At a recent New York Bar Association conference, Wayne Carnall, Chief Accountant of the SEC’s Division of Corporation Finance, warned registrants to avoid relying on the long-standing ABA-auditor “treaty” between lawyers and auditors when deciding what to report about litigation contingencies in financial statements. The American Bar Association’s (ABA) “Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information,” adopted in 1975, seeks to preserve attorney-client confidences by providing a structure for dialogue between auditors and corporate counsel regarding financial statement presentation of information on pending and potential litigation. Specifically, the treaty provides a template for the “auditor inquiry letters” directed to both inside and outside counsel, and cautions corporate counsel (both inside and outside) against providing certain kinds of information to outside auditors.

Chief Accountant Carnall warned attorneys and registrants that it was important to keep in mind that while both the ABA-auditor treaty and ASC 450 (formerly FAS 5) provide a framework for evaluating losses that may arise from litigation, the treaty is “not part of the accounting codification” and that the requirements of GAAP must control.

  • The ABA Statement of Policy cautions counsel against providing to auditors estimates about the amount or range of potential loss from a litigation (if the outcome should be unfavorable) unless the lawyer believes that the probability of inaccuracy is “slight.

By comparison:

  • ASC 450 requires registrants to evaluate whether a loss from litigation is “probable,” whether the amount of loss can be “reasonably estimated,” and, where the loss is both probable and can be reasonably estimated, to accrue an appropriate amount. Where accrual is not required, but a loss is nonetheless “reasonably possible,” the financial statements are required to include “an estimate of the possible loss or range of loss or a statement that such an estimate cannot be made.”

As a result of these two different standards, registrants were urged to keep in mind that the evaluation of potential losses arising from litigation could not depend solely on what was reported in the “auditor inquiry letters” and that registrants are required to conduct their own evaluation based on the ASC 450 standards. Carnall told the lawyers to “take a fresh look” at disclosure of litigation costs in preparing their clients’ quarterly and annual filings. “Don’t simply repeat what was done last year,” Carnall said. “Carefully, carefully comply with the standard.”

The Chief Accountant also echoed earlier remarks from the SEC that the staff is keeping a close eye on contingency disclosure to improve compliance with existing rules.