Academic journal article Journal of Accountancy

Limitations of Lawyers' Letters: Lawyers and Auditors Have Different Responsibilities in Litigation Reporting

Academic journal article Journal of Accountancy

Limitations of Lawyers' Letters: Lawyers and Auditors Have Different Responsibilities in Litigation Reporting

Article excerpt

Auditors must make inquiries of clients' lawyers to help them decide if the clients' financial statements should reflect possible future litigation losses. The usefulness of the lawyers' responses as audit evidence can be limited. Not understanding the limitations of lawyers' letters may lead auditors to violate professional standards unwittingly. When auditors receive lawyers' letters saying litigation losses are neither probable nor reasonably possible, is it safe to conclude financial statement disclosure is not required under accounting standards? Will a standard unqualified opinion meet audit requirements?

These questions are difficult to answer because lawyers' interpretations of their responsibilities in replying to auditors are different from auditors' expectations. Lawyers are reluctant to provide CPAs with estimates of the likelihood and corresponding dollar amounts of losses; thus, any information they provide must be evaluated carefully before it is used. This article discusses the accounting, auditing and legal issues related to reporting litigation loss contingencies; highlights differences in lawyer and CPA responsibilities that can lead to problems; and suggests procedures to overcome these difficulties.

ACCOUNTING AND AUDITING REQUIREMENTS

Proper accounting and auditing for litigation loss contingencies present numerous practice problems. The accounting and auditing standards for these contingencies--which result from litigation, claims, assessments and unasserted claims against a client--are general and require the exercise of considerable professional judgment.

The primary accounting requirements for litigation loss contingencies are outlined in Financial Accounting Standards Board Statement no. 5, Accounting for Contingencies, and FASB Interpretation no. 14, Reasonable Estimation of the Amount of a Loss. The auditing requirements are included in American Institute of CPAs Statement on Auditing Standards no. 12, Inquiry of a Client's Lawyer Concerning Litigation, Claims, and Assessments, and SAS no. 58, Reports on Audited Financial Statements. Exhibit 1, page 63, summarizes the accounting and auditing reporting requirements. Both the financial statement treatment and the impact on the audit report are affected by whether the likelihood of loss is remote, reasonably possible or probable.

EXHIBIT 1 Reporting on uncertainties

Likelihood of occurrence of event or events

Remote (slight chance)

Financial statement treatment

No disclosure is necessary (unless generally accepted accounting principles require one in a specified circumstance).

Effect on audit report

No explanatory paragraph is necessary.

Likelihood of occurrence of event or events

Reasonably possible (more than remote, but less than likely)

Financial statement treatment

Note disclosure is necessary.

Effect on audit report

Consider the need for an explanatory paragraph. The auditor is more likely to add an explanatory paragraph as the amount of reasonably possible loss becomes larger and/or the likelihood of occurrence of a material loss increases.

Likelihood of occurrence of event or events

Probable (likely to occur)

Financial statement treatment

a. Amount is capable of reasonable estimation--adjust accounts. b. Amount is not capable of reasonable estimation--note disclosure is necessary.

Effect on audit report

No explanatory paragraph is necessary.

Explanatory paragraph is required.

SAS no. 12, which deals specifically with lawyers' letters, says auditors should obtain evidential matter on litigation by determining

a. The existence of a condition, situation or set of circumstances that indicates uncertainty as to whether a possible loss to an entity could arise from litigation.

b. The period in which the underlying cause for legal action occurred. …

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