Question

Refer to textbook chapter 14 section titled Reviewing and Assessing Contingencies. This question deals with probabilities and estimations of potential litigation claims. In Accounting Standards Codification (ASC) 450 (formerly Statement of Financial Accounting Standard (SFAS) No. 5, “Accounting for Contingencies”), the Financial Accounting Standards Board (FASB) provides the standard for accruing and disclosing three categories of potential losses that can be reasonably estimated. Those categories reflect the contingent nature of those losses and the guiding criteria are organized around probability of outcomes classified as (1) probable, (2) reasonably possible, and (3) remote.

The basis for this question is that the audit client is being sued for $500,000 for discriminatory hiring practices. Match the appropriate action with respect to each of the circumstances below.

The lawyer stated that the client will probably lose and the amount of the loss could be anywhere between $250,000 and $500,000, but most likely will lose $400,000. The client accrued a $250,000 contingent loss and disclosed the situation.

The lawyer stated that there is a remote chance that the client will lose. The client did not accrue any contingent loss or disclose this situation.

The lawyer stated that the client will probably lose, and the amount of loss could be anywhere between $250,000 and $500,000, with no amount within that range being more likely than another. The client disclosed this situation, but did not accrue a loss.

The lawyer stated that there is a reasonable possibility that the client will lose. The client disclosed this situation and accrued a loss of $250,000.

The auditor should ask the client to accrue the minimum of the range of $250,000 and disclose the contingency and the fact that the loss could be as much as $500,000.

The auditor should ask the client to adjust the accrual to $400,000. The disclosure should indicate the range and the amount actually accrued.

No action is necessary. The client has properly handled this.

The auditor should ask the client to adjust the accrued loss to zero and to disclose the contingency.

Answer 1

Standard provides that a contigent provision is required where it is probable that cash outflow is more likely than not arising out of past actions. Standard requires the accrual of losses when:

1. they are probable,

2. they can be reasonably estimated, and

3. they relate to events or activities of the current or prior periods.

Standard classifies the range of possible losses as probable, reasonably possible (the chance of the future event or events occurring is more than remote but less than likely), and remote (the chance of the future event or events occurring is slight).

Disclosure is not required of a loss contingency involving an unasserted claim or assessment if there has been no manifestation by a potential claimant of an awareness of a possible claim or assessment unless both of the following conditions are met:

1. It is considered probable that a claim will be asserted.

2. There is a reasonable possibil

Hence, following is conclussion of the given situations-

A. The lawyer stated that the client will probably lose and the amount of the loss could be anywhere between $250,000 and $500,000, but most likely will lose $400,000. The client accrued a $250,000 contingent loss and disclosed the situation.-

In the given situation loss amount most likely is $400,000 and based on the guidance it is probable that they will loose the case and hence, contigent loss of 400,000 should have been accrued.

The auditor should ask the client to adjust the accrual to $400,000. The disclosure should indicate the range and the amount actually accrued.

B. The lawyer stated that there is a remote chance that the client will lose. The client did not accrue any contingent loss or disclose this situation.

In the given situation, probability is remote and does not even meet the disclosure thresold. Hence, no action is required.

C. he lawyer stated that the client will probably lose, and the amount of loss could be anywhere between $250,000 and $500,000, with no amount within that range being more likely than another. The client disclosed this situation, but did not accrue a loss.

Standard provides that a company shall accrue the loss when it is resonably estimated. In the given situation, loss of 250,000 is minimum. hence, the auditor should ask the client to accrue the minimum of the range of $250,000 and disclose the contingency and the fact that the loss could be as much as $500,000.

D. The lawyer stated that there is a reasonable possibility that the client will lose. The client disclosed this situation and accrued a loss of $250,000.

Standard provides that a company shall accrue the loss when it is resonably estimated. The lawyer has not stated the amount. Hence, client has estimated a loss of 250,000 and accrued it.

Thus, No action is necessary. The client has properly handled this.