Definition – Contingent Liabilities

An existing condition, situation, or set of circumstances involving uncertainty as to a possible obligation that is dependent upon the occurrence or non-occurrence of one or more future events.

Auditing Procedures-Contingencies

1.    Ask management
2.    Review current and previous years’ IRS agent reports for income tax settlements.
3.    Review the minutes of BOD and stockholders’ meetings
4.    Analyze legal expense for the audit period and review invoices from legal counsel.
5.    Obtain a letter from each major attorney performing legal services for the client
6.    Review working papers for any information that may indicate a potential contingency (bank confirmation may indicate notes receivable discounted or guarantees of loans).
7.    Examine letters of credit in force as of the B/S date and confirm used and unused balance.

Inquiry of Client’s Attorneys

Purpose:
- Evaluate known litigation or other claims
- Identify additional litigation and claims
- Auditor relies on attorney’s expertise and knowledge of client’s legal affairs
- Request opinion about the expected outcome of existing lawsuits and likely liability
- Attorney likely to know of pending litigation and claims that may have been overlooked by management.

Attorneys may be reluctant to provide certain information to auditors due to
- Lack of knowledge and
- Confidential information which may exacerbate a legal loss.

What if attorney refuses to give information?

If an attorney refuses to provide the auditor with info about material existing lawsuits (asserted claims) and unasserted claims, the auditor must modify his/her audit report to reflect the lack of available evidence.

Review for Subsequent Events

A subsequent event is one that occurs after the balance sheet date

Procedures are required by SAS 1 (AU 560):
- auditor must review transactions and events occurring after the balance sheet date
- to determine whether anything occurred that might affect the presentation or disclosure of the current-period F/S.

Types of Subsequent Events

KEY POINT: When subsequent events happen, must distinguish between:
- conditions that existed at the B/S date (Direct Effect)

 

-those that came into being after the end of the year (No Direct Effect)

Direct Effect Subsequent Events

Event or transaction provides additional information to:
- management in determining account balances as of B/S date
- auditors in verifying the balances

Requires adjustment of financial statements for effects of event.
Example: Auditors use subsequent sales activity (e.g., inventory sold as scrap vs. viable product) to provide information regarding inventory valuation at the B/S date

Examples: Direct Effect Subsequent Events

- Bankruptcy by a customer with an outstanding A/R balance due to deteriorating financial condition.

- Settlement of litigation at an amount different from the amount recorded at YE.

 

- Disposal of equipment not being used in operations at a price below the current BV.

    – Key is it was already out of use at year end
Sale of held to maturity investments at a price below recorded cost

No Direct Effect Subsequent Events

Subsequent events of this type
- provide evidence of conditions that did not exist at the B/S date
- but are so significant that they require disclosure even though they do not require adjustment.

Typically, footnote disclosure will suffice.

Sometimes, pro-forma F/S incorporating the information are added as a supplement.

Examples: No Direct Effect Subsequent Events

- Decline in the market value of securities held for temporary investment or resale.

- Issuance of bonds or equity securities.
- Decline in the market value of inventory as a consequence of government action barring further sale of a product.
- Uninsured loss of inventories due to fire.
- A merger or acquisition.

Dual Dating

When the auditor determines that a subsequent event (SE) occurred
- after field work was completed, and
- before the audit report was issued

SAS 1 (AU 530) requires the auditor to extend audit tests to ensure correct disclosure.

The auditor has two options for expanding SE tests:
- Expand all SE tests to the new date (single date) or
- Restrict the SE review to matters related to the new subsequent event (dual date)

Final Evidence Accumulation

- Perform final analytical procedures.
        - Big-picture review
- Evaluate the going concern assumption.
- Obtain a management representation letter.
- Read other information in the annual report.

Evaluate Going Concern Assumption

SAS 50 (AU 341) requires auditor to evaluate whether there is substantial doubt about a client’s ability to continue as a going concern for at least 1 year beyond the B/S date.

When the auditor has reservations about the client’s ability to continue as a going concern, must:
- Evaluate management’s plans to avoid bankruptcy and
- Evaluate the feasibility of achieving

Obtain Mgt. Representation Letter

Auditor required to obtain a letter of representation for 2 purposes:

- To impress upon management its responsibility for assertions in the F/S.

- To document the responses from management to inquiries about various aspects of the audit
- provides written documentation of client representations in the event of disagreement or a lawsuit between the auditor and client

*Note that this is not considered reliable evidence

4 Categories of Mgt. Representation Letter Matters

    Financial Statements


    Completeness of Information


    Recognition, Measurement, and Disclosure


    Subsequent Events