In February 2008, Ceramic Crucibles of America was notified by the state of Colorado that the state was investigating the company's Durango facility to determine if there were any violations of federal or state environmental laws. In formulating your opinion on the 2007 financial statements, you determined that, based primarily on management's representations, the investigation did not pose a serious threat to the company's financial well-being.

The company subsequently retained a local law firm to represent it in dealing with the state commission. At the end of 2007, you concluded that the action did not represent a severe threat. However, you have just received the attorney's letter, which is a little unsettling. It states:

On January 31, 2008, the U.S. Environmental Protection Agency (EPA) listed the Durango site in Durango, Colorado, on the National Priorities List under the Comprehensive Environmental Response, Compensation, and Liability Act (Superfund). The site includes property adjoining the western boundary of Ceramic Crucibles' plant in Durango and includes parts of Ceramic Crucibles' property. The EPA has listed Ceramic Crucibles as one of the three "potentially responsible parties" ("PRPs") that may be liable for the costs of investigating and cleaning up the site. The EPA has authorized $400,000 for a "Remedial Investigation and Feasibility Study" of the site, but that study will not begin until sometime later in 2008. Thus, we do not deem it possible or appropriate at this time to evaluate this matter with regard to potential liability or cost to the company.

You immediately set up a meeting with Dave Buff, Ceramic Crucibles' vice president; Ron Bonner, the company's attorney; and Margaret Osmond, an attorney who specializes in EPA-related issues. At the meeting you ascertain that

• Ceramic Crucibles bought the Durango facility from TW Industries in 1997.

• TW Industries had operated the facility as a manufacturer of ceramic tiles, and it had used lead extensively in incorporating color into the tile.

• The site has been placed on the National Priorities List ("the List") apparently because each state must have at least one site on the List. All sites on the List are rated on a composite score that reflects the relative extent of pollution. The Durango site has a rating of 8.3 compared to a rating of no less than 25 for the other sites on the List.

• The most severe lead pollution (based on toxicity) is in an area located on the other side of a levee behind Ceramic Crucibles' facilities. Although the area close to the building contains traces of lead pollution, the toxicity in this area is about 50 parts per million (ppm), compared to 19,000 ppm beyond the levee.

• Although Ceramic Crucibles used lead in coloring its crucibles until about 1999, the lead was locked into a ceramic glaze that met FDA requirements for appliances used in the preparation of food. Apparently, the acids used in determining the leaching properties of lead for EPA tests are stronger than that used by the FDA. Since 1999, Ceramic Crucibles has used lead-free mud in its crucibles.

• Affidavits taken from present and former employees of Ceramic Crucibles indicate that no wastewater has been discharged though the levee since Ceramic Crucibles acquired the property in 1997.

• The other PRPs and TW Industries are viable companies that should be in a position to meet their responsibilities resulting from any possible EPA action.

Materiality for purposes of evaluating a potential loss is $10 million to $13 million. This is based on the assumption that the loss would be deductible for income tax purposes. In that case, the loss would represent a reduction in stockholders' equity of 4.5 percent to 7.0 percent. Your best guess is that the company's exposure does not exceed that amount. Further, based on the financial strength of the company and its available lines of credit, you believe such an assessment would not result in financial distress to the company.

The creation of the Environmental Protection Agency (EPA) and that of the Comprehensive Environmental Response, Compensation, and Liability Act is a result of the increasing concern of Americans about pollution. An amendment to the act permits the EPA to perform the cleanup. The EPA has a national priorities list of several thousand sites thought to be severely damaged. The average cost of conducting remedial investigation and feasibility studies ranges from $750,000 to over $1 million, and such studies may take as long as three years. Cleanup costs can often exceed $10 million to $12 million. It is said that the current estimates of $100 billion to clean up nonfederal hazardous waste sites may be conservative.

The law requires the EPA to identify toxic waste sites and request records from PRPs. The PRPs are responsible for the cost of cleanup, but if they lack the funds, the EPA uses its funds for the cleanup. The EPA has spent $3.3 billion from its trust fund and collected only $65 million from polluters since the passage of the legislation

 

Requirements:

i. How would this type of contingency be classified in the accounting literature, and how should it be accounted for?

ii. Would the amount be material to the financial statements?

iii. What additional evidence would you gather, and what kinds of representations should you require from the client?

(i).

Accounting and reporting for contingencies x that is to say, potential gains and losses x is a topic that is not regularly on the front burner of finance and accounting professionals. It usually is covered in just a few pages in the standard intermediate accounting college textbook. Now, however, the increase in recession-induced merger and acquisition activity, the enhancement of executive exposure as a result of the Sarbanes-Oxley Act (SOX), and the business leadership focus on global risk management all point to the need for a renewed focus on accounting for contingencies. Also, related disclosures can shed valuable light on the potential of corporations to meet future reported earnings and cash flow goals.

Accounting Standards Codification→ (ASC) 450, “Contingencies” (formerly Statement of Financial Accounting Standards No. 5 (SFAS No. 5), “Accounting for Contingencies”), applies to both gain and loss contingencies. With the exception of tax loss carry forwards, gain contingencies are not generally recognized because they could result in recognition of revenue before it is realized. In contrast, many types of loss contingencies are recognized. Principally, these include loss contingencies that result in liabilities, as well as those that involve asset impairments.

ASC 450-20-25 (450, Contingencies; 20, Loss Contingencies; 25, Recognition) requires consideration of the likelihood that a contingency will be realized, as well as an assessment of whether the amount of the loss is reasonably estimable.1 Likelihood estimates range along a continuum from probable to reasonably possible to remote.

(ii).

Materiality underlies the application of International Standards on Auditing. Materiality thus has a pervasive effect in a financial statement audit. In conducting an audit, the auditor should consider materiality in planning the audit and in evaluating the fair presentation of the financial statements in accordance with an identified financial reporting framework.

The determination of materiality is a matter of professional judgment. In determining the materiality of an item, the auditor considers not only the item’s nature and amount relative to the financial statements, but also the needs of financial statement users.
Materiality has to be considered before a detailed audit program can be prepared. In the initial planning, however, an auditor cannot anticipate all of the factors that will ultimately influence the materiality judgment in the evaluation of audit results at the completion of the audit. Therefore, these factors must be considered as they arise, and materiality must be evaluated throughout the audit.

Materiality has significant implications for audit efficiency. To be efficient, an auditor should not spend time examining balances where there is no chance of a material error. Sometimes, in an audit of a small entity, there is a temptation to audit everything because it does not seem as though it will take much time when individual items are considered. The unnecessary time can, however, add up to a significant amount overall.

The concept of materiality
Material information means information that matters, is important or essential. In terms of accounting, it pertains to information that is to be recognised, measured or disclosed in accordance with the requirements of an Accounting Standard. In measuring or disclosing accounting information, emphasis is on the needs of known or perceived users. In auditing materiality pertains to the largest number (threshold) of uncorrected errors, misstatements, or erroneous disclosures or omissions that exist in the financial statements and yet are not misleading. The auditor plans and executes an audit with a reasonable expectation of detecting material misstatements. The assessment of what is material is a matter of the auditor's professional judgement of the needs of the reasonable person relying on the information.

Preliminary judgements about materiality
The auditor makes preliminary judgements about materiality levels in planning the audit. This assessment, often referred to as planning materiality, may ultimately differ from the materiality levels used at the conclusion of the audit in evaluating the audit findings, because the surrounding circumstances may change and additional information about the entity will have been obtained during the course of the audit. For example, the client may have obtained the financing needed to continue as a going concern, which was in doubt when the audit was planned, and the audit may affirm that the company's short-term solvency has significantly improved during the year. In such cases, the materiality level used in evaluating the audit findings might be higher than planning materiality.

(iii).

Relevance

Probably the most fundamental rule of evidence states that, with few exceptions, “relevant evidence is admissible, irrelevant evidence is not.” Information is said to be relevant if it “tends to prove, or disprove, a fact in issue.” In fraud or corruption investigations, this means that a piece of evidence is probably relevant (and hopefully, compelling and convincing) if it tends to prove, or disprove, an element of proof of an offense, including proof of knowledge and intent. This means that fraud and corruption investigators must know:

·         The elements of proof of the suspected offenses and

·         The type of evidence – direct or circumstantial – that would be relevant to prove them,

The source of the evidence:

The source of the evidence refers to the basis for a witness’s knowledge: is the witness testifying to what he or she knows for a fact, or what the witness overheard on the train, or what the witness supposes or thinks might have happened? Obviously, evidence of which the witness has direct personal knowledge is considered to be weightier than information overheard from another or supposition. Investigators should always look for witnesses with direct personal knowledge (although in practice, as we’ll see below, it might not be so easy in many cases to know the source of the information.)

Direct and circumstantial evidence:

Direct evidence as the name implies, is evidence that tends to prove a fact directly – for example, a statement from an eyewitness or the cancelled check used for a bribe payment or a confession by the subject. Direct evidence is usually considered to be the strongest method of proof, but circumstantial evidence – evidence that tends to prove a fact indirectly, or by inference from other facts – also can be quite persuasive if presented correctly