There has been some confusion over the role of lawyer audit response letters under the ABA Statement and related AICPA auditing standard (together the so-called “Treaty”) and the relationship of those response letters to the accounting standards governing the accrual and disclosure of loss contingencies. This confusion is reflected in reactions to the FASB’s proposal to revise the accounting standard for loss contingencies and to a recent statement by Wayne Carnall, Chief Accountant of the SEC’s Division of Corporation Finance, warning companies against over-reliance on the Treaty in reporting litigation contingencies in financial statements. If the Treaty is properly understood, that statement should not, itself, be cause for concern.
The Treaty is an auditing standard designed to provide audit support for a company’s accounting for loss contingencies in accordance with applicable accounting standards, principally Accounting Standards Codification 450-20 (formerly Financial Accounting Standard No. 5). As an auditing standard, the Treaty addresses the lawyer’s response to the auditors and is just one part, though a key part, of the auditing process in which auditors gather and verify information. It does not address the disclosure requirements for the company’s accounting for loss contingencies, but rather deals with the information lawyers are to provide to the auditors. The Treaty was carefully constructed so that it provides audit comfort to the auditors, as a third party, while preserving the confidentiality of client communications and the fundamental protections of attorney-client privilege, thereby encouraging consultation by the client with counsel as critical to promoting voluntary legal compliance. Thus, the information provided by lawyers in the audit response letter to auditors is more tailored than the information companies may be required to disclose pursuant to the accounting standards. The Treaty does not foreclose the auditor from obtaining additional information from the company consistent with the underlying purposes of the Treaty. Nor does the Treaty address the advice lawyers give their client companies regarding the company’s disclosure obligations. Significantly, audit response letters under the ABA Statement reaffirm the role of lawyers, when appropriate in connection with their engagement, in advising clients regarding disclosure.
The lawyer’s audit response letter provides meaningful information to the auditors by identifying overtly threatened and pending claims being handled by the lawyer and unasserted claims as to which the client specifically requests comment. In this way, the auditors are alerted to the existence of claims against the client. By confirming that the lawyer fulfills his or her professional responsibility, the audit response letter permits the auditor to rely on the continued involvement of the lawyer.
To illustrate the distinction between lawyer audit responses and company financial statement disclosures, lawyers in their audit response letter do not speculate on the amount of potential loss. Under the Treaty, they provide an estimate only if the risk of error in the estimate is “slight.” On the other hand, under ASC 450-20, a company may have to estimate the potential loss or range of losses and, if it cannot, explain why it cannot. The SEC has made this disclosure requirement clear as it seeks to ensure compliance with the existing accounting standard. Compliance with this requirement is the best way to convince the FASB that adoption of revised standards, which are likely to be more problematic, is not necessary.