Question

During 20X1, litigation filed against TWD five years previous alleging that TWD discharged pollutants into state waterways was dropped by the state. Loss contingency disclosures that TWD included in prior years' financial statements are being removed for the 20X1 financial statements. The audit risk would:

A)Increase, as the removal of loss contingency disclosures may lead to incomplete financial reporting.
B)Decrease, as the resolution of the litigation reduces uncertainty about potential losses.
C)Remain unchanged, as the audit risk is not affected by changes in loss contingency disclosures.
D)Fluctuate, depending on the reasons for dropping the litigation and the impact on TWD's financial position.

Answer 1

Audit risk for TWD would likely decrease after the resolution of litigation and the related loss contingency disclosures are removed, as this action reflects a reduction in uncertainty regarding potential losses.

Step-by-step explanation:

The question pertains to the impact of litigation resolution on audit risk for a company named TWD. During 20X1, TWD had litigations against it dropped, which alleged that the company discharged pollutants into state waterways. This resulted in the removal of loss contingency disclosures from the financial statements that were present in prior years. The correct answer to the impact on audit risk is B) Decrease, as the resolution of the litigation reduces uncertainty about potential losses.

The removal of these disclosures can be seen as a positive indication of reduced legal and financial uncertainties, which in turn generally lowers the level of audit risk. However, auditors must carefully consider the reasons behind the dropping of litigation and ensure that the removal of disclosures is appropriate and that all material information is properly reported.

It's worth noting that the audit risk would not necessarily remain unchanged or increase just because the disclosures are removed, unless there is a sign of incomplete or inappropriate financial reporting. Nor does the risk fluctuate based on the dropping of litigation alone, as it should primarily reflect the current circumstances and the accurate portrayal of the company's financial position.