UNIVERSITY OF SAN CARLOS OF GUATEMALA

FACULTY OF ECONOMIC SCIENCES

AUDIT SCHOOL

AUDIT III

“CONTINGENT LIABILITIES AND

SUBSEQUENT EVENTS”
 INTRODUCTION

The purpose of this work is to study Contingent Liabilities and Subsequent

Events, which is part of the Audit III course, of the Public Accounting and Auditing
Degree.

International Accounting Standard No. 37 “Provisions, Contingent Assets and

Contingent Liabilities” prescribes the accounting and financial information to be
provided when a provision for a liability has been made, or when there are
contingent assets and liabilities.

In the section on contingent liabilities, the appropriate bases for the recognition and
valuation of provisions and liabilities of a contingent nature will be discussed, as
well as the financial information to be disclosed, through notes to the financial
statements, in order to understand the nature, timing and amounts of the above
items.

In subsequent events, the auditor's responsibility for subsequent events will be

studied. The term subsequent events refers to events that occur between the date
of the financial statements and the date of the auditor's report, and events
discovered after the date of the auditor's report.
 1. CONTINGENT LIABILITY
Definition
A contingent liability is a possible obligation arising from past events that will be
confirmed only by the occurrence, or failing that, by the non-occurrence, of
uncertain events in the future that are under the entity's control. It may also be a
present obligation, which arose from previous events and which has not been
recognized in the accounts because:

➢ There is a probability that the entity will not have to satisfy it.
➢ The amount of the obligation cannot be measured reliably.

1.1. Provisions and other liabilities

A provision is a liability for which there is uncertainty about its amount or
maturity. A liability is a present obligation of the entity, which arises through past
events, and when settled, the entity intends to dispose of economic resources that
suggest benefits. A provision should be recognized if and only if one of the
following circumstances occurs:

Provisions can be distinguished from other liabilities, such as trade payables

and other accrued obligations that are subject to estimation, by the existence of
uncertainty about the time of maturity or the amount of future disbursements
necessary to settle them.

✓ The company has a present obligation (legal or assumed by the entity), as a

result of a past event.

✓ It is probable (i.e., there is a greater chance of occurrence than otherwise)

that the company will have to part with resources that involve economic
benefits in order to settle the obligation.
✓ The amount of the relevant debt can be reliably estimated. The Standard
notes that only in extremely rare cases will it not be possible to estimate the
 amount of the debt.

In a general sense, all provisions are contingent in nature, since there is

uncertainty about the time of maturity or the corresponding amount. However, in
this Standard, the term “contingent” is used to designate assets and liabilities that
have not been recognized in the financial statements because their existence will
be confirmed only upon the occurrence, or non-occurrence, of one or more
uncertain future events that are not entirely under the control of the enterprise.

On the other hand, the term “contingent liability” is used to designate liabilities
that do not meet the criteria necessary for their recognition.

The International Accounting Standard distinguishes between:

✓ Provisions that have already been recognized as liabilities because they
represent present obligations and it is probable that in order to satisfy them
the company will have to dispose of resources that incorporate economic
benefits.

✓ Contingent Liabilities: which have not been recognized as liabilities

because they are:
a) Possible obligations, to the extent that it has yet to be confirmed
whether the company has a present obligation that may involve an
outflow of resources incorporating economic benefits; or
b) Present obligations that do not meet the recognition criteria of this
Standard (either because it is not probable that their settlement will
result in an outflow of resources incorporating economic benefits, or
because a sufficiently reliable estimate of the amount of the
obligation cannot be made).

A provision must be recognized when the following conditions are met:

 ✓ The company has a present obligation (whether legal or constructive) as a
result of a past event;

✓ The company may have to dispose of resources that embody economic

benefits to settle such an obligation; and

✓ A reliable estimate of the amount of the obligation can be made.

If the three conditions indicated are not met, the company should not recognize the
provision.

An obligation recognized as a liability implies, in all cases, the existence of a

third party with whom it has been contracted, and to whom the amount must be
paid. However, it is not necessary to know the identity of the third party to whom
payment must be made, since the obligation may even be with the general public.
Since an obligation always implies a commitment made to a third party, any
decision made by the management or administrative body of the company will not
give rise to an implicit obligation on the balance sheet date, unless such decision
has been communicated before that date to those affected, in a manner sufficiently
explicit to create a valid expectation for those third parties with whom the company
must fulfil its commitments or responsibilities.

To recognize a liability, not only must there be a present obligation, but also
the probability that there will be an outflow of resources, incorporating economic
benefits to settle such obligation.
The use of estimates is an essential part of the preparation of financial
statements and their existence does not in any way affect the reliability that they
must have. This is especially true in the case of provisions, which are more
uncertain by nature than other balance sheet items. Except in extremely rare
cases, the company will be able to determine a set of possible outcomes of the
uncertain situation and will therefore be able to make an estimate of the amount of
the obligation that is sufficiently reliable to be used in recognizing the provision.
 Contingent liabilities may evolve differently than initially expected. They will
therefore be subject to ongoing reconsideration in order to determine whether the
eventuality of an outflow of resources incorporating future economic benefits has
become probable. If it were considered probable, for an item previously treated as
a contingent liability, that such economic resources would be outflowed in the
future, the corresponding provision would be recognised in the financial statements
of the period in which the change in the probability of occurrence occurred (except
in the extremely rare circumstance that a reliable estimate of such amount cannot
be made).

1.2. Contingent Assets

Contingent assets typically arise from unexpected or unplanned events, which
give rise to the possibility of an influx of economic benefits into the company. An
example could be a claim that the company is pursuing through a legal process,
the outcome of which is uncertain.

Contingent assets are not recognized in the financial statements, since this
could mean recognizing income that may never be realized. However, when the
realization of the income is practically certain, the corresponding asset is not
contingent in nature and therefore, it is appropriate to proceed to recognize it.

In the event that the entry of economic benefits to the company is likely due to
the existence of contingent assets, these will be reported in the notes, as required.
Contingent assets must be evaluated on an ongoing basis to ensure that their
evolution is appropriately reflected in the financial statements.

In the event that the inflow of economic benefits to the company becomes
practically certain, the income and the asset are recognized in the financial
statements of the year in which said change took place. If the inflow of economic
benefits has become probable, the company will report in notes on the
corresponding contingent asset

1.3. Accounting for contingencies

Including a contingency means making an estimate of events that, due to their
nature, cannot be determined (calculated exactly). Starting with International
Accounting Standard 37, "contingent" liabilities and assets begin to be mentioned.

In this context, a contingency is an event for which neither the exact amount
nor the exact time at which it will occur is known.

This standard (and in general, all international standards) do not prescribe a

methodology for making these estimates, so that the estimates that each company
makes reflect the approach and knowledge they have of the risks they face. The
more knowledge there is about the risk, the more refined and appropriate the result
will be to the particular circumstances of each company.

International Accounting Standards establish that it is necessary to have

provisions to cover eventualities. Such forecasts are not a percentage of the
budget or sales; they are an opportunity for the organization to study the risk it
faces and, therefore, can make the disclosures required by this regulation, and
should also be the start of a change of mentality within the organization, since the
ultimate goal is to diversify risks.

Because International Accounting Standards do not prescribe a recipe for

making these calculations, a mathematical description of the risk is necessary.

International Accounting Standard 37 prescribes the accounting and financial

information to be provided when a provision for a liability has been made, or when
there are contingent assets and liabilities, except for the following:
 ✓ Those derived from financial instruments that are recorded according to
their fair value.

✓ Those arising from contracts pending execution, unless the contract is

onerous in nature and losses are anticipated. Pending execution contracts
are those in which the parties have not fulfilled any of the obligations to
which they committed, or those in which both parties have partially
executed, and to an equal extent, their commitments.

✓ Those that appear in insurance companies, derived from the policies of the
insured.

✓ Those dealt with by another International Accounting Standard.

1.4. Classification of contingencies

When a loss contingency exists, the probability that the future event or events
will confirm such loss, or impairment of an asset, or creation of a liability may vary
from the probable to remote range, as follows:

✓ Probable: When the future event or events will probably occur, (can be
expected to occur).

✓ Reasonably Possible: When the probability of the event or events

occurring is more than remote but less than probable. (Between probable
and remote).
✓ Remote: When the probability of the future event or events occurring is
slight (Improbable).

1.5. Types of commitments

The event that gives rise to an obligation is the fact from which a payment
obligation arises, whether legal or implicit for the entity, such that the entity has no
alternative but to settle the corresponding amount.

A legal obligation is one that arises from:

✓ A contract (whether from its express or implied terms).

✓ The legislation.
✓ Another legal cause.

An implicit obligation is one that arises from the actions of the entity itself, in which:

✓ Due to an established pattern of past behavior, publicly known standards, or

a statement made in a sufficiently specific manner, the entity has made
clear to third parties that it is willing to accept certain types of
responsibilities.

✓ As a result of the above, the entity has created a valid expectation for those
third parties with whom it must fulfill its commitments or responsibilities.

1.6. Types of Uncertainty

In the normal course of its operations, a large number of transactions related to
its business activities are carried out in the company and, at the same time, it is
affected by external economic events that, sometimes, escape any control. This
uncertainty or risk, inherent in transactions and events that affect an entity, is
known as contingency.

What it means in accounting terms, a condition, situation or set of

circumstances that involve a certain degree of uncertainty that may result, through
the consummation of a future event, in the acquisition or loss of an asset or in the
origination or cancellation of a liability and that generally results in a profit or a loss.
 In accordance with the realization principle, a reasonable quantification of
contingencies in monetary terms should be attempted in order to give them form
and effect in the financial statements.

When such quantification is not possible, the existence of the contingency must
be disclosed through notes to the financial statements, in order to comply with the
principle of sufficient disclosure.
For quantification purposes, contingencies can be classified into the following
groups:

A. Those of a repetitive nature, which are susceptible to reasonably

approximate measurement as a whole, through experience or the
empirically or statistically established probability of their occurrence.

Examples of these contingencies include:

✓ Unrecoverable accounts receivable.

✓ Obsolescence and slow inventory movement.
✓ Product service guarantees.
✓ Probable cost assignable to each fiscal year of pension plans, retirement,
compensation, bonuses and other deferred benefits granted to personnel,
subject to the fulfillment of a future condition.
✓ Probable effect, assignable to each fiscal year, of the income tax whose
payment is deferred or anticipated by virtue of compensable differences
between accounting profit and net taxable income.
✓ Granting of guarantees by endorsement or discount of notes receivable.

B. Those of an isolated nature in which, at a given time, there are elements of

judgment, estimation or opinion that allow the probable result to be
measured within reasonable limits.
 The most common examples of this type of contingency are litigation, tax
claims and other matters of a similar nature, such as labor claims, the probable
outcome of which can be reasonably estimated.

The above classification of contingencies clearly indicates that, in order to

comply with the realization principle, it is essential that the result of the reasonable
estimate that has been made of them is reflected in the financial statements when
it gives rise to the emergence of a cost or loss.

On the other hand, the criterion of prudence requires that assets and contingent
income or profits are not normally recognized, but that their inclusion in the
financial statements only occurs when there is practically absolute certainty about
their realization.

For the reasons stated above, financial statements should normally include
provisions or reasonably determined estimates for quantifiable contingencies, such
as those mentioned in previous paragraphs.

As additional examples, the following can be pointed out as non-quantifiable

contingencies:

✓ Commitments to purchase or sell in the future in a fluctuating or unstable

market.

✓ Warranties granted on new products for which there is no experience to

calculate an appropriate estimate.

✓ Requirements for additional payment of taxes and penalties.

✓ Long-term investments, such as the purchase of shares in subsidiary

companies or research and development expenses, whose future outcome
is random, representing a problem, their correct valuation at a given time.
 2. SUBSEQUENT EVENTS
Definition
The term "subsequent events" or "subsequent events" is used to refer to
both events that occur between the date of the financial statements and the date of
the auditor's report, and facts that are discovered after the date of the auditor's
report.

2.1. Extent of Subsequent Events in the Financial Statements Examined

We found the following subsequent events in the financial statements examined

2.1.1. Date of financial statements

It is the date of the end of the most recent period covered by the financial
statements, which is normally the date of the most recent balance sheet in the
financial statements subject to audit.

2.1.2. Date of approval of financial statements

It is the date on which those having recognized authority assert that they
have prepared the entity's complete set of financial statements, including the
related notes, and that they have responsibility for them. In some jurisdictions, law
or regulation identifies the persons or bodies that are responsible for concluding
that a complete set of financial statements have been prepared, and specifies the
necessary approval process.

The date of approval of financial statements for the purposes of ISAs is the
first date on which those having recognized authority determine that a complete set
of financial statements has been prepared.

2.1.3. Date of auditor's opinion

It is the date chosen by the auditor to date the opinion on the financial
statements. The auditor's report is not dated before the date on which the auditor
has obtained sufficient appropriate audit evidence on which to base the opinion on
the financial statements.

2.1.4. Date on which the financial statements are issued

The date on which the auditor's report and the audited financial statements
are made available to third parties, which may be, in many circumstances, the date
on which they are submitted to a regulatory authority.

2.2. Audit procedures

They are the set of research techniques applicable to an item or a group of
facts and circumstances related to the financial statements subject to examination,
through which the public accountant obtains the bases to base his opinion.

Because the auditor generally cannot obtain the knowledge needed to

support his opinion in a single test, it is necessary to examine each item or set of
facts using several techniques applied simultaneously or successively.

2.3. Nature of audit procedures

The different systems of organization, control, accounting and in general the
details of business operations make it impossible to establish rigid testing systems
for the examination of financial statements. The auditor must apply his professional
judgment and decide which audit technique or procedure, or set of them, will be
applicable in each case to obtain the certainty that underlies his objective and
professional opinion.

2.4. Extent or scope of audit procedures

 Since business operations are repetitive and consist of numerous individual
transactions, it is not possible to carry out a detailed examination of all the
individual transactions that make up a global item. For this reason, the procedure
of examining a representative sample of individual transactions is used to derive
the result of the examination of such sample. In the field of auditing it is known as
selective testing. The relationship of the transactions examined with respect to the
total that make up the universe is what is known as the extension or scope of the
audit procedures and its determination is one of the most important elements in the
planning and execution of the audit.

2.5. Timing of audit procedures

The time in which audit procedures are to be applied is called the
opportunity. It is not essential, and sometimes it is not convenient, to carry out the
audit procedures related to the examination of the financial statements, at the date
of the examination of the financial statements.

2.6. Audit techniques

These are the practical research and testing methods that public accountants
use to verify the reasonableness of financial information that allows them to issue
their professional opinion. The audit techniques are as follows:

✓ General study: Assessment of the physiognomy or general characteristics

of the company, its financial statements and the important, significant or
extraordinary items and items.

This assessment is made by applying the professional judgment of the

Public Accountant, who, based on his training and experience, will be able
to obtain from the data and information of the company that he is going to
examine, important or extraordinary situations that may require special
attention.
✓ Analysis. Classification and grouping of the different individual elements
that make up a given account or item, in such a way that the groups
constitute homogeneous and meaningful units. The analysis is generally
applied to accounts or items in the financial statements to determine how
they are integrated and are as follows:

a) Analysis of balances
b) Analysis of movements

✓ Inspection: Physical examination of tangible assets or documents, with

the aim of verifying the existence of an asset or an operation recorded or
presented in the financial statements.

✓ Confirmation: Obtaining written communication from a person

independent of the company being examined and who is able to know the
nature and conditions of the operation and, therefore, confirm it in a valid
manner. This technique is applied by asking the audited company to
contact the person from whom confirmation is requested, so that they can
respond in writing to the auditor, giving them the information requested
and can be applied in different ways:
▪ Positive
▪ Negative
▪ Blind or blank hint

✓ Research: Obtaining information, data and comments from the company's

own officials and employees.

✓ Declaration: Written statement, signed by the interested parties, of the

 results of investigations carried out with the company's officers and
employees.

✓ Certification: Obtaining a document that confirms the truth of a fact,

generally legalized with the signature of an authority.

✓ Observation: Physical presence of how certain operations or events are

carried out.

✓ Calculation: Mathematical verification of a game.

The procedures applicable to the examination of contingencies could be:

✓ Review the order accounts, in cases where these have been opened for
control, because their amount is known.

✓ Exchange views on the matter with the accountant and senior management,
inquiring about the existence of contingencies.

✓ Study the minutes of the board of directors and existing contracts.

✓ When reviewing all the accounts in the financial statements, you should be
alert to discover any indication of their existence.

✓ It is necessary to ask the company's lawyer for confirmation of the status of

the trials or litigation.

✓ Given the difficulty in locating contingencies, it is considered a

recommended procedure to obtain a confirmation letter from the company's
directors, indicating that all contingencies that could affect the company and
 that are known have been recorded in the financial statements or in a
supplementary note to them.

2.7. Period in which the required work is carried out

The work required to determine the existence of subsequent events or
events will be developed by applying the audit procedures once the field work has
been completed, and the public accountant and auditor is issuing and dating the
report or opinion.

The application of the procedures is carried out on the last day that the
public accountant and auditor is in the company's offices, and if some time elapses
between that date and the date of the opinion, the work must be updated, applying
the procedures again.
 CONCLUSIONS

o Debt sustainability is essential to sustain the long-term economic growth of an

entity, which requires the help of indicators that allow monitoring the capacity of
entities to meet their obligations acquired over time.

o The importance of analyzing contingent liabilities lies in the fact that, although
these are not part of an explicitly contracted obligation, they can potentially
increase the value of an obligation, with a possible impact on fiscal activity.

o Subsequent events are those events that occur between the date of issue of
the financial statements and the auditor's report and also those that occur after
the date of issue of the report.
 RECOMMENDATIONS

o Use provisions for contingent liabilities to support the economic growth of an

entity and thus be able to control the obligations acquired over time.

o Keep track of the provisions made to determine how much they will affect the
entity's financial statements.

o Perform alternative audit procedures to determine the existence of subsequent

events after the date of issue of the financial statements whose importance is of
relative importance to the entity.
 LITERATURE

International Accounting Standard No. 37 “Provisions, Contingent Assets and

Contingent Liabilities”. 2009.

International Accounting Standard No. 10 “Events after the balance sheet date”.
2009

International Auditing Standard 560 “Subsequent Events”