Audit Chapter 15

Contingent Liability

An existing condition involving uncertainty about a potential financial obligation that will be resolved when a future event occurs or fails to occur

How do auditors test for contingent liabilities?

1. Review meeting minutes

2. Examine contracts

3. Confirm guarantees

4. Inspect legal documents

5. Review tax returns

3 levels of likelihood for contingent events

1. Probable: likely

2. Reasonably possible: more than remote, but less likely

3. Remote: slight chance

Purpose of a legal letter

A formal communication to obtain information about potential legal issues, pending litigation, and contingent liabilities affecting financial statements

When should legal letters be sent during an audit?

Near the completion of the audit, before finalizing financial statements, as part of the contingent liability identification process

Type 1 subsequent events

Events providing evidence of conditions existing at financial statement date, requiring adjustment

Type 2 subsequent events

Events providing evidence of conditions arising after financial statement date, requiring no adjustment

How are subsequent events audited?

1. Interview management about potential events

2. Read meeting minutes

3. Review interim statements

4. Scan accounting records

5. Consult legal counsel

What are the key steps in final audit evaluation?

1. Perform analytical procedures

2. Evaluate misstatements

3. Reevaluate materiality and risks

4. Consider fraud indicators

Management representation letter

A document corroborating significant oral representations made by management during the audit

When should the management representation letter be dated?

The same date as the financial statements

What is the going concern assessment period?

One year beyond the issuance date of financial statements

What must be communicated to the audit committee per PCAOB AS 1301?

Critical accounting policies, practices, and estimates

Who receives communications about legal noncompliance?

Those charged with governance

How do auditors evaluate going concern?

Assess entity’s ability to continue operations and draw conclusions about substantial doubt

Who do we send legal letters to?

Sent to the client’s attorneys or legal counsel, typically addressing the law firm representing the company

Importance of legal letters

1. Obtain independent confirmation of potential legal risks

2. Identify and undisclosed legal issues

3. Ensure comprehensive risk assessment

4. Gather evidence about possible contingent liabilities that could materially impact the financial statements

When do we get a management representation letter?

To be obtained right at completion of audit