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Lecture 9

BUS 426 Lecture Notes - Lecture 9: Contingent Liability, Analytical Review, Financial Statement

Business Administration
Course Code
BUS 426
Michael Favere- Marchesi

of 6
Lecture 9
Contingent Liabilities (CL)
Commitments ©
Subsequent Events (SE)
Contingent Liabilities
CLs are existing conditions or situation that will be resolved at
some future time eg. Lawsuit
How to Search for CL
o Enquire of management
o Review minutes of shareholders
Board of Director meetings
o Read contracts, agreements + related correspondence
o Legal inquiry most important
Legal Inquiry = Legal confirmation
o Confirmation letter in a specific format (fig. 21-1, p.
Requesting information about pending litigation or other
relevant information with respect to legal claims
2 Categories of Claims
o Outstanding or Asserted Claims
Client has been notified of the suit or the suit has
already been filed
o Possible or Unasserted Claims
Client is aware of a situation that could lead to
Legal Expenses
o Analysis to get indication of contingent liabilities
o Identify law firms where confirmations are required
o Identify events that need to be confirmed by law firms
Evaluate Known Contingent Liabilities
o Once the CL has been identified and documented, then
management’s disclosure of the CL needs to be
o Based on the likelihood of event
CL may require an adjustment (likely to occur and
amount can be determined)
CL need to be in footnotes (likely to occur but
amount is not determinable OR the likelihood
cannot be estimated)
CL need not to be disclosed (unlikely to occur)
Commitments are certain, as opposed to CL where there is
uncertainty with respect to the outcome
Usually disclosed in the footnotes
Use the same procedures to identify and document the
commitments as we did for the contingent liability
Together, CL + C are very important because
o They represent encumbrances of potentially material
amount of future resources (especially cash)
o Potentially will affect future cash flows
o GAAP requires their disclosure
Subsequent Events
Transactions and events that occur after the balance sheet
Auditor must examine subsequent events up to the audit
report date
2 Types of Subsequent Events
o Those that require adjustment to the financials
o Those that require only disclosure in footnotes
Subsequent Events requiring Adjustments (Hindsight)
o Subsequent Events have a direct effect on financial
declaration of bankruptcy by a customer with a large
outstanding accounts receivable balance
o Settlement of a litigation for an amount =/= than the
amount recorded in the books
o Disposal of equipment not in operation at a price below
current book value
o Sale of investment below recorded cost
Very important to distinguish between conditions that
existed at the balance sheet date from those conditions
that came into being after the balance sheet date
o Sale of raw material inventory as scrap after year end if
obsolescence took place before year end Adjust
inventory value
o Sale of raw material inventory as scrap after year end if
obsolescence took place after year end Not adjust
inventory value
Subsequent Events requiring only Disclosure
o These subsequent events have no direct, or indirect
effect on financials
o E.g.: A decline in the market value of securities held for
temporary investments or for resale
o Issuance of bonds or stock
How to get Subsequent Events Evidence
o Discussion with management
o Legal letters
o Examination of subsequent internal financials or other
internal documents
o Review of shareholders meetings or directors minutes
o Letter of representation from management
o Cutoff timing
Final Evidence Accumulation
Analytical Procedures
Evaluate and conclude on the going-concern assumption
Obtain client representation letter (or management
representation letter)
o Confirms the information provided to the auditor in the
course of the audit
o Auditor is required to obtain
Annual report
o Aside from financial statements... CAS 720 says that
The primary responsibility of auditor is to ensure
financial statements and the related footnotes and the
auditor’s report are accurately and faithfully reproduced
in the annual report”
o However, auditor must ensure that other financial
information contained in the annual report is consistent
with information on the financial statements and
reported footnotes
Management Discussion and Analysis
Sufficiency of Evidence
Audit partner responsible for overseeing evidence in the
context of engagement risks and client profile risk
Detailed review to ensure that all fieldwork has been
completed and outstanding queries have been cleared
Final Analytical Review
Useful as a final review for material misstatements or
financial problem not noted during other testing
Final objective look at financials after adjustment
Evaluation of Going Concern Consumption
Results of analytical review and financial statement review
will guide the auditor with respect to the risk of business