What we've got here is a failure to communicate.1
Pending litigation can be a significant source of potential liability for public companies. The lack of adequate disclosure of this potential liability has caused confusion for investors, lenders, and other financial statement users. Auditors are required to assess the appropriateness of financial statement disclosures regarding pending litigation. However, the auditor's ability to do so depends upon receiving information from the company's attorneys. Obtaining this information, however, is problematic because the accounting and auditing standards that guide auditors and the professional standards that guide attorneys have been at odds for the past thirty years. Recent scandals2 have resulted in legislation3 and increased scrutiny of the disclosure of contingent liabilities from pending litigation, thus magnifying this conflict between auditors and attorneys.
Parts II and III of this Article discuss the U.S. accounting standards and auditing standards applicable to pending litigation. Part IV identifies the issues raised by communications between attorneys and auditors, including the attorney-client privilege, the work product doctrine, and the American Bar Association guidelines4 on communications with a client's auditor. Part V describes three possible solutions offered by previous commentators to the conflict between attorneys and auditors and an assessment of the viability of these solutions. Finally, Part VI provides our conclusions and a recommendation for addressing this conflict.
II. U.S. ACCOUNTING STANDARDS REGARDING PENDING LITIGATION
Certified Public Accountants ("CPAs")5 play a critical role in the U.S. financial markets. Investors and lenders rely heavily on the information provided in a company's financial statements in making investment, lending, and other decisions regarding business with a particular company. As independent auditors, CPAs express their opinion regarding the reliability and integrity of a publicly traded company's financial statements based upon their examination and testing of the company's books and records.6 The U.S. Supreme Court has recognized the important role auditor's play, as discussed in the following statement:
The independent public accountant performing this special function [the audit] owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This "public watchdog" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.
As one commentator describes it, the auditor's duty is "to the reader of the client's financial reports and is public in nature."8
To form their opinion as to the fairness of the company's financial statements, the auditors must determine which items are material to the financial condition of the company, and this determination is "a matter of professional judgment made in light of surrounding circumstances, and necessarily involves both quantitative and qualitative considerations."9
Since 1973, the financial accounting principles that govern the preparation of financial statements for public companies have been the Generally Accepted Accounting Principles ("GAAP"), issued by the Financial Accounting Standards Board ("FASB").10 GAAP is "a technical accounting term that encompasses the conventions, rules, and procedures necessary to define accepted accounting practice . . . and . . . provide a standard by which to measure financial presentations."11 Thus, the FASB is the organization recognized as setting accounting and reporting standards in the United States.12
With regard to pending litigation, the relevant accounting standard is Statement of Financial Accounting Standard ("SFAS") No. 5 - Accounting for Contingencies,13 which provides the criteria for determining whether a company must accrue or disclose loss contingencies. …