Question Tag: Contingent Liability

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  • 3 Marks

FR – July 2023 – L2 – Q2d – Contingent Liabilities and Assets (IAS 37)

Explanation of contingent liabilities and contingent assets according to IAS 37.

The objective of IAS 37: Provisions, Contingent Liabilities, and Contingent Assets is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities, and contingent assets, and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing, and amount.

Required:
Explain Contingent Liability and Contingent Asset as used in the statement above.
(Total: 3 marks)

Contingent Liability:

  • A possible obligation depending on whether some uncertain future event occurs, or
  • A present obligation, but payment is not probable, or the amount cannot be measured reliably.
    (1.5 marks)

Contingent Asset:

  • A possible asset that arises from past events, and
  • Whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.
    (1.5 marks)
  • 15 Marks

AA – Nov 2017 – L2 – Q5a – Audit and Assurance Risk Environment

Summary: Discuss the impact of an ongoing lawsuit on the audit report if the matter remains unresolved.

Lexon Institute provides tuition for accountancy studies writing professional examinations. You are the audit manager of DAR and Co. Chartered Accountants. The following were identified during the financial audit of Lexon. Revenue is GH¢30m, Profit before tax is GH¢10 million and total assets is GH¢25 million.

i) The regulator of the Accountancy profession has filed a lawsuit against Lexon Institute for GH¢3.9 million alleging a non-compliance with the Regulators rules and regulations for running a tuition center. This case is ongoing and will not be resolved prior to the audit report being signed. The matter is disclosed as a contingent liability.
(4 marks)

ii) Depreciation has been calculated on the total of land and buildings. In previous years it has only been charged on buildings. Total depreciation is GH¢2·5 million and the element charged to land is GH¢2 million.
(4 marks)

iii) Lexon Institute’s computerised purchases is backed up daily, however for a period of three months the purchases records and the back-ups have been corrupted, and therefore cannot be accessed. Purchases for these three months amounted to GH¢4m.
(4 marks)

Required:
Discuss each of these issues and describe the impact on the audit report if the above issues remain unresolved.

(Total: 15 marks)

i)

  • Materiality: The GH¢3.9 million lawsuit represents 39% of Lexon Institute’s profit before tax (GH¢3.9 million/ GH¢10 million), making it a material issue that could influence users of the financial statements.
  • Contingent Liability Disclosure: Since the lawsuit is ongoing and the outcome is uncertain, Lexon has appropriately disclosed the matter as a contingent liability in accordance with IAS 37. However, if management fails to adequately disclose this, it would require the auditor to modify the report.
  • Audit Report Impact: If Lexon properly discloses the contingent liability but the outcome remains unresolved, the auditor may issue an unmodified opinion with an emphasis of matter paragraph to highlight the uncertainty surrounding the lawsuit and its potential impact on the financial statements.
  • Qualification: If Lexon fails to disclose the contingent liability, the auditor would issue a qualified opinion due to material misstatement, as this omission would affect the users’ understanding of the financial position of the company.

(4 marks)

ii)

  • Depreciation on Land and Buildings
    Depreciation has been provided on the land element of property, plant, and equipment, and this is contrary to IAS 16 “Property, Plant and Equipment,” as depreciation should only be charged on buildings and not land. Land typically does not have a finite useful life, and hence it should not be subject to depreciation.
  • Materiality
    The error is material, as it represents 20% of the profit before tax (GH¢2 million out of a profit before tax of GH¢10 million). Given the materiality, the financial statements are misstated if this error is not corrected, and this could mislead the users of the financial statements.
  • Audit Report Impact
    If management does not correct this error, the audit report will need to be modified. Since management has not complied with IAS 16, and the error is material but not pervasive, the auditor will issue a qualified opinion. The opinion will be “except for” the misstatement related to the depreciation charged on land.
  • Basis for Qualified Opinion
    A basis for qualified opinion paragraph will be required to explain the material misstatement related to the depreciation charged on land. The opinion paragraph will be qualified “except for” the material misstatement.

(4 marks)

iii)

  • Corruption of Purchases Records
    Lexon Institute’s purchases records and backups have been corrupted for a period of three months, and the purchases during this time amounted to GH¢4 million. This represents 40% of profit before tax (GH¢4 million out of GH¢10 million). This is a material issue, as it impacts the completeness of recorded purchases.
  • Audit Evidence
    The auditor must attempt to verify the purchases by other means, such as reviewing supplier invoices, delivery notes, or payment records. If this alternative evidence cannot be obtained, the completeness of purchases for the three-month period will not be verifiable.
  • Audit Report Impact
    If the auditor cannot obtain sufficient appropriate audit evidence for these purchases, and the amount involved is material, the auditor will need to modify the audit report. Given that the issue relates to a material but not pervasive element of purchases, the auditor will issue a qualified opinion due to limitation of scope.
  • Basis for Qualified Opinion
    A basis for qualified opinion paragraph will be required, explaining the limitation in obtaining sufficient appropriate audit evidence for purchases during the three-month period. The opinion paragraph will be qualified “except for” the limitation of scope regarding the purchases records.

(4 marks)

 

 

  • 7 Marks

AA – May 2017 – L2 – Q4b – Audit and Assurance Evidence

Explanation of a contingent liability and audit procedures for its verification.

At a meeting to discuss the draft accounts with senior management of Good Old Days Ltd, the external auditors, Gelian Chartered Accountants, asked management to confirm the amount of contingent liability of GH¢100 million in respect of a pending legal suit against the company. The CEO quizzed the chief accountant to explain how the amount of GH¢100 million was arrived at.

Required:
i) Describe briefly what a contingent liability is, giving examples where appropriate. (2 marks)
ii) Explain in detail the audit procedures for the verification of contingent liabilities. (5 marks)

i) Contingent liability: A contingent liability is a potential liability that may occur depending on the outcome of an uncertain future event. It is recognized only if the probability of the event occurring is more than likely and the amount can be reasonably estimated. An example would be pending legal claims or guarantees issued on behalf of another entity.
(2 marks)

ii) Audit procedures for verification of contingent liabilities:

  1. Review management’s procedures for identifying and recording contingent liabilities.
  2. Examine board minutes for discussions relating to any legal claims or potential liabilities.
  3. Inquire with legal advisors: Obtain a direct confirmation from the company’s legal advisors about the likelihood and potential amount of the liability.
  4. Review correspondence with external legal counsel and other relevant parties to assess the status of the case.
  5. Review subsequent events: Check for any developments after the reporting date that might impact the outcome of the contingent liability.
  • 10 Marks

AA – May 2021 – L2 – Q5b – Completion Procedures and Reporting

Discuss the impact of unresolved issues related to redundancy provision and contingent liability on the Auditor’s report.

Logistics Ltd is a logistics and freight forwarding company based in the port city of Takoradi, and you are the Audit Manager in charge of the year-end audit. The draft financial statements show a profit before tax of GH¢2.6 million and total assets of GH¢18 million.

In your discussion with management, the following issues came up:

i) Management informed you that due to the ongoing coronavirus pandemic, shipping from China has slowed down considerably, and as a result, many employees have been laid off. A redundancy provision of GH¢220,000 is included in the draft financial statements. The audit review and calculations confirmed that the redundancy provision should be GH¢450,000. The Finance Director is, however, not willing to adjust the draft financial statements. (5 marks)

ii) An employee has filed a wrongful dismissal lawsuit against Logistics Ltd for GH¢1.2 million. This case is ongoing and will not be resolved before the Auditor’s report is signed. The matter is disclosed as a contingent liability. (5 marks)

Required:
Discuss each of the issues and describe their impact on the Auditor’s report, if any, should these issues remain unresolved in terms of ISA 705 (revised); Modification of the Auditor’s Opinion.

i) Redundancy Provision:
Under IAS 37 (Provisions, Contingent Liabilities, and Contingent Assets), if the economic outflow to discharge an obligation is probable, a provision must be recognized. Logistics Ltd has under-declared the provision for employee redundancy by GH¢230,000, which represents 8.5% of profit before tax (GH¢230,000/ GH¢2.6 million). This is material but not pervasive.

Impact on Auditor’s Report:
According to ISA 705 (Revised), the Auditor should inform those charged with governance about the Finance Director’s refusal to adjust the provision. If management does not amend the financial statements, the Auditor should issue a qualified opinion due to the material misstatement in the financial statements. The basis for the opinion should include the description and quantification of the financial effects of the under-declared provision. (5 marks)

ii) Contingent Liability:
The wrongful dismissal lawsuit for GH¢1.2 million represents 46% of profit before tax (GH¢1.2 million / GH¢2.6 million), making it a material issue. Under IAS 37, contingent liabilities must be disclosed if the economic outflow is possible. Logistics Ltd has disclosed this matter as a contingent liability.

Impact on Auditor’s Report:
If the matter remains unresolved, the Auditor should issue a qualified opinion based on materiality. The basis for the qualified opinion should explain the disclosure of the contingent liability and its potential impact. Since the outcome of the lawsuit is uncertain, it should be disclosed in the contingent liability note in the financial statements. (5 marks)

  • 10 Marks

AA – April 2022 – L2 – Q4a – Completion Procedures and Reporting

Discusses the need to amend financial statements based on subsequent events and the auditor's responsibility in the post-year-end period.

a) Aseye Ltd is in the manufacturing sector and its year-end is 30 September 2019. The final audit is nearly complete and it is proposed that the financial statements and audit report will be signed on 10 November 2019. Revenue for the year is GH¢80 million and profit before taxation is GH¢9 million. Subsequent to the year-end, a lawsuit was filed against Aseye Ltd. Below are the details of the lawsuit:

A key supplier of Aseye Ltd is suing the company for breach of contract. The lawsuit was filed on 10 October 2019, and the sum claimed by the supplier is GH¢2 million. This has been disclosed as a contingent liability in the notes to the financial statements; however, correspondence has just been received from the supplier indicating that they are willing to settle the case for a payment by Aseye Ltd of GH¢1 million. It is likely that the company will agree to this.

Required:
i) For the event above:

  • Discuss whether the financial statements require amendment. (2 marks)
  • Describe audit procedures that should be performed to enable the Auditor to draw a conclusion on the amendment. (2 marks)

ii) Describe the auditor’s responsibility for subsequent events occurring between:

  • The year-end date and the date the auditor’s report is signed. (3 marks)
  • The date the auditor’s report is signed and the date the financial statements are issued. (3 marks)

i) Financial Statement Amendment:

  • The financial statements should be amended as the event provides evidence of a condition that existed at the reporting date (30 September 2019). The contingent liability should be adjusted from GH¢2 million to a provision of GH¢1 million, as it is probable that Aseye Ltd will agree to this settlement. This is in accordance with IAS 37: Provisions, Contingent Liabilities and Contingent Assets.

Audit Procedures:

  • Review correspondence with the supplier to confirm the settlement amount of GH¢1 million.
  • Discuss with management to verify their intention to settle the lawsuit for GH¢1 million.
  • Obtain a written representation from management confirming the likelihood of settling for GH¢1 million.
  • Contact the company’s legal advisors to assess the probability and amount of the settlement.

ii) Auditor’s Responsibility:

  • Between year-end date and the date the auditor’s report is signed:
    The auditor has an active responsibility to perform procedures to identify subsequent events that require adjustment or disclosure. This includes reviewing management procedures, inquiring of management, and considering if further adjustments are necessary based on subsequent events, as outlined by ISA 560: Subsequent Events.
  • Between the date the auditor’s report is signed and the date the financial statements are issued:
    After the report is signed, the auditor is not required to perform any audit procedures unless they become aware of facts that may materially affect the financial statements. If such events occur, the auditor should discuss them with management and determine whether the financial statements need to be amended. If amendments are made, the auditor may need to extend their review to cover the period up to the new report date.
  • 20 Marks

AAA – May 2021 – L3 – Q3 – Reporting | The audit approach

Evaluate the appropriateness of draft auditor’s reports for two clients and discuss the use of emphasis of matter and other matter paragraphs in audit reports.

You have recently been promoted to Senior Manager of Life Matters and Associates, a firm of Chartered Accountants. As part of your job description, you are to handle two clients in a given month. Below are some issues you will be faced with during the audit of these clients. The financial year-end for each client is 30 September 2020.

You are reviewing the Audit Senior’s draft auditor’s reports for the two clients, Factory Co Ltd and Toys Co Ltd.

Toy Co Ltd

The Audit Senior suggests that Toys Co Ltd’s audit opinion should not be qualified but should include an emphasis of matter paragraph after the audit opinion to highlight the situation below:

In October 2020, a legal claim was filed against Toys Co Ltd by a toy retailer. The suit was from a customer who slipped on a greasy step outside one of the retail outlets. The matter has been fully disclosed as a material contingent liability in the notes to the financial statements. Audit working papers also provided sufficient evidence that no provision is necessary as Toys Co Ltd’s lawyers have stated in writing that the likelihood of the claim succeeding is remote. The amount of the claim is fixed and is adequately covered by cash resources.

Factory Co Ltd

Factory Co Ltd, a listed company, permanently closed several branches in May 2020, with all closure costs finalised and paid in August 2020. The said branches all produced the same items, which contributed 10% of Factory Co Ltd’s total revenue for the year ended 30 September 2020 (2019 – 23%). The closure has been discussed accurately and fully in the Chairman’s statement and Directors’ Report. However, the closure was not stated in the notes to the financial statements nor separately disclosed on the financial statements.

The audit senior has proposed an unmodified audit opinion for Factory Co Ltd as the matter has been fully addressed in the Chairman’s statement and Directors’ Report.

Required:

a) Evaluate whether the Audit Senior’s draft auditor’s report is appropriate, and where you disagree, recommend the amendment necessary to the draft auditor’s report of:

i) Toy Co Ltd (4 marks)

ii) Factory Co Ltd (6 marks)

b) Assuming the auditors of Life Matters and Associates are contemplating whether to use an emphasis of matter paragraph and other matter paragraph in the audit report, explain both options and the situations when each is relevant. (10 marks)

a) Evaluation of Draft Auditor’s Reports:

i) Toy Co Ltd:

  • Legal Claim Evaluation: The claim was an event after the balance sheet date. Suppose the accident occurred before the year-end of 30 September 2020. In that case, the claim gives additional evidence of a year-end condition and thus meets the definition of an adjusting post-balance sheet event. In this case, the matter appears to have been properly disclosed in the notes to the financial statements per IAS 10: Events After the Balance Sheet Date and IAS 37: Provisions, Contingent Liabilities, and Contingent Assets. A provision would only be necessary if the claim was probable to succeed, and there is sufficient appropriate evidence that this is not the case. There is, therefore, no material misstatement.
  • Audit Opinion Recommendation: The audit manager is correct to propose an unmodified opinion. However, the audit report doesn’t need to contain an emphasis of matter paragraph. ISA 705: Modifications to the Independent Auditor’s Report states that an emphasis of matter paragraph should be used to highlight a matter where there is significant uncertainty. Uncertainties are only regarded as significant if they involve a level of concern about the company’s going concern status or would have an unusually significant effect on the financial statements. This is not the case here, as there is enough cash to pay the damages in the unlikely event that the claim goes against Toys Co Ltd. This appears to be a one-off situation with a low risk of the estimate being subject to change, and thus there is no significant uncertainty.

(4 marks)

ii) Factory Co Ltd:

  • Discontinued Operations: The factory closures constitute a discontinued operation per IFRS 5: Non-Current Assets Held for Sale and Discontinued Operations due to discontinuing a separate major component of the business. It is a major component due to the 10% contribution to revenue in the year to 30 September 2020 and 23% contribution in 2019. In addition, it is a separate business component of the company due to the factories having made only one item, indicating a separate income-generating unit.
  • Disclosure Requirements: Under IFRS 5, there must be separate disclosure on the face of the income statement of the post-tax results of the discontinued operation and of any profit or loss resulting from the closures. The revenue and costs of the discontinued operation should be separately disclosed either on the face of the income statement or in the notes to the financial statements. Cash flows relating to the discontinued operation should also be separately disclosed per IAS 7: Cash Flow Statements. In addition, as Factory Co Ltd is a listed company, IFRS 8: Operating Segments requires separate segmental disclosure of discontinued operations.
  • Audit Opinion Recommendation: Failure to disclose the above information in the financial statements is a material breach of International Accounting Standards. The audit opinion should therefore be qualified on the grounds of disagreement on disclosure requirements of IFRS 5, IAS 7, and IFRS 8. The matter is material but not pervasive, and therefore an ‘except for’ opinion should be issued. The opinion paragraph should clearly state the reason for the qualification and indicate the financial significance of the matter. The audit opinion relates only to the financial statements that have been audited. Therefore, the contents of the other information (Chairman’s statement and Directors’ Report) are irrelevant when deciding if the financial statements show a true and fair view or are fairly presented.

(6 marks)

b) Emphasis of Matter and Other Matter Paragraphs:

  • Emphasis of Matter Paragraph:
    • An ’emphasis of matter’ paragraph is used to draw the reader’s attention to a matter presented or disclosed in the financial statements, which is fundamental to understanding those financial statements.
    • When an auditor’s report contains an emphasis of matter paragraph, the opinion is not modified. Therefore, it can only be used where the auditor has obtained sufficient appropriate audit evidence that the matter is not materially misstated in the financial statements. (If the matter is materially misstated, a modified opinion is required.)
    • Although the opinion is not modified, there is an item in the financial statements, properly presented or disclosed, that the auditor wishes to bring to the attention of users because it is fundamental to an understanding of the financial statements.
  • Circumstances for Emphasis of Matter Paragraph:
    • Where there is an uncertainty relating to the future outcome of exceptional litigation or regulatory action.
    • A significant subsequent event that occurs between the date of the financial statements and the date of the auditor’s report.
    • Where the entity has adopted a new IFRS early, which has had a pervasive effect on the financial statements.
    • To draw attention to a major catastrophe that has had, or continues to have, a significant effect on the entity’s financial position.
    • Early application of a new accounting standard that has a pervasive effect on the financial statement.
  • Other Matter Paragraph:
    • An ‘other matter’ paragraph is used if the auditor considers it necessary to communicate a matter other than those included in the financial statements that, in his opinion, is relevant to users’ understanding of the audit, the auditor’s responsibilities, or the auditor’s report.
    • This is the paragraph that is used to highlight a matter that has not adequately been presented and disclosed in the financial statements but, in the auditor’s judgment, is fundamental for users’ understanding of the audit, audit work, and the auditor’s responsibility.
  • Circumstances for Other Matter Paragraph:
    • Where the auditor is unable to resign from the engagement even though the possible effect of a limitation of scope imposed by management is pervasive (relevant to users’ understanding of the audit). This should be rare in practice.
    • Where local law or custom allows the auditor to elaborate on his responsibilities in his report (relevant to users’ understanding of the auditor’s responsibilities or auditor’s report).
    • Another example when an other matter paragraph might be used is when the prior year financial statements were audited by a previous auditor, or not audited because this is the first-year audit for the current auditor.
    • The auditor is reporting on a set of financial statements prepared using different frameworks, e.g., both IFRS and GAAP.

(10 marks)

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