Scenario: An auditor is auditing the financial statements of a nonissuer. The auditor discovers that the client has been sued for patent infringement. Management's legal counsel refuses to provide an estimate of the potential loss, stating only that the outcome is 'uncertain'. Management has disclosed the lawsuit in the notes but has not accrued a liability. <br/><br/>What is the auditor's responsibility?

Answer options:

Issue a qualified opinion due to the inability to estimate the loss.

Conclude that the disclosure is adequate if the likelihood of an unfavorable outcome is reasonably possible but not estimable.

Require management to accrue the minimum amount of the potential loss range.

Withdraw from the engagement due to scope limitation.

How to approach this question

GAAP Rules for Contingencies: Probable + Estimable = Accrue. Reasonably Possible = Disclose. Remote = Ignore. If you can't estimate, you can't accrue.

Full Answer

B.Conclude that the disclosure is adequate if the likelihood of an unfavorable outcome is reasonably possible but not estimable.✓ Correct

Conclude that the disclosure is adequate if the likelihood of an unfavorable outcome is reasonably possible but not estimable.

If a loss is reasonably possible (or even probable) but the amount cannot be reasonably estimated, GAAP requires disclosure of the nature of the contingency. No accrual is made. If the client followed this, the financial statements are fair.

Common mistakes

Thinking all lawsuits must be accrued; confusing inherent uncertainty with scope limitation.

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