Companies may have pending lawsuits, assessments, or claims filed against them. The auditor must determine if these contingenciesA gain or loss that may occur due to an existing condition and depends on the outcome of some future event outside of an entity's control. represent a loss that needs to be disclosed or reflected as a liability in the financial statements.

Once a loss contingency is identified, the auditor must determine proper accounting. A loss contingency should be accrued to a contingent liability account only when the pending resolution will probably result in a penalty and that penalty can be reasonably estimated. Both conditions must be met before a contingency is accrued.

(Choice A) When an asset is impaired, an actual loss is recorded. If GAAP guidelines are met, a loss contingency is accrued as a contingent liability before the actual amount and timing of the penalty is determined.

(Choice B) A loss contingency would not be accrued on the current period balance sheet because reasonable estimation occurred after the balance sheet date. The company must be able to reasonably estimate the liability and expect that the amount is likely to occur before accruing a liability. However, the auditor will need to determine if disclosure is appropriate and is likely to note this for the following year's audit.

(Choice C) The unfavorable judgment expected from litigation must be both probable and estimable to accrue a loss contingency.

Things to remember:
Loss contingencies can arise from pending lawsuits, assessments, or claims. Accrual for these contingencies occurs only when the company will probably incur a penalty and the amount of that penalty can be reasonably estimated.