Contingent liabilities, when present, are very important audit items because they normally represent risks that are easily misunderstood or dismissed. For companies in the United States, the Financial Accounting Standards Board, or FASB, sets specific criteria for how contingent liabilities are to be assessed, disclosed and audited. Auditors are expected to apply recognition, measurement and disclosure criteria per FASB accounting standards codification.
Importance of Proper Contingent Liability Disclosure
Contingent liabilities are those future expenses that might occur. Common examples include lawsuits, warranties on company products and unsettled taxes. Because of the risks they impose and the increased frequency with which they occur in contemporary finance, contingent liabilities should be carefully considered by every private and government auditor. Credit rating agencies, creditors and investors rely on audits to expose hidden risks to counterparties. The opposite risk is also present. A company might overstate its contingent liabilities and scare away investors, pay too much interest on its credit or fail to expand sufficiently for fear of loss.
Importance of Audits
Audits protect the integrity of financial information. Trust, reputation and fair dealings are crucial elements in any business transaction, but they are even more important when dealing with securities and large loans among parties without working relationships. The auditor keeps an eye on undisclosed contingent liabilities. If the company's claims are confirmed and shown to be reasonable, the auditor can then validate the information presented to the public. If, for whatever reason, some liabilities were listed incorrectly or left out or if taxes were not properly disclosed, the auditor is responsible for correcting those errors and alerting the proper authorities.
Reviewing Contingent Liabilities in an Audit
An auditor should never assume company management has always disclosed all contingent liabilities. This is particularly true with legal expenses and unsettled taxes. Auditors have the authority to review all Internal Revenue Service, or IRS, reports for possible undisclosed tax liabilities. All legal expenses are to be accompanied by supporting documents.
An auditor may not always be a sufficient legal authority on a specific topic to understand the likelihood of the expense. Also, the legalese may be written to be intentionally obtuse. In such cases, the auditor can review precedent or consult with an expert before making a ruling on possible contingencies.
Materiality and Likelihood
For contingent liabilities, a possible expense is only material if it represents a significant impact on the company's finances. For example, a $1,000 liability is not material for Berkshire Hathaway even if it had a 95% chance of occurring. Once materiality is determined, it is up to the company, first, and the auditor, second, to determine if the contingent liability's realization is remote, reasonably possible or probable.
The FASB allows auditors to use their best judgment when deciding between the three levels of likelihood. Large contingent liabilities can dramatically affect the expected future profitability of a company, so this judgment should be wielded carefully. All important footnotes need to be added to the balance sheet.