Auditing and Attestation- Certified Public Accountant (CPA) Practice Exam -

Under what condition would an entity accrue a loss contingency during the audit period?

1. A reasonable estimate was determined for a liability incurred post year-end.

2. Communications indicated an unfavorable outcome was possible.

3. A claim with a probable adverse outcome was estimated before the audit report issuance.

4. The amount of an asset impairment was identified as of year-end.

The correct answer is: A claim with a probable adverse outcome was estimated before the audit report issuance.

An entity would accrue a loss contingency during the audit period when there is a reasonable likelihood that a liability will occur, and the amount can be reliably estimated. This situation is particularly applicable when a claim has been identified with a probable adverse outcome. By the time of the audit report issuance, if the entity has determined that the likelihood of the loss occurring is probable, this requires the recognition of a liability in the financial statements. Accruing the loss contingency at this point is necessary to ensure that the financial statements present an accurate picture of the entity's liabilities and financial position. Recognizing a loss reflects a responsible accounting treatment that adheres to the principles of conservatism, thereby allowing for the anticipation of losses that are probable and can be estimated, without waiting for the situation to fully materialize. In contrast, recognizing a liability based on unfavorable outcomes being possible but not probable would not meet the criteria for accrual. Therefore, accruing based on a mere possibility or after the fiscal year-end is insufficient to justify recognition in the current period. The determination of impairment is also a separate assessment from loss contingencies and does not trigger the same accrual requirement unless it is directly related to a liability that is both probable and estimable.