What are the two types of subsequent events that an auditor should consider?And explain how is each type treated in the financial statements?

Case Facts
Delco Enterprises is a publicly traded company that was founded in 1962 in Grand Rapids, Michigan, as a manufacturer of children’s toys. The company has experienced steady growth and profitability for more than 20 years. For the past eight years, Delco’s financial statements have been audited by KSRP, LLP, a mid-sized public accounting firm headquartered in Detroit. KSRP has enjoyed its relationship with Delco because of the honest and up-front nature of the company’s top management team. KSRP’s audits of Delco have always gone smoothly, and they have never had any significant disagreements with the client.

During the audit of the financial statements for the year ended December 31, 20X1, KSRP was informed by management that Delco had been named in a class-action lawsuit involving alleged safety issues with one of its popular toys. The suit claims that some young children have choked on small parts that have broken off of the toy and that the parts had broken due to low-quality materials being used to manufacture the toy. Although the lawsuit was filed in November 20X1, the company had no clear indication at that time of the likelihood that it would be held liable for these claims. Delco performed in-house testing of the product to determine whether the case had any merit. Delco feels the raw materials used in the production of the toy are high in quality, and thus its management believes the company will most likely prevail in its defense. Delco has disclosed what little information it has received about the case in the footnotes of the financial statements.

On February 5, 20X2, KSRP completed its audit fieldwork and obtained a representation letter from management, which included very little new information regarding the lawsuit. The audit report was dated February 5, 20X2. Based on all available information from attorneys involved in the case, both Delco and KSRP concluded at that time that the probability of a loss due to the lawsuit was remote. Delco planned to issue its financial statements on February 14, 20X2. On February 12, 20X2, new information was provided to KSRP regarding the lawsuit, which suggested the likelihood that Delco would be held liable for damages suffered by those injured by the toy parts was “probable.” Although no firm dollar amount was provided, it is clear that damages would be at least $10 million and would not likely exceed $20 million.

QUESTIONS

1. What are the two types of subsequent events that an auditor should consider? How is each type treated in the financial statements?

2. What two characteristics of a contingent loss require an accrual to be recognized in the financial statements?

3. Considering the fact that KSRP had completed its fieldwork and dated the audit report prior to the revelation of the new information, is KSRP responsible for ensuring that the new information regarding the lawsuit is properly treated in the client’s financial statements? Explain.

4. Research ASC 450-20 and AS 2801. How should the Delco lawsuit be treated in the company’s December 31, 20X1 financial statements? Be specific in your response in terms of dollar amounts and other information to be provided in the financial statements. Support your conclusion by citing authoritative literature.

5. What would the date of KSRP’s audit report be for this audit?

What are the two types of subsequent events that an auditor should consider?And explain how is each type treated in the financial statements?

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