COMPLETING THE ENGAGEMENT
Answers to Review Questions
17-1 A contingent liability is defined as an existing condition, situation, or set of
circumstances involving uncertainty as to possible loss to an entity that ultimately will be
resolved when some future event occurs or fails to occur. SFAS No. 5, "Accounting for
Contingencies" (FAS5), classifies uncertainties into three categories:
1. Probable: The future event is likely to occur.
2. Reasonably possible: The chance of the future event occurring is more than
remote but less than likely.
3. Remote: The chance of the future event occurring is slight.
Examples of contingent liabilities include:
Pending or threatened litigation.
Actual or possible claims and assessments.
Income tax disputes.
Product warranties or defects.
Guarantees of obligations to others.
Agreements to repurchase receivables that have been sold.
17-2 The auditor requests that the attorney provide the following information on
pending or threatened litigation:
A list and evaluation of any pending or threatened litigation to which the attorney has
devoted substantial attention. The client may provide the list.
A listing of unasserted claims and assessments considered by management to be
probable of assertion and reasonably possible of unfavorable outcome.
A request that the attorney describe and evaluate the outcome of each pending or
threatened litigation. This should include the progress of the case, the action the entity
plans to take, the likelihood of unfavorable outcome, and the amount or range of
A request for additions to the list provided by management or a statement that the list
A request that the attorney comment on unasserted claims where his or her views
differ from management's evaluation.
A statement by management acknowledging an understanding of the attorney's
professional responsibility involving unasserted claims and assessments.
A request that the attorney indicate if his or her response is limited and the reasons for
A description of any materiality levels agreed upon for the purposes of the inquiry
An unasserted claim or assessment is one in which the injured party or potential
claimant has not yet notified the entity of a possible claim or assessment. Attorneys may
be reluctant to provide the auditor with information about the unasserted claims because
of client-attorney privilege. Attorneys may also be concerned that disclosure of the
unasserted claim may itself result in lawsuits.
17-3 Two examples of long-term commitments are the purchase of raw materials or the
sale of products at a fixed price. When the fair market value of the good is less than the
purchase price included in the contract, the entity will have to recognize a loss on a long-
term commitment even though there has been no exchange of goods.
17-4 The two types of subsequent events that require consideration by management
and evaluation by the auditor are:
1. Events that provide additional evidence about conditions that existed at the
date of the balance sheet and affect the estimates that are part of the financial
statement preparation process. These types of events require adjustment of
the financial statements.
2. Events that provide evidence about conditions that did not exist at the date of
the balance sheet but arose subsequent to that date. These types of events
usually require financial statement disclosure. In some instances, where the
effect of the event or transaction is significant, pro forma financial statements
may be necessary in order to prevent the financial statements from being
Examples of the first type of event or condition are:
An uncollectible account receivable resulting from continued deterioration of a
customer's financial condition leading to bankruptcy after the balance sheet date.
The settlement of a lawsuit after the balance sheet date for an amount different from
the amount recorded in the year-end financial statements.
Examples of the second type of event or condition are:
Purchase or disposal of a business by the entity.
Sale of a capital stock or bond issue by the entity.
Loss of the entity's manufacturing facility or assets resulting from a casualty such as a
fire or flood.
Losses on receivables arising from conditions such as a casualty arising subsequent to
the balance sheet date.
17-5 The auditor would consider dual-dating the audit report when a subsequent event
is recorded or disclosed in the financial statements after completion of the field work but
before the issuance of the financial statements (refer to Figure 17-1 in the text).
17-6 Auditing standards (AU 329), requires that the auditor perform analytical
procedures at the final review stage of the audit. The objectives of conducting analytical
procedures near the end of the engagement is to help the auditor assess the conclusions
reached on the financial statement components and evaluate the overall financial
17-7 The auditor obtains a representation letter in order to corroborate oral
representations made to the auditor and to document the continued appropriateness of
such representations. The representation letter also reduces the possibility of
misunderstanding concerning the responses provided by management to the auditor's
17-8 An concurring or second partner is generally not associated with the details of the
engagement and is expected to provide an independent review of the audit. The second
partner can protect the firm from an inappropriate or nonindependent relationship
between the audit partner and the client. In conducting the review, the second partner
should understand the audit approach, findings, and conclusions for critical audit areas
and should review the audit report, financial statements, and footnotes for consistency.
17-9 Three overall steps in the going-concern evaluation process are as follows:
1. Consider whether the results of audit procedures performed during the
planning, performance, and completion of the audit indicate whether there is
substantial doubt about the entity's ability to continue as a going concern for a
reasonable period of time not to exceed one year.
2. If there is substantial doubt, the auditor should obtain information about
management's plans to mitigate the going-concern problem and assess the
likelihood that such plans can be implemented.
3. If the auditor concludes, after evaluating management's plans, that there is
substantial doubt about the ability of the entity to continue as a going concern,
he or she should consider the adequacy of the disclosures about the entity's
ability to continue and include an explanatory paragraph in the audit report.
17-10 The four major categories of events or conditions that may indicate going-concern
problems and examples of each are:
Recurring operating losses.
Negative net worth.
Negative working capital.
Negative cash flow.
Negative income from operations.
Inability to meet interest payments.
Other financial difficulties:
Default on loans.
Dividends in arrears.
Restructuring of debt.
Denial of trade credit by suppliers.
No additional sources of financing.
Uneconomic long-term commitments.
Dependence on the success of one particular project.
Loss of a major customer or supplier.
Loss of a key franchise, license, or patent.
17-11 The following items should be included in the auditor's communication with an
The auditor's responsibility under GAAS.
Significant accounting policies.
Management judgments and accounting estimates.
Significant audit adjustments.
Disagreements with management.
Consultation with other accountants.
Major issues discussed with management prior to being retained as auditors.
Difficulties encountered during the audit.
Fraud involving senior management and fraud that causes material misstatements of
the financial statements.
The auditor’s communication with the audit committee would normally take place
at or near the end of the engagement. However, if a significant event occurs, such as
fraudulent activities by senior management, the auditor would normally contact the audit
17-12 Generally, when previously issued financial statements contain material
misstatements due to unintentional or intentional actions by management, the financial
statements will require revision.
If the client refuses to cooperate and make the necessary disclosures, the auditor
should notify the board of directors and take the following steps, if possible:
1. Notify the client that the auditor's report must no longer be associated with the
2. Notify any regulatory agencies having jurisdiction over the client that the
auditor's report can no longer be relied upon.
3. Notify each person known to the auditor to be relying on the financial
statements. Usually, notification to a regulatory agency such as the SEC is the
only practical way to provide appropriate disclosure.
Answers to Multiple-Choice Questions
17-13 C 17-18 C
17-14 D 17-19 A
17-15 C 17-20 A
17-16 C 17-21 B