24-23, 24-24, 24-25, 24-26
24-23 (OBJECTIVE 24-2) In an audit of the Marco Corporation as of December 31, 2016, the
following situations exist. No entries have been made in the accounting records in relation to
these items.
1. During the year 2016, the Marco Corporation was named as a defendant in a suit for damages by
the Dalton Company for breach of contract. An adverse decision to the Marco Corporation was
rendered and the Dalton Company was awarded $4,000,000 damages. At the time of the audit, the
case was under appeal to a higher court.
2. On December 23, 2016, the Marco Corporation declared a common stock dividend of 1,000 shares
with a par value of $1,000,000 of its common stock, payable February 2, 2017, to the common
stockholders of record December 30, 2016.
3. The Marco Corporation has guaranteed the payment of interest on the 10-year, first mortgage
bonds of the Newart Company, an affiliate. Outstanding bonds of the Newart Company amount to
$5,500,000 with interest payable at 5% per annum, due June 1 and December 1 of each year. The
bonds were issued by the Newart Company on December 1, 2014, and all interest payments have
been met by that company with the exception of the payment due December 1, 2016. The Marco
Corporation states that it will pay the defaulted interest to the bondholders on January 15, 2017.
a. Define contingent liability.
A contingent liability is a potential future obligation to an outside party for an unknown amount
resulting from activities that have already taken place. The most important characteristic of a
contingent liability is the uncertainty of the amount; if the amount were known it would be included
in the financial statements as an actual liability rather than as a contingency
b. Describe the audit procedures you would use to learn about each of the situations listed.
The following procedures apply to all three items:
●Discuss the existence and nature of possible contingent liabilities with management and
obtain appropriate written representations.
●Review the minutes of directors’ and stockholders’ meetings for indication of lawsuits or other
contingencies.
●Analyze legal expense for the period under audit and review invoices and statements of legal
counsel for indications of contingent liabilities.
●Obtain letters from all major attorneys performing legal services for the client as to the status
of pending litigation or other contingent liabilities.
The following are additional procedures for individual items:
Lawsuit Judgment — no additional procedures; see above list of procedures applicable to all three
items.
Stock dividend
●Confirm details of stock transactions with registrar and transfer agent.
●Review records for unusual journal entries subsequent to year-end.
Guarantee of interest payments
●Discuss, specifically, any related party transactions with management and include information
in letter of representation.
●Review financial statements of affiliate, and where related party transactions are apparent,
make direct inquiries of affiliate management, and perhaps even examine records of affiliate if
necessary
c. Describe the nature of the adjusting entries or disclosure, if any, you would make for each of
these situations.
1. The lawsuit should be described in a footnote to the balance sheet. In view of the court decision,
retained earnings may be restricted for $4,000,000, the amount of the first court decision. Also, in
view of the court decision any reasonable estimate of the amount the company expects to pay as a
result of the suit might be used in lieu of the $4,000,000. A current liability will be set up as soon as a
final decision is rendered or if an agreement as to damages is reached. If liability is admitted to by
Marco, and only the amount is in dispute, a liability can be set up for the amount admitted to by the
company with a corresponding charge to expense or shown as an extraordinary item if the amount is
material.
2. The declaration of such a dividend does not create a liability that affects the aggregate net worth in
any way. The distribution of the dividend will cause a reduction in retained earnings and an increase
in capital stock. No entry is necessary, but an indication of the action taken, and that such a transfer
will subsequently be made, should be shown as a footnote or as a memorandum to Retained Earnings
and Common Stock in the balance sheet.
