Case 1.6 Star Technologies, Inc.
Star's bank indicated in the waiver of the debt covenant violations that it did not intend to accelerate the maturity date of the $5.8 million loan. Was that statement a sufficient basis for classifying the loan as a long-term liability rather than as a current liability?
Debt covenants are agreements between a firm and its creditors in which the creditor places certain limits and restrictions on the borrower. The borrower must operate within these restrictions and limits in order for it to avoid breach or violation of the terms and conditions of the debt covenants. Common restrictions placed on the borrower in such covenant agreements often specify that the borrower must achieve a minimum level of revenues and or profits for a given fiscal period or that the borrower must maintain a certain level of working capital or that the borrower must have a desired level of net worth. If any one or more of the debt covenants is breached by the borrower then the loans typically become callable meaning that they become immediately due and payable. In certain situations the creditor and borrower may renegotiate the terms and conditions of the debt agreement or the creditor may grant a waiver of debt covenant violations.1
Due to substandard operating results during the 1989 fiscal period Star Technologies Inc. violated several debt covenants which were part of a loan agreement that Star had with its bank. As a result of these debt covenant violations, the maturity date of a $5.8 million bank loan was accelerated which meant that the loan was immediately due and payable. Star's bank chose to grant a waiver of the debt covenant violations for a period of five months. Also, in the waiver of the debt covenant violations, Star's bank stated that it did not intend to accelerate payment of the $5.8 million loan. Price Waterhouse audit engagement partner, Clark Childers, believed that this statement was a sufficient basis for classifying the loan as a long-term liability rather than as a current liability.2 Childers stood firm on his opinion even though his fellow engagement partner, Paul Argy, disagreed with him. In Argy's opinion the waiver was not sufficient to classify the loan as a long-term liability.3
Statements of Financial Accounting Standards (SFAS) No. 78, Classification of Obligations that are callable by the Creditor requires that debt with covenant violations be classified as a current liability unless a waiver of the debt covenant violations is granted by the creditor/lender for more than a period of one year.4 As indicated earlier, Star's bank did not grant Star a waiver of debt covenant violations for a period longer than one year. Instead, Star's bank granted Star a temporary waiver in which it waived the debt covenant violations for only a five month period. As a result, according to the requirements set forth under SFAS No. 78, the $5.8 million loan should have been classified as a current liability rather than as a long-term liability.
Furthermore, Financial Accounting Standards Board (FASB) has concluded that the proper classification of a borrower's debt should be based on facts and objective evidence rather than on subjective statements and circumstances such as the bank's statement that expressed that it was not their intention to accelerate payment of the loan due to Star's violations of debt covenants.5 FASB has also concluded if the creditor has the right to demand repayment of the debt due to a violation or breach of the debt covenants, then the debt should be classified as a current liability regardless of whether or not the creditor actually or explicitly demands repayment.6
Price Waterhouse auditor Clark Childers should have based his decision on the proper classification of the $5.8 million dollar loan by following the requirements of SFAS No. 78 and the conclusions and recommendations set forth by FASB instead of relying on the statement provided by Star's bank. Had Childers done so he would have realized that the $5.8 million loan should have been classified as a current liability and that the bank's statement was an insufficient basis from which to determine the proper classification of the loan. Also, due to Star's poor operating results, Childers should have been concerned about the companies' ability to repay the loan within the five month waiver period that the bank granted Star. Childers should have realized that given Star's financial condition it would be unlikely that the company would be able to repay the loan in this period of time, thus making the loan immediately due and payable and therefore a current liability.
Explain why industry knowledge is so important to an audit engagement team. Identify risk factors commonly posed by companies in high-tech industries.
Auditing standards require an auditor to acquire a basic understanding and knowledge of a client's industry as well as the economic forces that impact that industry. It is also important for the audit engagement team to understand and have knowledge about industry regulations and competition.7 This understanding and knowledge of a client's industry is so important to the audit engagement team because it provides the auditors with valuable insight which allows auditors to effectively analyze and interpret the accuracy of the client's financial statement assertions.8 Industry knowledge also allows auditors to better understand the true nature of certain business transactions of the client and whether or not such transactions are indeed legitimate business transactions or if they are part of an overall scheme by a client's management to cover up and conceal fraudulent activity.9 In turn, industry knowledge can help prevent the auditors firm from being subject to costly and embarrassing lawsuits by the federal government or other stakeholders and users of the auditors' reports.10 Furthermore, it is important to acquire knowledge of a client's industry because such knowledge enables auditors to identify and assess risks that are present within particular industries, which affects the auditors' assessment of client business risk and audit risk.11 Also, industry knowledge may aid auditors in their decision of whether or not to accept a particular firm as a client especially when a firm is in an industry with a greater than average degree of risk.12
Some risk factors commonly posed by high technology companies include but are not limited to high-tech companies' dependency on a limited number of products, short product life, rapid changes in technology which often leads to obsolete and out of date inventory. These risks were all risks that were evident in the case of Star technologies. Star marketed so called supercomputers for highly specialized uses which meant that they targeted a particular niche in the computer market. Their operating results during this time fluctuated up and down which could have reflected by the buyers demand and willingness to buy these supercomputers. Also, due to rapid changes in technology within the computer industry, many of Star's computer products such as the ST-100 experienced a short product life and were rendered obsolete after only a short period of time which in turn affected the companies' targeted financial projections and overall profitability. Another risk common within the high-tech industry is the amount and level of competition from competing companies and the constant battle between these companies for dominance over market share and to be the leader in technology innovation. These risks place pressure on high tech companies to achieve good operating results which could increase the risk that there are material misstatements reported on the companies' financial statements.
1Clifford W. Smith, Jr., A Perspective on Accounting-Based Covenant Violations. The Accounting Review (1993) 289-303
2Michael C. Knapp, Contemporary Auditing 6th ed. 75-81.
3Knapp.
4Finacial Accounting Standards Board. 1983. Statement of Financial Accounting Standards No. 78, Classification of Obligations That Are Callable by the Creditor.
5same
6same
7Merle Erickson, Brian W. Mayhew, and William L. Felix, Why DO Audits Fail? Journal of Accounting Research (2000) 170-175.
8Erickson, Mayhew, and Felix.
9Erickson, Mayhew, and Felix.
10Alvin A. Arens, Randal J. Elder, and Mark S. Beasley, Auditing and Assurance Servces 12th ed. 215.
11Arens, Elder, and Beasley 214.
12Arens, Elder, and Beasley 214.
Works Cited
Arens, Alvin A., Elder, Randal J., and Mark S. Beasley. Auditing and Assurance Services
12th ed. (2008): 214-215.
Erickson, Merle, Mayhew, Brian W., and William J. Felix. Why Do Audits Fail?
Journal of Accounting Research. (2000): 170-175.
Financial Accounting Standards Board. 1983. Statement of Financial Accounting
Standards No. 78. Classification of Obligations That Are Callable by the
Auditor.
Knapp, Michael C., Contemporary Auditing 6th ed. (2006): 75-81.
Smith, Clifford W., A Perspective on Accounting-Based Covenant Violations.
The Accounting Review. (1993) 289-303.
