Question 1. An audit client is being sued for $500,000 for discriminatory hiring practices.
Required: Indicate the appropriate action the auditor should take for each of the following independent responses to the letter of audit inquiry:
a. The lawyer stated that the client had a "meritorious defense."
b. The lawyer stated that there is only a remote chance that the client will lose. The client did not accrue any contingent loss or disclose this situation.
c. The lawyer stated the client will probably lose, and the amount of the loss could be anywhere between $250,000 and $500,000, with no amount within that range being more likely than another. The client disclosed this situation but did not accrue a loss.
d. The lawyer stated that there is a reasonable possibility that the client will lose. The client disclosed this situation but did not accrue a loss.
e. The lawyer stated the client will probably lose between $250,000 and $500,000, but most likely will lose $400,000. The client accrued a $250,000 contingent loss and disclosed the situation.
Question 2. An alfalfa co-op has an agreement with its farmers to purchase alfalfa at a price that is currently above the existing market price. In addition, the co-op has agreed to pay the farmers interest at 2% for each moth delivery is delayed beyond December 31, 2006. Management expects that at least 14,500 tons will be delivered sometime after the balance sheet date.
a. What factors should be considered in making an estimate of the loss accrual?
b. What information should management disclose in the footnotes to the financial statements concerning this purchase commitment?