Responding to Auditors on Loss Contingencies. How to Keep the Peace Under the Treaty. Steven Miller

Transcription

1 Responding to Auditors on Loss Contingencies How to Keep the Peace Under the Treaty Steven Miller

2 The Auditors Process 2

3 GAAP, GAAS and the Standards Applicable to Auditors Auditors conduct audits of financial statements in accordance with industry standards referred to as Generally Accepted Auditing Standards (GAAS). The financial statements are presented in accordance with Generally Accepted Accounting Principles (GAAP). The pronouncements of the Auditing Standards Board of the AICPA are the primary source of GAAS and are designated as AU Sections. The primary source of GAAP is the Accounting Standards Codification (ACS) adopted by the Financial Accounting Standards Board. SEC accounting guidance is also authoritative and binding on companies reporting to the SEC. The PCAOB develops auditing standards for publicly traded companies and these standards rely heavily on AU. 3

4 Audit Procedures Performed by the Auditors The procedures an independent auditor should consider for identifying litigation, claims and assessments when performing an audit are described in AU Section 337. AU 337 was initially published by the AICPA in 1975 as SAS (Statement on Auditing Standards) No. 12 in conjunction with the issuance by the ABA of its policy (see Part III below). AU 337 emphasizes that management is primary source of information about litigation, claims and assessments. 4

5 Audit Procedures Performed by the Auditors Among other procedures, AU 337 states that the auditor should request the client s management to send a letter of inquiry to those lawyers with whom management consulted concerning litigation, claims and assessments. The audit objective is to corroborate information furnished by management. AU 337 states that audit evidence obtained from the client s inside general counsel or legal department may provide the necessary corroboration. However, audit evidence obtained from inside counsel is not a substitute for information outside counsel refuses to furnish. 5

6 Audit Procedures Performed by the Auditors AU 337 describes the matters that should be covered in a letter of audit inquiry as including (among other things): A list prepared by management (or a request by management that the lawyer prepare a list) that describes and evaluates pending or threatened litigation, claims and assessments with respect to which the lawyer has been engaged and to which he has devoted substantive attention on behalf of the company in the form of legal consultation or representation. A list prepared by management that describes and evaluates unasserted claims and assessments that management consider to be probable of assertion, and that, if asserted, would have at least a reasonable possibility of an unfavorable outcome with respect to which the lawyer has been engaged and to which he has devoted substantive attention on behalf of the company in the form of legal consultation or representation. 6

7 Audit Procedures Performed by the Auditors With respect to each matter, a request that the lawyer furnish the following information: A description of the nature of the matter, the progress of the case to date, and the action the company intends to take. An evaluation of the likelihood of an unfavorable outcome and an estimate, if one can be made, of the amount or range of potential loss. 7

8 Audit Procedures Performed by the Auditors As to each matter on the list supplied by management, a request that the lawyer comment on those matters as to which his or her views concerning the description or evaluation of the matter may differ from those stated by management. 8

9 Audit Procedures Performed by the Auditors A statement by the client that the client understands that whenever, in the course of performing legal services for the client with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for financial statement disclosure, the lawyer has formed a professional conclusion that the client should disclose or consider disclosure concerning such possible claim or assessment, the lawyer, as a matter of professional responsibility to the client, will so advise the client and will consult with the client concerning the question of such disclosure and the applicable requirements of ASC 450; and a request that the lawyer confirm whether the understanding described above is correct. 9

10 Audit Procedures Performed by the Auditors AU 337 states that a lawyer may appropriately limit his or her response to matters to which he or she has given substantive attention in the form of legal consultation or representation. AU 337 provides that a lawyer s refusal to furnish the information requested would be a limitation on the scope of the audit sufficient to preclude an unqualified audit opinion. A refusal to respond is distinguished from an inability to form a conclusion with respect to a matter of judgment. 10

11 The GAAP Standards for Accounting for Loss Contingencies 11

12 Auditors Objective The auditors overall objective in making inquiry of a client s lawyers is to verify the accuracy of both the financial statement accrual and the disclosure regarding loss contingencies. The standards governing how loss contingencies are presented in financial statements are set out in the applicable GAAP accounting standards, principally ASC

13 Accounting for Loss Contingencies ACS 450 contains the following accounting concepts and requirements: A loss contingency is an existing condition, situation or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when one or more events occur or fail to occur. 13

14 Accounting for Loss Contingencies When a loss contingency exists, the likelihood that a future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote. There are three areas within that range, defined as follows: i. Probable- The future events are likely to occur. ii. Reasonably possible- The chance of the future event or events occurring is more than remote but less than likely. iii. Remote- The chance of the future event or events occurring is slight. 14

15 Accounting for Loss Contingencies When a loss contingency exists, there are three possible financial reporting alternatives. Accrual of a liability, disclosure (usually in the footnotes), or no accrual or disclosure (only if the loss contingency is remote). Accrual in a client s financial statements by a charge to income of the reporting period will be required if both the following conditions are met: i. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss. ii. The amount of loss can be reasonably estimated. 15

16 Accounting for Loss Contingencies Disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred and either of the following conditions exist: i. An accrual is not made for a loss contingency because the required conditions are not met. ii. An exposure to loss exists in excess of the amount accrued. 16

17 Accounting for Loss Contingencies The disclosure shall indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or state that such an estimate cannot be made. Disclosure is not required of a loss contingency involving an unasserted claim or assessment if there has been no manifestation by potential claimants of an awareness of a possible claim or assessment unless it is considered probable that a claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable. 17

18 The Lawyer s Obligations to the Client 18

19 Applicable Alaska Ethics Rules Alaska Rules of Professional Conduct Rule 1.6 provides that a lawyer shall not reveal a client s confidence or secret unless the client gives informed consent. Alaska Rule 1.6 is narrower than Model Rule 1.6 in that it only restricts disclosure of confidences and secrets as opposed to information relating to a client. Informed consent is necessary to respond to auditors. 19

20 Discoverability Issues Waiver of the attorney-client and work product privileges is a risk with disclosing information to auditors. The ABA Policy is intended to reduce the likelihood of any waiver of privilege with respect to asserted and unasserted claims. It is structured so that a lawyer s response provides limited information regarding loss contingencies that can be found in the public record. There is no consensus among the courts that have addressed the discoverability of audit response letters. A 2004 California opinion held that a response letter was protected by the work product doctrine. See Laguna Beach County Water District v. Superior Court of Orange County, 22 Cal. Rptr. 3 rd 387 (Cal. App. 2004). However, the court reached the opposite conclusion in Medinol, Ltd. v. Boston Scientific Corp., 214 F.D.R. 113 (SDNY 2004). 20

21 The Lawyer s Response to Auditors 21

22 The ABA Statement of Policy In December 1975 the ABA issued its Statement of Policy Regarding Lawyers Responses to Auditors Requests for Information. See 31 Bus. Law 1709 (1976). The ABA Policy outlines the tension between the auditors objectives and the confidentiality responsibility of the lawyer, including the potential for waiving the attorney-client privilege against disclosure by responding to auditors inquiries. The ABA Policy distinguishes information regarding pending litigation with information regarding other contingencies and asserts that it is not in the public interest for lawyers to be required to respond to general inquiries regarding possible claims. 22

23 The ABA Statement of Policy The ABA Policy states that a lawyer may properly respond to the auditors request for information regarding loss contingencies subject to the following: Assuming that the client s initial letter requesting the lawyer to provide information to the auditor is signed by an agent of the client having apparent authority to make such a request, the lawyer may provide to the auditor information requested, without further consent, unless such information discloses a confidence or secret or requires an evaluation of a claim. In the normal case, the initial request letter does not provide the necessary consent to the disclosure of a confidence or secret or to the evaluation of a claim since such a consent may only be given after full disclosure to the client of the legal consequences of such action. Lawyers should bear in mind, in evaluating claims, that an adverse party may assert that any evaluation of potential liability is an admission. 23

24 Overall Limitations on a Lawyer s Response The ABA Policy states that it is appropriate for the lawyer to set forth in the response, by way of limitation, the scope of his or her engagement by the client. The ABA Policy also provides that, unless the response indicates otherwise, it is limited to matters which have been given substantive attention by the lawyer in the form of legal consultation since the beginning of the period being reported upon. Where the lawyer is limiting his or her response in accordance with the Statement of Policy, the response should so indicate. 24

25 Overall Limitations on a Lawyer s Response Unless otherwise stated in the lawyer s response, the response is solely for the auditors information in connection with the audit and is not to be quoted or otherwise referred to in any financial statements of the client or related documents. 25

26 Specific Information Regarding Loss Contingencies The ABA Policy states that when properly requested by the client, it is appropriate for the lawyer to furnish to the auditors information concerning the following matters if the lawyer has been engaged by the client to represent or advise the client professionally with respect thereto and has devoted substantive attention to them in the form of legal representation or consultation: Overtly threatened or pending litigation, whether or not specified by the client. A contractually assumed obligation, which the client has specifically identified and upon which the client has specifically requested, in the inquiry letter or a supplement, comment to the auditors. An unasserted possible claim or assessment which the client has specifically identified and upon which the client has specifically requested, in the inquiry letter or a supplement, comment the auditors. 26

27 Specific Information Regarding Loss Contingencies The ABA Policy states that the information that lawyers may properly give to the auditors concerning the matters described above would include an identification of the proceedings or matter, the stage of the proceedings, the claim asserted, and the position taken by the client. 27

28 Predicting Outcomes The ABA Policy takes a very circumspect view of what a lawyer should and should not provide regarding assessments of the outcome of a claim. The ABA Policy states: In view of the inherent uncertainties, the lawyer should normally refrain from expressing judgements as to outcomes except in those relatively few clear cases where it appears to the lawyer that an unfavorable outcome is either probable or remote; for purposes of any such judgement it is appropriate to use the following meanings: Probable - an unfavorable outcome for the client is probable if he prospects of the claimant not succeeding are judged to be extremely doubtful and the prospects for success by the client in its defense are judged to be slight. Remote - an unfavorable outcome is remote if the prospects for the client not succeeding in its defense are judged to be extremely doubtful and the prospects of success by the claimant are judged to be slight. 28

29 Predicting Outcomes The ABA Policy provides that if a lawyer does not express a judgement regarding an outcome of a claim or matter, no inference should be drawn, from the absence of such a judgement, that the client will not prevail. If the lawyer is asked to estimate in dollar terms the potential amount of loss or range of loss in the event that an unfavorable outcome is not viewed to be remote, the amount or range or potential loss will normally be as inherently impossible to ascertain, with any degree of certainty, as the outcome of the litigation. Therefore, it is appropriate for the lawyer to provide an estimate of the amount or range of potential loss (if the outcome should be unfavorable) only if he or she believes that the probability of inaccuracy of the estimate of the amount or range of potential loss is slight. In most cases the lawyer will not be able to provide any such estimate to the auditor. 29

30 Suggested Approaches for Response Letters Annex A to the ABA Policy contains an illustrative form of response letter for use by each of outside counsel and inside general counsel. Adopt procedures to identify all lawyers who may have information relevant to the response. 30

31 Suggested Approaches for Response Letters Adhere to the ABA Statement of Policy: State that the response is in conformity with the ABA Policy. Require a written request by client. Respond only in writing and provide only the types of information contemplated by the ABA Policy. Develop model forms and procedures and use them. Designate lawyers with expertise as reviewers. Treat it like an opinion letter. 31

32 Suggested Approaches for Response Letters In the situation where a lawyer cannot conclude that the outcome of a claim is probable or remote (and it is probable that this will involve most situations), the following paragraph is appropriate: The ABA Statement of Policy Regarding Lawyers Responses to Auditors Requests for Information (December 1975) defines very limited circumstances in which an attorney should provide auditors with the attorney s opinion on the outcome of litigation or potential range of loss in litigation. Consistent with that Statement, we do not provide an opinion as to the probable outcome of this case or as to a potential range of loss in the event of an unfavorable outcome. 32

33 Suggested Approaches for Response Letters In situations where the scope of the lawyer s engagement does not include disclosure, the following response may be appropriate. The Company's letter requested that we confirm to you that whenever, in the course of performing legal services for the Company with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for financial statement disclosure, we have formed a professional conclusion that the Company must disclose or consider disclosure concerning such possible claim or assessment, we, as a matter of professional responsibility to the Company, will so advise the Company and will consult with it concerning such disclosure and the applicable requirements of ACS 450. Our engagement by the Company is described in the second paragraph of this letter. We do not understand such engagement to include responsibility for advising the Company with respect to any requirement of disclosure; accordingly, we decline to confirm the understanding attributed to the Company. If it is the Company's desire that the scope of our engagement include advice on financial statement disclosure, we request such confirmation in writing and the opportunity to discuss with the Company the nature, extent, and cost of such engagement. 33

34 Suggested Approaches for Response Letters Audit letters sometimes request information that is beyond the scope of responses as set forth in the ABA Policy. Examples of these requests include a request to confirm the existence of any financing statement filed listing the client as a debtor or the existence of an assignment for the benefit of the client s creditors. The following paragraph may be an appropriate response. The Company s letter asked that we advise you as to. This request is beyond the scope of responses as set forth in the ABA Statement of Policy regarding Lawyer s Responses to Auditor s Requests for Information (December 1975) and, accordingly, we decline to respond to this request. 34

35 Audit Letter Updates 35

36 Recent Developments The Audit Response Committee of the ABA Business Law Section recently published its Statement on Updates to Audit Response Letters at 70 Bus. Law. 489 (2015). 36

37 Recent Developments This Statement provides a framework for responses to update requests including the following: A lawyer may only provide information to the auditor at the client s request. No specific form of authorization is required. It can be via or delivered orally, but it is advisable to document the request in some way. Clients and auditors should recognize that lawyers may have to perform internal review procedures to issue an update. Firms or law departments may only canvass lawyers who have performed services since the previous cutoff date. Updates ordinarily should be delivered in writing, not communicated orally. 37

38 Responding to Auditors on Loss Contingencies How to Keep the Peace Under the Treaty Steven Miller