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Contingencies: Reporting issues for an auditor

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An audit client is being sued for $500,000 for discriminatory hiring practices.


Indicate the appropriate action the auditor should take for each of the following independent responses to the letter of audit inquiry:


What should the auditor do in each case?

a) The lawyer stated that the client has a "merirorious defense."
b) The lawyer stated that there is only a remote chance that the client will lose. The client did not accrue any contingent loss or disclose this situation. c) The lawyer state 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.
d) The lawyer state that there is a reasonable possibility that the client will lose. The client disclosed this situation but did not accrue a loss.
e) The lawyer stated that the client will probably losebetween $250,000 and $500,000, but most likely will lose $400,000. The client accrued a $250,000 contingent loss and disclosed the situation.

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Statement of Financial Accounting Standards (SFAS) No. 5 tells us how to deal with contingencies, and surprisingly, this section is little changed since it was issued in March 1975.

There are three categories of contingent loss in which an unfavorable outcome might occur:

1. It is probable - likely to occur. Record and disclose
2. It is reasonably possible - more than remote but less than likely. Disclose and may record.
3. It is remote - chance of occurring is slight. No recording but may disclose.

Further SFAS No. 5 requires that a loss can be reasonably estimated. All three types of contingencies must be ...

Solution Summary

The 416 word solution carefully explains the concepts involved in assessing contingencies and their effects to financial statements, in general and specifically to the situations stated.

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unable to audit accounts receivable; contingent liabilities

Below are two independent situations:
A. Grinner and Greeter, CPAs, were engaged to perform an audit of the financial statements of Happy, Inc. Happy's management would not allow Grinner and Greeter to confirm any of the accounts receivable. All other auditing procedures were performed as considered necessary by Grinner and Greeter and no problems were found. However, Grinner and Greeter were unable to satisfy themselves with regard to the balance in the accounts receivable.
B. Tick and Tie , CPAs, were performing their annual audit of Johnson Manufacturing Company. Johnson is currently being sued for $2,000,000 related to an alleged defective product that they sold to a customer. Johnson's legal counsel has told Tic and Tie that it is probable that Johnson will lose the suit and have to pay the entire $2,000,000. Johnson's management has included information in the footnotes about the lawsuit. However, they have not recorded any loss or liability in income statement or balance sheet.
For each of the independent situations presented above, state what type of opinion should be issued on the company's financial statements. Briefly explain your rationale. Finally, state which paragraphs, if any, of the standard report would be modified

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