An auditor is testing the completeness of the liability for claims and assessments. The auditor sends a letter of inquiry to the client's external legal counsel. The lawyer's response states that the outcome of a material pending lawsuit is 'uncertain' and 'unable to be estimated'. How should this be reported in the financial statements?

Answer options:

Accrued as a liability.

Disclosed in the notes to the financial statements.

Ignored as it cannot be estimated.

Reported as a prior period adjustment.

How to approach this question

FASB ASC 450 (Contingencies): Probable + Estimable = Accrue. Reasonably Possible OR Probable but not Estimable = Disclose.

Full Answer

B.Disclosed in the notes to the financial statements.✓ Correct

Disclosed in the notes to the financial statements.

Under ASC 450, a loss contingency should be accrued only if it is Probable AND Reasonably Estimable. Since the lawyer says it is 'unable to be estimated', it cannot be accrued. However, since it is material and pending, it must be disclosed in the notes.

Common mistakes

Accruing a liability when the amount is not estimable.

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