Question

what are the audit risks associated with contingent liabilities? What steps does the auditor need to take to reduce those risks?

Answer 1

Audit risks associated to contingent liability

1. Detection risk- It is the auditors responsibility to exercise due diligence and identify any material contingent liability which may materialize in future. There are times when auditor fails to determine the liability and there lies the risk.

2.Imperfect informations and asymmetric informations

3.Presence of externalities

Steps taken to mitigate the risks are as follows:-

The most common source of contingent liabilities are outstanding lawsuits and product warranties. Auditors usually ask management to write a statement acknowledging they disclosed all known contingent liabilities.

Search for Undisclosed Contingencies

Management should disclose all contingent liabilities to their auditors. This doesn't always happen and auditors should perform extended search procedures after an initial inquiry. Auditors can review any company Internal Revenue Service reports for unsettled income tax liabilities. It's also helpful to search the board of director meeting minutes for discussion of potential or current lawsuits. Auditors should pay special attention to the content of any legal expense accounts in the accounting system. The supporting documentation for legal expense transactions may reveal contingent liabilities.

Evaluate Materiality- The auditor should assess the materiality of the liability as to quantum of liability if it gets matured and whether it will impact the financials of the company.

Evaluate Event Likelihood

If a contingent liability is a material amount or the amount can't be estimated, auditors should estimate the likelihood that the event will occur. The likelihood can be remote, reasonably possible or probable. U.S. generally accepted accounting principles do not offer specific percentage definitions of these three levels, so auditors must use their professional judgment. The company must disclose material contingent liabilities that are possible or probable by adding a footnote to the financial statement.

Look at Probable Events

Auditors should pay special attention to any contingent liabilities in the "probable" category, because they may require special accounting treatment. If the contingent liability is probable,