Academic journal article Auditing: A Journal of Practice & Theory

An Experimental Investigation of the Efficacy of Lawyers' Letters

Academic journal article Auditing: A Journal of Practice & Theory

An Experimental Investigation of the Efficacy of Lawyers' Letters

Article excerpt

INTRODUCTION

Organizations are routinely subjected to various types of litigation. Although the ultimate outcome of pending or threatened litigation is often uncertain, SFAS No. 5 (FASB 1975) requires that a company report a liability and an accompanying expense in its financial statements for litigation contingencies when an unfavorable outcome is (1)probable and (2) reasonably estimable. (1) However, the concepts "probable" and "reasonably estimable" permit substantial latitude in interpretation and application by management. (2)

With regard to litigation loss contingencies, SAS No. 12 (AICPA 1976) requires auditors to have management request from its outside lawyers, letters directed to the auditor discussing the legal matters with which the lawyers have had substantive involvement (hereafter, "lawyers' letters"). Among the information to be provided to the auditor is "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" (AICPA 2000, AU 337.09). (3)

Auditors rely heavily on corroborating information contained in lawyers' letters in evaluating management's representations about litigation contingencies. If, for example, a lawyer concludes in his/her letter that a potential litigation loss is either not probable or cannot be reasonably estimated, then the auditor has little, if any, basis for requiring management to report a liability and the corresponding expense in its financial statements. Other audit procedures specified in SAS No. 12, such as inquiries of management and examination of the client's correspondence with legal counsel, are not alternatives for the corroboration provided by lawyers' letters. Moreover, auditors generally cannot turn to other legal experts (including their own counsel) because of the inability of such experts to access confidential details about the litigation and their lack of knowledge about how the client's lawyers plan to defend against the action (see Behn and Party 1995, 67). Accordingly, it is important for auditors to determine the relative effectiveness of lawyers' letters in corroborating clients' litigation contingencies. Unfortunately, the accounting literature discussed below suggests that lawyers may be reluctant to provide auditors with estimates of likelihoods and corresponding losses because of the lack of privilege protection covering the communications with auditors and the differences between auditors' and lawyers' interpretations of "probable." We also question whether the relative materiality of the potential damages may affect lawyers' willingness to respond.

The purpose of this study is to conduct the first exploratory empirical investigation of the efficacy of lawyers' letters. Law students are used as surrogates for practicing lawyers in an experimental design that manipulates privilege, likelihood of an unfavorable outcome, and materiality of potential loss. The results of the study indicate that the absence of privilege and likelihoods of unfavorable litigation outcomes that approach auditors' lower bound for accrual may inhibit lawyers' responses to auditors, suggesting that liabilities and expenses may be undetected by auditors and underreported in audited financial statements.

The remainder of this paper is organized as follows. The next section draws on relevant literature in developing the hypotheses, while the third section describes the method. The results are presented in the fourth section, and the final section is devoted to a discussion of results and suggestions for future research.

RELEVANT LITERATURE AND HYPOTHESES DEVELOPMENT

The accounting literature bearing directly on lawyers' letters consists of interpretative commentary on the relevant authoritative pronouncements, which are SFAS No. 5, SAS No. 12, and the Board of Governors of the American Bar Association's (ABA) (1975) Statement of Policy Regarding Lawyers' Responses to Auditors' Requests for Information (hereafter "Statement") and accompanying "Commentary" (reproduced as an appendix to SAS No. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.