Chapter (4)

COMPLETING THE AUDIT

Objective (1): Review for contingent liabilities and commitments.
A) Contingent liabilities
 A contingent liability is a potential future obligation to an outside party for an
unknown amount resulting from activities that have already taken place. 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.
 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.
 Likelihood of Occurrence and Financial Statement Treatment

 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
 Auditing standards make it clear that management, not the auditor, is responsible for
identifying and deciding the appropriate accounting treatment for contingent liabilities. In
many audits, it is impractical for auditors to uncover contingencies without management’s
cooperation. The auditor’s primary objectives in verifying contingent liabilities are:

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 - Evaluate the accounting treatment of known contingent liabilities to determine whether
management has properly classified the contingency (classification presentation and
disclosure objective).
- Identify to the extent practical any contingencies not already identified by management
(completeness presentation and disclosure objective).

B) Commitments
 Closely related to contingent liabilities are commitments. They include such things
as agreements to purchase raw materials or to lease facilities at a certain price and to
sell merchandise at a fixed price, as well as bonus plans, profit-sharing and pension
plans, and royalty agreements. The most important characteristic of a commitment
is the agreement to commit the firm to a set of fixed conditions in the future, regardless
of what happens to profits or the economy as a whole.
 All commitments are ordinarily either described together in a separate footnote or combined
in the contingencies footnote.

B. Audit Procedures for Finding Contingencies

B. Evaluation of Known Contingent Liabilities

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 If auditors conclude that there are contingent liabilities, they must evaluate the
significance of the potential liability and the nature of the disclosure needed in
the financial statements to obtain evidence about the occurrence and rights and
obligations presentation and disclosure objective.
 In some instances, the potential liability is sufficiently well known to be included in the
statements as an actual liability under the probability threshold approach. In other instances,
disclosure may be unnecessary if the contingency is highly remote or immaterial.

C. Audit commitments
 The search for unknown Procedures forisFinding
usually Commitments
performed as a part of the audit of
D.
each audit area.
 For example, in verifying sales transactions, the auditor should be alert for sales
commitments. Similarly, commitments for the purchase of raw materials or equipment can
be identified as a part of the audit of each of these accounts.
 The auditor should also be aware of the possibility of commitments when reading minutes,
contracts, and correspondence files.

E. Inquiry of Client’s Attorneys

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 NOTES:
- The standard inquiry to the client’s attorney, prepared on the client’s letterhead
and signed by one of the company’s officials.
- The nature of the refusals by attorneys to provide auditors with complete information
about contingent liabilities falls into two categories:
1. The attorneys refuse to respond due to a lack of knowledge about matters involving contingent liabilities.
2. The attorneys refuse to disclose information that they consider confidential.
- If an attorney refuses to provide the auditor with information about material
existing lawsuits (asserted claims) or unasserted claims, auditors must modify their
audit report to reflect the lack of available evidence (a scope limitation, which requires
a qualified or disclaimer of opinion).
Objective (2): Review for Subsequent Events (Post-Balance-Sheet-Events).
 Subsequent events are events that occur after a company’s year-end period but before the
release of the financial statements. The auditor’s responsibility for reviewing subsequent
events is normally limited to the period beginning with the balance sheet date and ending
with the date of the auditor’s report.

Types of Subsequent events

1- Those that have a direct effect on the financial statements and require adjustment:
Subsequent period events, such as the following, require an adjustment of account
balances in the current year’s financial statements if the amounts are material:
- Declaration of bankruptcy by a customer with an outstanding accounts receivable balance
because of the customer’s deteriorating financial condition
- Settlement of litigation at an amount different from the amount recorded on the books
- Disposal of equipment not being used in operations at a price below the current book value

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2- Those that have no direct effect on the financial statements but for which disclosure
is advisable.
- A decline in the market value of securities held for temporary investment or resale
- The issuance of bonds or equity securities
- A decline in the market value of inventory as a consequence of government action barring
further sale of a product
- The uninsured loss of inventories as a result of fire
- A merger or an acquisition

Audit Tests

 Review Records Prepared Subsequent to the Balance Sheet Date: Auditors should
review journals and ledgers to determine the existence and nature of significant
transactions related to the current year. If journals are not kept up-to-date, auditors
should review documents that will be used to prepare the journals.
 Review Internal Statements Prepared Subsequent to the Balance Sheet Date: In the
review, auditors should emphasize changes in the business compared
to results for the same period in the year under audit and changes after year-end.
They should pay careful attention to major changes in the business or environment
in which the client is operating. Auditors should discuss the interim statements
with management to determine whether they are prepared on the same basis as
the current period statements, and also inquire about significant changes in the
operating results.
 Examine Minutes Issued Subsequent to the Balance Sheet Date Auditors
must examine the minutes of stockholders and directors meetings subsequent to

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 the balance sheet date for subsequent events affecting the current period financial
statements.
 Correspond with Attorneys: As discussed earlier in the chapter, auditors
correspond with attorneys as a part of the search for contingent liabilities. Auditors
normally request the attorney to date and mail the letter as of the expected completion
date of field work to fulfill the auditors’ responsibility for subsequent events.
 Inquire of Management: Inquiries vary from client to client, but normally include
significant changes in the assets or capital structure of the company after the balance
sheet date, the current status of items that were not completely resolved at the balance
sheet date, and unusual adjustments made subsequent to the balance sheet date.
 Obtain a Letter of Representation: The letter of representation written by the
client’s management to the auditor formalizes statements made by management
about different matters throughout the audit, including discussions about subsequent
events. This letter is mandatory and includes other relevant matters.