non-financial debt covenants. The traps that the team may have fallen into include both a rush to solve and a
judgment trigger in that they may have considered only the same approach or alternative as was used in the
prior year, even though conditions have changed in important ways. The step in the judgment process most
affected in this scenario is Step 2, “Consider Alternatives.”