Contingent Liabilities and Attorney Letter | Auditing and Attestation | CPA Exam

IN this session, I will discuss contingent liabilities and attorney letter.
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Conduct a review for contingent liabilities and commitments.

Obtain and evaluate letters from the client’s attorneys.
Inquiry of the client’s attorneys is a major procedure auditors rely on for evaluating known litigation or other claims against the client and identifying additional ones. A contingent liability is a potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place
The auditor relies on the attorney’s expertise and knowledge of the client’s legal affairs to provide a professional opinion about the expected outcome of existing lawsuits and the likely amount of the liability, including court costs. The attorney is also likely to know of pending litigation and claims that management may have overlooked.

Conduct a review for contingent liabilities and commitments.
. Material contingent liabilities must be disclosed in the footnotes. Three conditions are required for a contingent liability to exist:
1. There is a potential future payment to an outside party or the impairment of an asset that resulted from an existing condition
2. There is uncertainty about the amount of the future payment or impairment
3. The outcome will be resolved by some future event or events
For example, a lawsuit that has been filed but not yet resolved meets all three conditions.
Accounting standards use two primary approaches in dealing with uncertainty in loss contingencies. The first measures the contingency using a fair value approach. The second approach uses a probability threshold. With the probability threshold, the standards describe three levels of likelihood of occurrence (ranging from remote to probable) and the appropriate financial statement treatment for each likelihood.
Auditors are especially concerned about certain contingent liabilities:
• Pending litigation for patent infringement, product liability, or other actions
• Income tax disputes
• Product warranties
• Notes receivable discounted
• Guarantees of obligations of others
• Unused balances of outstanding letters of credit
Audit Procedures for Finding Contingencies
Many of these potential obligations are verified as an integral part of various segments of the audit rather than as a separate activity near the end of the audit. For example, auditors test for unused balances in outstanding letters of credit as a part of confirming bank balances and loans from banks. Similarly, auditors consider the possibility of income tax disputes as a part of analyzing income tax expense, reviewing the general correspondence file, and examining revenue agent reports. Even if contingencies are verified separately, auditors commonly perform the tests well before the last few days of completing the audit to ensure their proper verification. Tests of contingent liabilities near the end of the audit are more of a review than an initial search.
The first step in the audit of contingencies is to determine whether any contingencies exist (occurrence presentation and disclosure objective). As you know from studying other audit areas, it is more difficult to discover unrecorded transactions or events than to verify recorded information. Once the auditor knows that contingencies exist, evaluating their materiality and the footnote disclosures can ordinarily be satisfactorily resolved.
The following are some audit procedures commonly used to search for contingent liabilities, but not all are applicable to every audit:
• Inquire of management (orally and in writing) about the possibility of unrecorded contingencies. In these inquiries, the auditor must be specific in describing the different kinds of contingencies that may require disclosure as reminders to management of contingencies they overlooked or do not fully understand. If management overlooked a contingency or does not fully comprehend accounting disclosure requirements, the inquiry can be helpful to identify required disclosures. At the completion of the audit, auditors typically ask management to make a written statement as a part of the letter of representation (discussed later in this chapter) that it is aware of no undisclosed contingent liabilities. Naturally, inquiries of management are not useful in uncovering the intentional failure to disclose contingencies.