24-26 (Objective 24-1, 24-2) Elizabeth Johnson, CPA, has completed the audit of

Question

24-26 (Objective 24-1, 24-2) Elizabeth Johnson, CPA, has completed the audit of notes payable and other liabilities for Valley River Electrical Services and now plans to audit contingent liabilities and commitments. Required a. Distinguish between contingent liabilities and commitments and explain why both are important in an audit. b. Describe how Johnson’s testing in phases I-III of the audit of notes payable might help her obtain evidence about the four presentation and disclosure objectives. c. Identify three useful audit procedures for uncovering contingent liabilities that Johnson will likely perform in the normal conduct of the audit, even if she had no responsibility for uncovering contingencies. d. Identify three other procedures Johnson is likely to perform specifically for the purpose of identifying undisclosed contingencies. 24-28 (Objective 24-3) In analyzing legal expense for the Boastman Bottle Company, Mary Little, CPA, observes that the company has paid legal fees to three different law firms during the current year. In accordance with her CPA firm’s normal operating practice, Little requests standard attorney letters as of the balance sheet date from each of the three law firms. On the last day of field work, Little notes that one of the attorney letters has not yet been received. The second letter contains a statement to the effect that the law firm deals exclusively in registering patents and refuses to comment on any lawsuits or other legal affairs of the client. The third attorney’s letter states that there is an outstanding unpaid bill due from the client and recognizes the existence of a potentially material lawsuit against the client but refuses to comment further to protect the legal rights of the client. Required a. Evaluate Little’s approach to sending the attorney letters and her follow-up on the responses. b. What should Little do about each of the letters?

Explanation / Answer

a. Distinguish between contingent liabilities and commitments and explain why both are important in an audit.
A contigent liabilities are uncertain obligations that may or may not arise in future based on past events wheras commitments is an agreement which have fixed expiration dates or other termination clauses and may require payment of a fee.
Contingent Liabilities and Commitments both are important in an audit as both of them affect the future cash flow available to stakeholders. As per the GAAP contingent liability and commitment should be disclosed properly.

b. Describe how Johnson’s testing in phases I-III of the audit of notes payable might help her obtain evidence about the four presentation and disclosure objectives.
Auditor obtaines evidence about the four presentation and disclosure objectives  by testing phase I-III of the notes payable. Testing phase I-III consists of test of control and substantive tests of transactions. The test of control includes payment of notes payable , interest expense , provide information about scheduled debt payments and related interest rate term. The substantive tests of transaction will give appropriate evidences about the ending balances related notes payable terms
c. Identify three useful audit procedures for uncovering contingent liabilities that Johnson will likely perform in the normal conduct of the audit, even if she had no responsibility for uncovering contingencies.
The three useful audit procedures for uncovering contingent liabilities that Johnson will likely perform in the normal conduct of the audit, even if she had no responsibility for uncovering contingencies are as follows:-
1) Evaluating and reviewing internal revenue agent reports of income tax settlements.
2) Reviewing of minutes of board of directors and stockholders.
3) Confirmation of used and unused balances of lines of credit.

d. Identify three other procedures Johnson is likely to perform specifically for the purpose of identifying undisclosed contingencies.
The three other procedures Johnson is likely to perform specifically for the purpose of identifying undisclosed contingencies are:-
1) Ask the management about undisclosed contingencies liabilities.
2)  Review the legal expenses for indication of contingencies liabilities.
3) Ask the letter of attorney regarding the status of proceedings and other potential contingent liabilities.

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