Illustruative Case: Violations of Debt Covenants

In the audit of a large construction company, the auditors found the client's working capital to be far below the minimum level stipulated in the indenture of long-term secured bonds payable. In addition, the client had allowed the required insurance coverage of pledged assets to lapse. These violations of the indenture were sufficient to cause the bond issue to become payable on demand.

Although the client agreed to reclassify the bond issue as a current liability and disclose the problem in the financial statements, the auditors were unable to satisfy themselves that the client could meet the obligation if the bondholders demanded payment. Also, if the bondholders foreclosed on the pledged assets, the ability of the client to continue as a going concern would be questionable. Thus, even after the liability was reclassified as current, the auditors added an explanatory paragraph to their report referring to the uncertainty regarding the company's ability to meet its obligations and remain a going concern.

In the audit of a large construction company, the auditors found the client's working capital to be far below the minimum level stipulated in the indenture of long-term secured bonds payable. In addition, the client had allowed the required insurance coverage of pledged assets to lapse. These violations of the indenture were sufficient to cause the bond issue to become payable on demand.

Although the client agreed to reclassify the bond issue as a current liability and disclose the problem in the financial statements, the auditors were unable to satisfy themselves that the client could meet the obligation if the bondholders demanded payment. Also, if the bondholders foreclosed on the pledged assets, the ability of the client to continue as a going concern would be questionable. Thus, even after the liability was reclassified as current, the auditors added an explanatory paragraph to their report referring to the uncertainty regarding the company's ability to meet its obligations and remain a going concern.

Required: Explain the case and the key points about it