Auditing Contingencies and Going Concern

Transcription

1 Auditing Contingencies and Going Concern READING MATERIAL 1 I. Contingencies 1 A. Overview 1 B. Measurement principles 1 1. Definition of a contingency 1 2. Loss contingencies 1 3. Probability classification of a loss contingency 1 4. Unasserted claims 2 5. Gain contingencies 2 C. Risks and uncertainties 2 1. Nature of the entity s operations 3 2. Use of estimates 3 3. Certain significant estimates 3 4. Vulnerability due to concentrations 4 D. Disclosures 4 II. Environmental liabilities 6 A. Recognition 6 1. What constitutes commencement or probable commencement of litigation 6 2. Factors in developing cost estimates 6 B. Stages of remediation process 7 III. Guarantor accounting for guarantees 7 IV. Liquidation of the entity 10 A. General approach to liquidation accounting 10 B. Determining liquidation values 11 C. Subsequent adjustment of liquidating values 12 D. Liquidation basis financial statements 12 E. Statement of net assets in liquidation 12 F. Statement of changes in net assets in liquidation 13 G. Disclosures Basis of accounting Description of liquidation plan Significant assumptions Description of accruals 14 LEARNING QUESTIONS 15 HOMEWORK 17 i

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3 Auditing Contingencies and Going Concern I. Contingencies A. Overview READING MATERIAL An estimated loss from a contingency should be charged to operations if it is probable that an asset has been impaired or a liability incurred, and the amount can be reasonably estimated. A loss contingency that does not meet both of these conditions should be disclosed but not recorded. An estimated gain from a contingency should not be recorded until it is actually realized. At the inception of a guarantee, the guarantor is required to recognize a liability for the obligation, measured at fair value. B. Measurement principles 1. Definition of a contingency A contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to a possible gain or loss that will ultimately be resolved when one or more future events occur or fail to occur. The term loss includes a charge to income that may otherwise be referred to as an expense. 2. Loss contingencies An estimated loss from a contingency should be accrued and charged to operations only if both of the following conditions are met: 1. Information available prior to the issuance of the financial statements indicates that it is probable (more likely than not) that an asset has been impaired or a liability incurred as of the date of the financial statements; and 2. The amount of the loss can be reasonably estimated. Reasonable estimation of the probable loss does not mean that it is necessary to estimate one single amount for accrual, but it should be estimated within a range. If some amount within the range appears to be a better estimate than any other amount within the range, that amount should be accrued. If no amount within the range is a better estimate than any other amount, the minimum amount in the range should be accrued. 3. Probability classification of a loss contingency When a loss contingency exists, the likelihood ranges from remote to probable. Following are probability classifications of loss contingencies: Remote -- The chance of the future event occurring is slight. Reasonably possible -- The chance of the future event occurring is more than remote but less than likely. Probable -- The future event is more likely than not to occur. 1

4 Accrual of an expected loss should be made only when it is probable that the future event will occur. If there is at least a reasonable possibility that a loss has been incurred, but criteria for accrual is not met, disclosure is required. If the possibility that a loss has been incurred is remote, disclosure is generally not required, but may still be deemed necessary to provide full and informative disclosure. The following is a list of loss contingency examples: Collectability of receivables. Obligations related to product warranties and product defects. Risk of loss or damage of property by fire, explosion, or other hazards. Threat of expropriation of assets. Pending or threatened litigation. Actual or possible claims and assessments. Risk of loss from catastrophes assumed by property and casualty insurance enterprises. Guarantees of indebtedness of others. Obligations of commercial banks under standby letters of credit. Agreements to repurchase receivables (or to purchase the related property) that have been sold. 4. Unasserted claims If it is determined that assertion of a claim is not probable, no accrual is required. If, however, assertion is probable, accrual should be made only if both of the following criteria are met: 1. An unfavorable outcome is probable; and 2. The amount of potential loss can be reasonably determined. If an unfavorable outcome is probable but the amount of loss cannot be reasonably estimated, disclosure is required. If an unfavorable outcome is reasonably possible but not probable, disclosure is still required. 5. Gain contingencies Contingencies that might result in gains should not be reflected in the financial statements. To include this information would be to recognize income before it is realized. Disclosures, however, may be made. The choice of wording should be made carefully so as to avoid misleading implications as to the likelihood of realization. C. Risks and uncertainties FASB ASC requires disclosures of risks and uncertainties beyond those otherwise required concerning the following matters: The nature of the entity s operations. The use of estimates in the preparation of financial statements. The use of certain significant estimates. The entity s current vulnerability due to certain concentrations. FASB ASC allows the required disclosures to be grouped, as necessary, placed in different parts of the financial statements and related footnotes, or combined with other information disclosed pursuant to other authoritative pronouncements. 2

5 1. Nature of the entity s operations The following specific information should be disclosed: A description of the entity s major products or services. Not-for-profit entities should briefly describe the principal services performed and the primary source of revenue. The principal markets (e.g., industries and types of customers) for the entity s products or services. The relative importance of each line of business, together with the basis for making that determination (e.g., based on sales, assets, earnings). This information need not be quantified; however, relative importance could be conveyed through the use of terms such as predominantly, about equally, or major. 2. Use of estimates The financial statements or a footnote should include a general statement that the preparation of financial statements requires the use of estimates by management. 3. Certain significant estimates FASB ASC requires disclosure regarding specific estimates used in the determination of the carrying values of assets and liabilities or in the determination of contingent gains or losses. Disclosure regarding such estimates should be made when both of the following conditions are met: It is at least reasonably possible that the estimate will change in the near term; and The effect of the change would be material. Disclosure should indicate the nature of the uncertainty and include an indication that it is at least reasonably possible that a change in the estimate will occur in the near term (i.e., within one year of the date of the financial statements). If the estimate involves a loss contingency covered by FASB ASC , the disclosure also should indicate an estimate of the possible loss or range of loss, or a statement that such an estimate cannot be made. Disclosure of the factors that cause the estimate to be sensitive to change is encouraged but not required. Disclosure of the risk-reduction techniques used to mitigate losses or the uncertainty of future events is likewise encouraged but not required. The following are items that may be based on estimates and that could be particularly sensitive to change in the near term: Inventory subject to rapid technological obsolescence; Specialized equipment subject to technological obsolescence; Deferred tax assets based on significant future taxable income; Deferred policy acquisition costs of insurance enterprises; Capitalized motion picture film production costs; Capitalized computer software costs; Environmental-related liabilities; Litigation-related liabilities; Contingent liabilities for debt of other entities; Amounts reported for long-term obligations (e.g., related to pension and postemployment benefits); Valuation allowances for commercial and real estate loans; Estimated net proceeds recoverable, the provisions for expected loss to be incurred, or both, on the disposition of a business or assets; and Amounts reported for long-term contracts. 3

6 The following are examples of events or changes in circumstances that indicate that an estimate associated with the carrying amount of a long-lived asset may be particularly sensitive to change in the near term: A significant decrease in the market value of an asset. A significant change in the extent or manner in which an asset is used. A significant adverse change in legal factors or in the business climate that affects the value of an asset. An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset. A history of losses associated with an asset, and/or a projection or forecast that demonstrates continuing losses associated with an asset. 4. Vulnerability due to concentrations Disclosure is required of any concentration (including a group concentration) that makes the entity vulnerable to a potential severe impact in the near term, if it is at least reasonably possible that the events that could cause the impact will occur. The term severe impact is defined as the effect of disrupting the normal functioning of the entity. It is thus intended to meet a higher threshold than materiality, but a lower threshold than a catastrophe. The following are concentrations that might subject an entity to vulnerability requiring disclosure: Concentrations in the volume of business transacted with a particular customer, supplier, lender, grantor, or contributor. Concentrations in revenue from particular products, services, or fund-raising events. Concentrations in the available sources of supply materials, labor, or services, or of licenses or other rights used in the entity s operations. Concentrations in the market or geographic area in which an entity conducts its operations. In general, disclosure of concentrations should be sufficient to inform users of the general nature of the associated risk. For labor subject to collective bargaining arrangements, disclosure should specifically include both the percentage of the labor force covered by a collective bargaining agreement and the percentage of the labor force covered by a collective bargaining agreement that will expire within one year. For operations located outside the entity s home country, disclosure should specifically include the carrying amounts of net assets and the geographic areas in which they are located. D. Disclosures For a gain contingency, disclosure should be made of its nature. In some cases, the amount may also be disclosed, but extreme care should be exercised to avoid a misleading implication as to the likelihood of realization. For a loss contingency, the following information should be disclosed: a. If an estimated loss has been accrued: (i) The nature of the contingency. (ii) The amount of accrued loss. 4

7 b. If an exposure to loss exists in excess of the amount accrued (as in the case of accruing the minimum amount within the range of possible loss): (i) The nature of the contingency. (ii) An estimate of the possible loss. (iii) A statement that exposure to an additional amount exists (usually the maximum amount in the range of possible loss). (iv) The amount that was accrued. c. If no accrual has been made: (i) The nature of the contingency. (ii) The estimate of possible loss (or a statement that such estimate cannot be made). Information may become available after the date of the financial statements but before they are issued regarding a loss contingency that existed either at the date of the financial statements without meeting the conditions for accrual or subsequent to the date of the financial statements. Disclosure of these types of loss contingencies may be necessary for a fair presentation. If so, the following information should be provided: The nature of the contingency. An estimate (or range) of the possible loss (or a statement that such an estimate cannot be made). The following information is required for each covered guarantee (or for each group of similar guarantees), even if the likelihood of having to make payments is remote: The nature of the guarantee, the circumstances under which it arose, and the events or conditions requiring performance. The maximum potential amount of (undiscounted) future payments (not reduced by potential recoveries under recourse or collateral provisions). The carrying amount of the liability whether the guarantee is freestanding or is embedded in another contract. The nature of: (1) recourse provisions enabling potential recovery from third parties of amounts paid; and (2) assets held as collateral that could be liquidated for recovery purposes (along with an approximation of the amount expected to be recovered, if estimable). For product warranties (and for other contracts excluded from the initial recognition and measurement provisions): The accounting policy and methodology used in determining the amount of the liability. The amount of any liability (e.g. deferred revenue) associated with extended warranties. A tabular reconciliation of the beginning and ending balances of the aggregate liability, separately identifying: (1) reductions for payments made; (2) changes in accruals related to warranties issued in the current period; and (3) changes in accruals related to preexisting warranties. 5

8 II. Environmental liabilities FASB ASC provides guidance on accounting for environmental remediation liabilities, except as follows: The pollution control costs relating to current operations. For future site restoration or closure costs required when operations are ceased or facilities are sold. For environmental remediation actions undertaken at the sole discretion of management and that are not induced by the threat of litigation (by governments or other parties) or of assertions of a claim or assessment. For recognition of liabilities by insurance companies for unpaid claims. For impairment of assets associated with environmental remediation liabilities. A. Recognition In the context of environmental remediation, a liability should be recorded when it is probable that an asset has been impaired or a liability has been incurred. Probability consists of the following two elements: 1. Litigation has commenced or a claim or an assessment has been asserted, or, based on available information, commencement of litigation or assertion of a claim or an assessment is probable. In other words, it has been asserted (or it is probable that it will be asserted) that the entity is responsible for participating in a remediation process because of a past event. 2. Based on available information, it is probable that the outcome of such litigation, claim, or assessment will be unfavorable. In other words, an entity will be held responsible for participating in a remediation process because of the past event. 1. What constitutes commencement or probable commencement of litigation What constitutes commencement or probable commencement of litigation or assertion or probable assertion of a claim or an assessment in relation to particular environmental laws and regulations may require legal determination. There is a presumption that: (a) if litigation has commenced or a claim or an assessment has been asserted or if commencement of litigation or assertion of a claim or assessment is probable; and (b) if the reporting entity is associated with the site (i.e., if it in fact arranged for the disposal of hazardous substances found at a site or transported hazardous substances to the site or is the current or previous owner or operator of the site) the outcome of such litigation, claim, or assessment will be unfavorable. 2. Factors in developing cost estimates FASB ASC also requires that, for a liability to be accrued, the amount of the loss (including a range of loss) must be subject to reasonable estimates. The following are some of the important factors to be considered in developing cost estimates: The extent and type of hazardous substances at a site. The range of technologies that can be used for remediation. Evolving standards of what constitutes acceptable remediation. The number and financial condition of other potentially responsible parties and the extent of their responsibility for the remediation (i.e., the extent and types of hazardous substances they contributed to the site). 6

9 When the overall liability is based on a range of estimated loss, the recorded amount is permitted to comprise amounts representing the lower end of a range of costs for some components of the liability and the best estimates within ranges of costs for other components. B. Stages of remediation process At the early stages of the remediation process, some components of the overall liability may not be reasonably estimable. This should not preclude recognition of a liability. In such a case, the components that are subject to reasonable estimation should be viewed as the minimum in the range of the overall liability. Likewise, uncertainties relating to the entity s share of an environmental remediation liability should not preclude the entity from recognizing its best estimate of its share of the liability or, if no best estimate can be made, the minimum estimate of its share of the liability, if the liability is probable and the total remediation liability associated with the site is reasonably estimable within a range. As the remediation process progresses, changes in estimates should be accounted for prospectively as a change in estimate. In some cases, an entity will be able to reasonably estimate a range of its liability very early in the process because the site situation is common or similar to situations at other sites with which the entity has been associated. In such cases, the criteria for recognition would be met and the liability should be recognized. In other cases, however, the entity may have insufficient information to reasonably estimate the minimum amount in the range of its liability. In these cases, the criteria for recognition would not be met at this time. An entity may receive a unilateral administrative order compelling it to take a response action at a site or risk penalties of up to four times the cost of the response action. Such response actions may be relatively limited actions such as the performance of a remedial investigation and feasibility study or performance of a removal action, or they may be broad actions such as remediating a site. The ability to estimate costs resulting from unilateral administrative orders varies with factors such as site complexity and the nature and extent of the work to be performed. Benchmarks should be considered in evaluating the ability to estimate such costs insofar as the actions required by the unilateral administrative order involve these benchmarks. The cost of performing the requisite work generally is estimable within a range, and recognition of an environmental remediation liability for costs of removal actions should not be delayed beyond this point. III. Guarantor accounting for guarantees Accounting by guarantors for guarantees issued is covered by FASB ASC , which generally applies to guarantees having one or more of the following characteristics: Contracts contingently requiring payment (in cash, other assets, shares of stock, or financial instruments) to the guaranteed party, based on changes in the price of an underlying (such as in interest rate, commodity price, foreign exchange rate, etc.) that is related to an asset or liability of the guaranteed party, including, for example: (1) a financial standby letter of credit; (2) a market value guarantee on securities or on a nonfinancial asset owned by the guaranteed party; (3) a guarantee of the market price of the guaranteed party s common stock; (4) a guarantee of the collection of scheduled contractual cash flows from individual assets held by a special-purpose entity (SPE); and (5) a guarantee granted to a business or to its owners that the revenue of the business (or a specific portion thereof) for a specified period will be at least a specified amount. 7

10 Contracts contingently requiring payment to the guaranteed party, based on another entity s failure to perform pursuant to an obligating agreement (a performance guarantee). Indemnification agreements contingently requiring payment to the indemnified party, based on changes in an underlying variable related to an asset, a liability, or an equity security of the guaranteed party (e.g., an adverse outcome of a lawsuit, an adverse ruling in a tax matter, the imposition of additional taxes caused by changes in tax laws). Indirect guarantees of the indebtedness of others, even though payment is not based on changes in an underlying variable related to an asset, liability, or equity security of the indemnified party. FASB ASC does not apply to the following: Commercial letters of credit and other loan commitments. Guarantees of an entity s own future performance. A non-contingent forward contract for which net settlement can flow from either party to the other. Securitizations and other arrangements, including the subordination of rights of a class or tranche of investors or creditors in favor of the rights of others. Guarantees specifically excluded from the scope of FASB ASC A lessee s residual value guarantee on a lease accounted for as a capital lease. A contract accounted for as contingent rent in accordance with FASB ASC A guarantee issued by an insurance (or reinsurance) entity subject to specialized insurance accounting principles. A contract providing for payments that constitute a vendor rebate. A guarantee whose very existence precludes the guarantor from accounting for a transaction as the sale of an asset related to the guarantee s underlying variable or from recognizing profit in current earnings from that sale transaction. A registration payment arrangement accounted for in accordance with FASB ASC In addition to the foregoing, the following guarantees, while subject to the disclosure requirements of FASB ASC , are not subject to the interpretation s recognition and measurement provisions: A guarantee accounted for at fair value as a derivative. A guarantee for which the underlying variable is related to the function (rather than the price) of non-financial assets owned by the guaranteed party (e.g., product warranties). A guarantee to pay contingent consideration in a business combination. A guarantee for which the obligation would properly be reported as equity (rather than as a liability) under GAAP. A guarantee by an original lessee that has become secondarily liable under a new lease that has relieved the original lessee of its primary obligation under the original lease. A guarantee issued between a parent and its subsidiary or between entities under common control. A parent s guarantee of its subsidiary s debt owed to a third party. A subsidiary s guarantee of its parent s debt owed to a third party or a subsidiary s guarantee of another subsidiary s debt owed to a third party. 8

11 At inception of a covered guarantee, the guarantor must recognize a liability for the obligation. If the guarantee is issued in a standalone arm s-length transaction, the amount of the liability recognized should (as a practical expedient) be equal to the premium received or due from the guaranteed party. If issued as part of a multiple-element transaction (e.g., in conjunction with the sale of equipment by the guarantor to a customer, accompanied by a guarantee of the customer s bank loan for which the proceeds are used to pay for the equipment), the amount of the liability recognized at inception should be its fair value, which may be (as a practical expedient) equal to the premium that would be required by the guarantor in a standalone arm s-length transaction. For a guarantee, which may have uncertainties both as to timing and amount, use of the expected value technique may be the most appropriate way to estimate fair value. Such technique uses a set of cash flows representing the probability-weighted average of all possible cash flow outcomes. Per one method of applying this technique, the amount of expected cash flows is adjusted for risk by subtracting a cash risk premium to arrive at a certainty equivalent amount, which is then discounted at the risk-free rate. Under another method, a risk premium is added to the risk-free interest rate, and that adjusted rate is used to discount the expected value of cash flows. In the absence of observable transactions for identical or similar guarantees, the expected present value of the guarantee may likely represent the best estimate of fair value. Note that expected present value refers to the sum of the probability-weighted present values of future outflows discounted at the same interest rate. If a guarantee is issued as a contribution (e.g., a guarantee of a bank loan made to a not-for-profit organization), the guarantor should also recognize a liability for the fair value of the obligation-that is, the guarantee should not be deemed a conditional promise to give under FASB ASC , because, upon issuance of the guarantee, the not-for-profit entity will have in fact received the gift. If, at inception, a liability is required to be accrued pursuant to FASB ASC for the related contingent loss (i.e., it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated), the amount of the guarantee liability to be recorded should be the greater of the guarantee s fair value or the amount required to be recognized by FASB ASC In most cases, the fair value of the guarantee will exceed the amount required under FASB ASC The FASB ASC liability could be more than a guarantee s fair value. For example, the undiscounted accrual under FASB ASC involves a guarantee whose payoff is expected to occur many years into the future (thus, it would normally be greater than the discounted present value of the liability). FASB ASC notes that the offsetting entry to initial recognition of the guarantee liability depends on the circumstances under which the guarantee was issued, as follows: If issued as a standalone guarantee, the offsetting entry would be cash (or a receivable) for the amount of the premium. If no consideration is received (or receivable), the offset would be to an expense. If issued in conjunction with the sale of assets by the guarantor, the full amount of the proceeds would be allocated between consideration for the guarantee and proceeds from the sale itself. 9

12 If issued in conjunction with the formation of a partially-owned (joint) venture accounted for under the equity method, recognition of the guarantee liability would have the effect of increasing the carrying amount of the guarantor s investment. If a residual value guarantee were provided by a lessee entering into an operating lease, the amount of the guarantee would be correspondingly reflected as prepaid rent. Though FASB ASC does not explicitly address subsequent measurement of such obligations, it notes that the initial amount recognized is typically reduced (with a corresponding credit to earnings) as the guarantor is released from risk under one of the following approaches: (1) only upon expiration or settlement of the obligation; (2) through systematic amortization over the term of the obligation; or (3) as the fair value of the guarantee changes from period to period (e.g., for guarantees accounted for as derivatives). IV. Liquidation of the entity Once an entity elects liquidation (or when liquidation is imminent), it is no longer a going concern. Instead, its assets will be realized and its liabilities will be settled within a relatively short period. The general goal of liquidation is to get the maximum amount of cash from the entity s assets, pay the creditors, and distribute the remaining cash and assets to the owners. While liquidations occur for a variety of reasons, small and midsize nonpublic entities usually liquidate because of foreclosure by creditors, loan work-outs, or sale of the business. A. General approach to liquidation accounting In April 2013, the FASB issued ASU No , Presentation of Financial Statements (Topic 205): Liquidation Basis of Accounting. The ASU generally is effective for entities that determine liquidation is imminent during annual reporting periods beginning after December 15, 2013, with early adoption permitted. It requires an entity to begin preparing its financial statements using the liquidation basis of accounting when liquidation is imminent, which is when the following conditions are met: The likelihood is remote that the entity will return from liquidation; and Either: (1) a plan for liquidation is approved by the person(s) with the authority to make such a plan effective, and the likelihood is remote that the execution of the plan will be blocked by other parties, or (2) a plan for liquidation is being imposed by other forces (for example, involuntary bankruptcy). Presentations of assets and liabilities at their historical bases are no longer relevant to liquidating entities. Therefore, financial statements of liquidating entities typically require an adjustment of the carrying amounts of assets and liabilities to the amounts expected in liquidation. This adjustment results in measuring the assets at net realizable value and the liabilities at net settlement value and discounting the values when the effect is significant. Since third-party fees, such as finder s fees for disposing of equipment, brokerage fees, and collection agency fees, are often required in a liquidation, they should be considered in the estimates. The definition of fair value assumes an orderly transaction, which is different than the environment in a liquidation. The carrying amounts determined for liquidation accounting do not meet the definition of fair value because they represent the net proceeds expected to be realized under the plan of liquidation. Thus, ASU No does not use the term fair value when discussing valuations by entities in 10

13 liquidation, instead saying that in some cases fair value may approximate the amount expected in liquidation. This section uses the term liquidation value to refer to amounts expected in liquidation. B. Determining liquidation values The liquidation period usually has a significant effect on the determination of liquidation values. This effect is at least partly because buyers perceive the liquidating entity as dealing from a position of weakness, and the negotiations are different than they are in a going concern. Therefore, the liquidation values must be determined within the context of the liquidation plan. The following are considerations of how liquidation plan strategies might affect liquidation values of specific account groups: Raw materials inventories -- For a going concern, the fair value of raw material inventories normally is the current replacement cost. However, discounts required to dispose of raw materials within a liquidation period often yield lower values. The buyers, often competitors and suppliers, view the liquidating entity as dealing from a position of weakness and demand lower prices. Retail inventories -- Although liquidations typically require greater markdowns than normal to turn the inventories, the amount of markdowns depends on the liquidation strategy. Generally, mark-downs increase as the liquidation period shortens. The strategy in a forced liquidation is usually to turn the inventory within a short period, regardless of the amount of discounts required. That approach generally results in the lowest fair value. The strategies in an orderly liquidation maximize the proceeds and often de-emphasize that the entity is liquidating; for example, by continuing to buy merchandise, offering modest discounts, and bundling the more desirable merchandise with the less desirable. However, even in an orderly liquidation, the values normally are less than those realized by a going concern. Equipment -- Usually, the fair value of a going concern s equipment is the cost of replacing it in its present condition. For specialized equipment, that may exceed the amount that could be realized in an orderly liquidation. Often, used markets do not exist for specialized equipment, and a liquidating entity s only alternative may be to sell the equipment to another entity in the same industry. If the number of potential buyers is small enough, selling the equipment during the liquidation period may not be possible, and selling for scrap value may be necessary. Real estate -- The value of many types of real estate varies depending on the intended use of the property. While a variety of techniques are available to value property, the underlying concept for operating real estate is often discounted cash flows. Potential cash flows from undeveloped land vary depending on whether it will be used as investment property or as a residential or commercial building. The degree of market activity affects the value. The fair value notion for a going concern yields a value that would be realized under optimum conditions. Even in an orderly liquidation, discounts often are required to attract a buyer within the time available. Liabilities -- Valuing the liabilities of a liquidating entity introduces a consideration not applicable to going concerns, that is, the willingness of a creditor to settle for less than the principal outstanding, regardless of current interest rates. Even secured creditors often agree to settle to avoid the time and money required for foreclosure proceedings, even if the loan agreement specifically waives the debtor s right to protest or demand a jury trial. Unsecured creditors generally believe they get more by settling than by forcing the entity into bankruptcy and standing behind secured creditors. Estimating the 11

14 settlement amounts requires judgment, but consulting with lawyers and others who have worked with liquidating entities normally provides useful information. C. Subsequent adjustment of liquidating values If values are estimated perfectly at the date of conversion, the disposition of assets and settlement of liabilities has no effect on the results of subsequent activities. However, estimates rarely are perfect, and changes in estimated values occur. Those changes should be recognized when management becomes aware of them instead of when they are realized. That requires considering the need to adjust the carrying amounts of assets and liabilities to more recent estimated liquidation values whenever financial position is reported. Management typically monitors the amounts expected in liquidation, so the necessary information generally is readily available. At the end of each reporting period, estimated values should be changed based on available information, and the changes should flow through net income. D. Liquidation basis financial statements While financial position certainly is relevant for liquidating entities, results of operations and cash flows are not. Activities consist entirely of winding down and there is no profit to report, only changes in estimated values. Similarly, the operating, investing, and financing activities of a going concern are not found in a liquidating entity. Therefore, often only a statement of net assets in liquidation and a statement of changes in net assets in liquidation are presented after the year of conversion from the going concern assumption to the liquidation assumption. When deciding which statements to present for the year in which the conversion occurs, the authors recommend preparing statements of income and retained earnings and cash flows from the beginning of the year to the date of conversion, a statement of changes in net assets in liquidation for the period from the date of conversion to the end of the year, and a statement of net assets in liquidation at the end of the year. When preparing the statement of changes in net assets in liquidation, the authors recommend reporting opening net assets in the statement using the amounts at the date of the conversion determined on a going-concern assumption and reporting liquidating gains and losses with other income and expenses. Even though the liquidation basis is a generally accepted accounting principle for preparing financial statements of liquidating entities, the financial statements under the liquidation basis are not comparable to financial statements based on the going-concern assumption, and the authors recommend that statements prepared on the two different bases not be presented in comparative form. Instead, if statements for periods prior to the conversion are presented, they should be on separate pages of the report. The statements for the prior period should be presented as originally issued rather than restating them to a liquidation basis. E. Statement of net assets in liquidation The presentation of financial position, accomplished through the statement of net assets in liquidation, is similar to that of a going concern. Some drafting recommendations include the following: Although customary statement headings such as balance sheet and statement of financial position are acceptable, the authors suggest modifying the title to notify the reader that the statements do not assume a going concern; for example, statement of net assets in liquidation, statement of net assets available for liquidation, statement of financial position-liquidation basis, or liquidating values of assets and liabilities. 12

15 Do not classify assets and liabilities as current and noncurrent because classification generally has no relevance for a liquidating entity. Present assets in the order they will be realized and liabilities in the order they will be settled. Use a caption such as net assets in liquidation or deficiency in net assets to describe the difference between assets and liabilities; the conventional equity captions are not relevant. There is no need to disclose the difference between historical and liquidation values. However, since gains and losses are not taxed until they are realized, differences between the liquidation values of assets and liabilities and their tax bases are temporary differences, and FASB ASC 740, Income Taxes, applies. Since carryforwards of a liquidating entity often expire unused, special attention should be given to the need for deferred tax asset valuation allowances. Amortization and depreciation are techniques a going concern uses to spread the cost of assets over the time they are used. They are not relevant to liquidating entities because asset values are adjusted to the amount of cash expected from their disposal. F. Statement of changes in net assets in liquidation The presentation of the liquidating activities is similar to a cash basis statement with an additional section to present changes in estimated values. The drafting recommendations include the following: Use a descriptive heading such as statement of liquidating activities or statement of changes in net assets in liquidation. The statement should reconcile the change in net assets during the period. Group activities into two primary sections: those that provided cash and those that required cash. Report changes in estimates as a separate component. As a general rule, the authors do not believe a distinction between realized and unrealized gains and losses is useful to readers of these financial statements. G. Disclosures Disclose the information that is relevant to the liquidation assumption and useful to the primary readers of the financial statements. Many of the disclosures provided by going concerns are not relevant to liquidating entities, such as the following: Lease and other commitments are not relevant because they will be settled during the liquidation, either through termination payments or assumption. Since long-term debt will be settled, annual maturities are not relevant. There is only one significant accounting policy -- the valuation of assets and liabilities at their liquidation values. ASU No requires the following disclosures. 1. Basis of accounting A note that describes the use of liquidation values and provides any other pertinent information about the process of liquidation, including the date of the decision to liquidate and the adoption of the liquidation basis. The following illustrates such a note: 13

16 NOTE A -- BASIS OF ACCOUNTING Effective June 30, 20X4, the Company decided to liquidate and, accordingly, revalued its assets and liabilities to the amounts expected to be collected and paid during the liquidation. The effect of the revaluation is included in the statement of net assets in liquidation as other expenses. It is not presently determinable whether the amounts realizable from the disposition of the remaining assets or the amounts that creditors will agree to accept in settlement of the obligations due them will differ materially from the amounts shown in the accompanying financial statements. Differences between the revalued amounts and actual cash transactions will be recognized in the year they can be estimated. The gains and losses from liquidation will be taxable on distribution. 2. Description of liquidation plan A description of the plan of liquidation, including the planned method of disposition of the assets and settlement of liabilities as well as the expected timeframe to complete the liquidation. 3. Significant assumptions Significant assumptions made in estimating liquidation values, such as settlements with creditors. The authors also recommend disclosing any significant uncertainties about the realizability of amounts at which assets are presented or about amounts that creditors will agree to accept in settlement of obligations due them. 4. Description of accruals A description of accruals including the type, amount, and timeframe revenues are expected to be earned or costs paid. 14

17 Auditing Contingencies and Going Concern LEARNING QUESTIONS 1. Which of the following is TRUE related to the definition of contingencies? A. It involves uncertainty with probable loss. B. It will ultimately be resolved when one or more future events occur or fail to occur. C. The financial impact is reasonably estimated. 2. Which of the following is an example of a contingency that may require accrual, as opposed to a commitment requiring disclosure? A. Guarantee for obligations to third parties. B. Unused lines of credit. C. Purchase commitments at fixed future prices. 3. Which of the following is a TRUE statement related to contingencies? A. Unasserted claims are not accrued, only disclosed. B. Exposure to risk automatically means that an asset has been impaired or a liability has been incurred. C. Uninsured losses may be accrued if the event took place prior to the financial statement date and the amount is reasonably estimable. 4. In accordance with generally accepted auditing standards, which of the following is NOT a responsibility of the auditor in a financial statement audit? A. Specifically opine as to whether the entity can continue as a going concern for an excess of one year from the balance sheet date. B. Assess the adequacy of gong concern disclosures asserted by reporting entity management. C. Determine the implications of any going concern uncertainty on the auditor s report. 5. Which of the following is a typical audit procedure performed when there is substantial doubt about an entity s ability to continue as a going concern for a reasonable period of time? A. Document and review the cause of any substantial doubt with management. B. Conclude on the likelihood of the ability to continue as a going concern, absent management s assertions. C. Disclaim an opinion if there is not absolute assurance that the entity will continue to be a going concern for at least a year from the balance sheet date. 6. Which of the following is a valid concern when evaluating the adequacy of management s plans to dispose of assets to alleviate a going concern uncertainty? A. How available is debt financing? B. What are the possible adverse effects of disposal of assets on long-term operations? C. How will delay of expenditures negatively impact the ability to maintain operations for a reasonable period of time? 15

18 7. The review of how sensitive driving factors are to fluctuations in the assumptions is typically referred to by which of the following terms? A. Cost review. B. Trend analysis. C. Sensitivity analysis. 8. Which of the following is a TRUE statement regarding the most likely impact on the auditor s report if substantial doubt about an entity s going concern is not concluded upon after further audit procedures are performed? A. Disclosure in footnotes is required whenever substantial doubt is evaluated. B. Disclosure in footnotes is only required if the auditor s report is modified. C. Absence of report modification does not mean that assurance is being provided that no going concern uncertainty exists. 9. Which of the following is TRUE statement related to a client s request to reissue an auditor s report should a going concern uncertainty change after original report issuance? A. The auditor must oblige the client s request if the going concern matter is resolved. B. There is no need to audit the event or transaction that prompted the request. C. Despite resolution of any initial concerns, the auditor should reconsider going concern uncertainty due to other matters at date of reissuance. 16

19 Auditing Contingencies and Going Concern HOMEWORK Exercise 1: Determination of Accounting Treatment Instructions: Assume the following facts and circumstances of ABC Company, Inc. as it prepares its financial statements for the year ended December 31, 20X5. The statements are expected to be issued on March 10, 20X6. Determine whether each commitment or contingency would be properly accrued for and/disclosed in the financial statements. Facts and Circumstances 1. ABC Company is a defendant in a lawsuit alleging breach of a 20X6 contract. The lawsuit was initiated on February 15, 20X6 and settled on March 1, 20X6 for $100, ABC Company is a defendant in a lawsuit alleging copyright infringement. This suit was filed on December 10, 20X5 seeking damages of $500,000. ABC Company s product is a direct competitor of the plaintiff. The pending litigation claims that a former employee was fired from ABC Company four years ago when ABC Company was in development phase of its own product. Plaintiff claims that trade secrets were pirated from plaintiff and incorporated into the design of ABC Company product. Based on progress made at March 5, 20X6, Company management estimates that it is likely to be required to pay damages of between $250,000 and $330,000. Outside legal counsel estimates that the likelihood of a negative future outcome against the client company is likely. Outside legal counsel estimated the possible ranges of costs and damages to range from $290,000 to $340,

20 3. At December 31, 20X5, ABC Company estimates that its product warranty costs associated with items sold in 20X5 will be approximately $100, ABC Company operates a manufacturing subsidiary in a country where there is a threat of expropriation of assets. This threat has loomed for approximately 10 years, and during that period no other companies operating in that country have had their assets expropriated. Net assets of the foreign subsidiary at December 31, 20X5 were $1,025,000. In the event of expropriation, ABC Company anticipates that the potential loss would be in that amount. 5. ABC Company is not insured against fire loss at its corporate headquarters. 6. A 20X5 receivable in the amount of $270,000 is considered uncollectible because the customer has filed for bankruptcy on January 15, 20X6. 18

21 7. ABC Company is involved in environmental remediation proceedings related to certain sites. There are approximately five sites on which a final settlement has not been reached where, along the others, the company has been designated as a potentially responsible party by the Environmental Protection Agency or other otherwise engaged in investigation. This includes cleanup activity at certain current and former manufacturing sites, which are continually monitored for environmental exposure. Probable liability is $1 million, to be paid over a period of up to 30 years. The exposure for environmental loss contingencies range from a probable low of $1 million and a reasonably possible high of $2 million, with no better estimate in between. Actual costs to be incurred at identified sites in future periods may vary from the estimates, given inherent uncertainties in evaluating environmental exposures. A significant increase to the reasonably possible upper exposure level could occur if a new site is designated, the scope of remediation is increased, a different remediation alternative is identified, or a significant increase in the proportionate share occurs. The Company does not expect that any sum we may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed would have a material adverse impact on our financial position or results of operations in any one year. 8. ABC Company has guaranteed repayment of some additional borrowings of certain unconsolidated equity affiliates. At December 31, the guarantees have terms that range from two to seven years, with maximum potential payments of $500, ABC Company has an unused line of credit for $2 million. 10. The auditor initially had a doubt about the entity s ability to continue as a going concern due to the extent of commitments and contingencies. However, based on the amounts actually deemed likely and accrued, this doubt was not deemed substantial. 19