TALKING TO THE AUDITORS:
ETHICAL PITFALLS IN COMMUNICATING WITH AUDITORS
June 24 – June 27, 2009
Erin K. Stewart, Moderator
University of North Texas System
Robert Roach
New York University
Brian R. Murphy
Dinse, Knapp & McAndrew, P.C.
Burlington, VT==
I.
LEGAL INQUIRY LETTERS: FROM THE ACCOUNTANT’S
PERSPECTIVE
A.
Auditing Standards: GAAP and GAAS.
Auditors are engaged to examine the financial statements of an organization or business
for the purpose of expressing an opinion whether the financial statements are “presented fairly,
in all material respects, in conformity with U.S generally accepted accounting principles.” 1
Related to this goal is the auditor’s obligation under “generally accepted auditing standards” to
obtain reasonable assurance that the financial statements are free from material misstatement in
order to support the expressed opinion.
In order to obtain reasonable assurance that the financial statements are free from material
misstatement, the auditor must gather various forms of audit evidence and perform audit
procedures in order to corroborate the assertions of management. In the case of a non-public
company, the standards governing an auditor’s work are set forth in “generally accepted auditing
standards” (“GAAS”), promulgated by the AICPA. In the case of a public company, the standards
governing an auditor’s work are established by the Public Company Accounting Oversight Board.2
It is important to understand that management is responsible for preparing the entity’s
financial statements in conformity with GAAP, and the auditor is responsible for auditing them
1
SAS No. 1, Codification of Auditing Standards and Procedures.
2
In the United States, the Auditing Standards Board (“ASB”), a body of the American Institute of Certified Public
Accountants (“AICPA”), formulates and interprets Generally Accepted Auditing Standards for auditors of nonpublic companies. The ASB issues authoritative pronouncements on auditing known as “Statements on Auditing
Standards,” commonly abbreviated “SAS.” For auditors of public companies, the Public Company Accounting
Oversight Board (“PCAOB”), a private-sector, nonprofit corporation created by the Sarbanes-Oxley Act, is
responsible for setting auditing, quality control, ethics, independence and other standards relating to the preparation
of audit reports. Internationally, auditing standards are set by the International Auditing and Assurance Standards
Board (“IAASB”), which issues guidance in the form of International Standards on Auditing (“ISAs”).
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in order to express an opinion whether the financial statements comply with GAAP. If assertions
by management contained in financial statements cannot be corroborated, the auditor may lack
the reasonable assurance to support its opinion as required by GAAS or PCABO auditing
standards. Thus, developments in GAAP cannot occur in isolation. They must be developed in
conjunction with the development of auditing standards. If GAAP requires a presentation or
disclosure that cannot be corroborated by the auditor, the auditor will be unable to express an
opinion on the entity’s financial statements (or at least with respect to the particular item). For
this reason, in evaluating amendments to the current rules governing accounting for loss
contingencies, FASB has been careful to understand how auditors corroborate management’s
assertions in communications with lawyers and the tension between promoting “transparency” in
financial statements (in order to provide financial statement users with the information they
need) and the competing goal of permitting organizations to freely communicate with their
lawyers (without prejudice that might result from those communications).
B.
Client’s Responsibilities with respect to Financial Statements.
In every audit engagement, the client is required to make a comprehensive set of
representations to the auditor in a letter commonly known as the “management letter.”
Specifically with respect to loss contingencies, the client will typically make the following
representations in the management letter: 3
“There are no (A) violations or possible violations of laws or regulations whose
effects should be considered for disclosure in the financial statements or as a basis for
recording a loss contingency, (B) unasserted claims or assessments that our lawyer has
advised us are probable of assertion and must be disclosed in accordance with Financial
Accounting Standards Board (FASB) Statement No. 5, Accounting for Contingencies, or
(C) other liabilities or gain or loss contingencies that are required to be accrued or
disclosed by FASB Statement No. 5.”
Note the client’s understanding that its lawyer will advise it with respect to loss
contingencies that are probable of assertion and must be disclosed in the financial statements in
accordance with SFAS No. 5
C.
Accounting for Loss Contingencies: SFAS No. 5.
In order for financial statements to be in compliance with GAAP, an organization must
record (or disclose in the footnotes) “loss contingencies” in accordance with Statement on
Financial Accounting Standards (SFAS) No. 5, “Accounting for Contingencies.” 4 The concept
of loss contingencies is much broader than potential losses from litigation and potential claims
3
See text at paragraph 11 of AU 333 sample letter (management representations letter).
4
Statements of Financial Accounting Standards, commonly abbreviated “SFAS,” are issued by the Financial
Accounting Standards Board (“FASB”). FASB is a nonprofit organization whose primary purpose is to develop
generally accepted accounting principles (GAAP) within the United States. FASB is not a governmental body. The
SEC has legal authority to establish financial accounting and reporting standards for publicly held companies under
the Securities Exchange Act of 1934, but historically the SEC has relied on the private sector for this function to the
extent that the private sector has demonstrated an ability to fulfill the responsibility.
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and includes potential losses attributable to uncollectible receivables, product warranties, risk of
loss or damage to property, guarantees of others, and the threat of expropriation of assets. (See
SFAS No. 5, Appendix A, ¶22-45). 5 The resolution of a contingency may reduce an asset or
existing liability or, as in the case of litigation, may result in the incurrence of a liability.
The implementation of the standards of SFAS No. 5 involves a two-step process. First,
the likelihood of the future event or events confirming the incurrence of a liability (or the loss or
impairment of an asset) is classified as either “probable,” “reasonably possible,” or “remote.”
Then, after the likelihood of the loss has been categorized, the contingency is evaluated to
determine whether it should be reflected in the financial statements, either by recording (i.e.,
accruing) the liability or loss on the balance sheet or by disclosing the potential loss in the
footnotes to the financial statements.
Step No. 1: Classification of Loss Contingency. When a loss contingency exists, SFAS
No. 5 uses the following terms to categorize the likelihood that a future event or events will
confirm the loss or liability:
“Probable” – If the future event or events confirming the loss are likely to occur,
the likelihood is considered “probable.” 6
“Reasonably possible” - If the chance of the future event or events occurring is
more than remote but less than likely, the likelihood of the loss is considered “reasonably possible.”7
“Remote” - - If the chance that the future event or events confirming the loss will
occur is slight, the likelihood of the loss is considered “remote.” 8
Step No. 2 – Determine Financial Statement Impact. A loss contingency is required to
be either recorded on the balance sheet, disclosed in the footnotes to the financial statements, or
not disclosed at all, as follows:
▪ Accrual Required -- If the amount of the loss is probable and can be “reasonably
estimated,”9 the loss or liability must be booked (i.e., accrued) on the financial statements.10
5
A copy of SFAS No. 5 may be obtained online at the FASB website at http://www.fasb.org/pdf/fas5.pdf
6
SFAS No. 5, ¶3a. IMPORTANT NOTE! The definition of “probable” set forth in the ABA Statement of Policy
is different from SFAS No. 5’s definition of “probable.” Paragraph 5 of the ABA Statement of Policy defines
“probable” as meaning “the prospects of the claimant not succeeding are judged to be extremely doubtful and the
prospects for success by the client in defending the claim are judged to be slight.”
7
SFAS No. 5, ¶3b.
8
SFAS No. 5, ¶3c.
9
When the reasonable estimate of the loss is a range and one amount appears to be a better estimate than any other
amount within the range, that amount shall be accrued. When no amount within the range is a better estimate than
any other amount, the minimum amount in the range shall be accrued. FASB Interpretation No. 14 (FIN 14),
Reasonable Estimation of the Amount of a Loss, ¶3. Disclosure of the exposure to loss above the minimum amount
is further required if there is at least a “reasonable possibility” of loss in excess of the minimum amount.
10
SFAS No. 5, ¶8. In order for a loss contingency to be subject to accrual under the rules of SFAS No. 5, the loss
contingency must exist as of the date of the financial statements (i.e., the end of the most recent accounting period
for which the financial statement are being presented). If a loss contingency that occurs after the date of the
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▪ Disclosure in Footnotes Required -- If the amount of the loss is not probable or
cannot be “reasonably estimated” but there is a “reasonably possibility” that a loss has been
incurred, the loss contingency must be disclosed in the footnotes to the financial statements. 11 In
the case of an unasserted claim, disclosure is only necessary if it is considered “probable” that a
claim will be asserted and there is a reasonable possibility that, if asserted, the outcome of the
claim will be unfavorable. If the potential claimant has not manifested an awareness of the
potential claim or assessment, that may indicate that assertion of the claim is not probable.
▪ No Accrual or Disclosure Required -- If there is not a “reasonable possibility”
that a loss has been incurred (i.e., likelihood of loss is “remote”), no accrual or disclosure of the
loss contingency is required.
D.
The Critical Distinction Between “Asserted” and “Unasserted Claims” under
SFAS No. 5.
SFAS No. 5 makes an important distinction between asserted claims and unasserted
claims. In the case of an unasserted claim, unless the judgment is that the assertion of the claim
is “probable,” there is no obligation to accrue or disclose the loss contingency. For example, a
company may believe that it has infringed another company’s patent rights. If the other
company has not indicated an intention to take any action regarding the infringement and has not
even indicated an awareness of the possible infringement, there is no obligation to accrue or
disclose the loss contingency unless the assertion of the potential claim is considered probable
(i.e., likely). In the case of a catastrophe, accident, or other similar physical occurrence that
would typically engender claims for redress, the assertion of claims may be probable. Similarly,
in the case of an investigation by a governmental agency that is known to the general public, the
assertion of private claims for redress may also be considered probable.12 The Commentary
accompanying the ABA Statement of Policy states with respect to unasserted claims that the
judgment concerning whether the assertion of a claim is “probable” will infrequently be one
within the professional competence of lawyers. 13
E.
Examples of SFAS No. 5 Footnote Disclosures.
AU 337 - Illustration 6 provides the following examples of financial statement
disclosures with respect to litigation, claims, and assessments:
financial statements (e.g., a threat of expropriation that occurs after the date of the financial statements and prior to
the issuance of the audit report, disclosure (but not accrual) may be necessary to keep the financial statements from
being misleading. SFAS No. 5, ¶11.
11
SFAS No. 5, ¶10. It is important to note that there may be cases where there is an exposure to loss in excess of the
amount that is required to be accrued (i.e., loss is probable and amount of loss may be reasonably ascertained) and
disclosure of the potential additional loss is appropriate because there is a “reasonable possibility” that the additional
loss may have been incurred. (See SFAS No. 5, ¶39 (example)).
12
SFAS No. 5, ¶38 (example).
13
ABA Statement of Policy, Commentary at ¶5.2.
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Example 1: No accrual is made for litigation because the likelihood of a material adverse
outcome is remote
The Company is a defendant in a case entitled Jones vs. the Company, which is in the
United States District Court in the Northern District of California. The case arose from
claims by Mrs. Jones, a former employee, that the Company had discriminated against her
during her employment at the Company. The suit seeks damages totaling $1,500,000. The
Company believes that the claims are without merit and intends to vigorously defend its
position. The ultimate outcome of this litigation cannot presently be determined. However,
in management’s opinion, the likelihood of a material adverse outcome is remote.
Accordingly, adjustments, if any, that might result from the resolution of this matter have
not been reflected in the financial statements.
Example 2: No accrual is made of potential liability because management does not believe
it is probable
A former employee of the Company has filed a workers’ compensation claim related to
injuries incurred in connection with the September 20X2 fire at the Company’s Temecula
facility. In the claim, the employee is requesting payment of an additional 15% award of
compensation, approximately $450,000, claiming the Company violated a state safety
statute in connection with the occurrence of his injury. As of December 31, 20X2, the
Company has not recorded a provision for this matter as management intends to vigorously
defend these allegations and believes the payment of the penalty is not probable. The
Company believes, however, that any liability it may incur would not have a material
adverse effect on its financial condition or its results of operations.
Example 3: Accrual is made but exposure exists in excess of amount accrued
The Company is a defendant in a lawsuit, filed by a former supplier of electronic
components alleging breach of contract, which seeks damages totaling $750,000. The
Company proposed a settlement in the amount of $500,000, based on the advice of the
Company’s legal counsel. Consequently, $500,000 was charged to operations in the
accompanying 20X2 financial statements. However, if the settlement offer is not accepted
by the plaintiff and the case goes to trial, the amount of the ultimate loss to the Company, if
any, may equal the entire amount of damages of $750,000 sought by the plaintiff.
Example 4: Unasserted claim relating to product defects
In September 20X2, the Company announced that it will conduct an inspection program to
eliminate a potential problem with an electrical component supplied to various
manufacturers of microwave ovens. The ultimate cost of the repair will not be known until
the inspection program is complete, which could have a material impact on the Company’s
financial condition and results of operations.
Example 5: Contingent liability resulting from government investigation
The Company is currently the subject of certain U.S. government investigations. If the
Company is charged with wrongdoing as a result of any of these investigations, the
Company could be suspended from bidding on or receiving awards of new government
contracts pending the completion of legal proceedings. If convicted or found liable, the
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Company could be fined and debarred from new government contracting for a period
generally not to exceed three years.
Example 6: Litigation settlement is subject to a confidentiality agreement
In January 20X2, Stuart Construction Co. (“Stuart”) filed suit against the Company alleging
that the Company had failed to provide coated, welded pipe, fittings, and joints in
accordance with contract specifications for a construction project in the Pacific Grove area.
In November 20X2, the parties involved agreed to settle the suit. The financial terms of the
settlement are subject to a confidentiality agreement; however, the settlement will not have
a material impact on the Company’s financial condition or results of operations.
F.
Statement on Auditing Standards No. 12, Inquiry of a Client's Lawyer
Concerning Litigation, Claims, and Assessments, (January 1976).
The auditor is required to perform audit procedures in order to obtain sufficient
appropriate evidence to support the auditor’s opinion. In performing audit procedures with
respect to loss contingencies, the auditing standards provide a variety of procedures to be
undertaken with respect to litigation, claims, and assessments, including discussions with
management and a review of documentation in the client’s possession regarding litigation,
claims, and assessments, including correspondence and invoices from lawyers.
To obtain sufficient appropriate audit evidence concerning loss contingencies, the auditor is
required to send a letter of audit inquiry to the client’s lawyer(s) as the primary means of
corroborating the information furnished by the management of the company regarding litigation,
claims, and assessments. The auditing standard indicates that the client’s inside general counsel or
legal department may provide the auditor with the necessary corroboration, but further states that
“evidential matter obtained from inside counsel is not a substitute for information outside counsel
refuses to furnish.” AU 337 ¶.08.
A sample audit inquiry letter is attached as Exhibit A.
Since issuance of SAS No. 12 in 1976, the Accounting Standards Board has periodically
issued interpretations of SAS No. 12 standards. These interpretations are set forth in AU Section
9337, Inquiry of a Client’s Lawyer Concerning Litigation, Claims, and Assessments: Auditing
Interpretations of Section 337. (See “Resources” section of this outline for weblink to AICPA
Statements on Auditing Standards).
G.
Lawyer’s Responses to Audit Inquiry Letters.
In reviewing a response from a lawyer, the auditor needs to evaluate the acceptability of the
response for auditing purposes. Some statements are not acceptable, such as “From what we
presently know, it appears that the company has a good chance of prevailing” or “We are unable to
express an opinion, but management believes . . . .” These types of statements do not corroborate
the probability of outcome or the amount or range of loss. The auditing literature provides the
following examples of lawyer’s responses that are clear and responses that are not clear:
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Examples of Lawyers’ Responses that are Not Clear About the Likelihood of an
Unfavorable Outcome (AU 337 – Illustration 4):
▪ “This action involves unique characteristics wherein authoritative legal precedents do not
seem to exist. We believe that the plaintiff will have serious problems establishing the company’s
liability under the act; nevertheless, if the plaintiff is successful, the award may be substantial.”
▪ “It is our opinion that the company will be able to assert meritorious defenses to this
action.” (The term “meritorious defenses” indicates that the company’s defenses will not be
summarily dismissed by the court; it does not necessarily indicate counsel’s opinion that the
company will prevail.)
▪ “We believe the action can be settled for less than the damages claimed.”
▪ “We are unable to express an opinion on the merits of the litigation at this time. The
company believes there is absolutely no merit to the litigation.” (If client’s counsel, with the
benefit of all relevant information, is unable to conclude that the likelihood of an unfavorable
outcome is “remote,” it is unlikely that management would be able to form a judgment to that
effect.)
▪ “In our opinion, the company has a substantial chance of prevailing in this action.” (A
“substantial chance,” a “reasonable opportunity,” and similar terms indicate more uncertainty
than an opinion that the company will prevail.)
Examples of Lawyers’ Responses that Are Clear that the Likelihood of an Unfavorable
Outcome is Remote (AU 337 – Illustration 5):
▪ “We are of the opinion that this action will not result in any liability to the company.”
▪ “It is our opinion that the possible liability to the company in this proceeding is
nominal in amount.”
▪ “We believe the company will be able to defend this action successfully.”
▪ “We believe that the plaintiff’s case against the company is without merit.”
▪ “Based on the facts known to us, after a full investigation, it is our opinion that no
liability will be established against the company in these suits.”
II.
THE DUTY OF COLLEGES AND UNIVERSITY TO DISCLOSE
INFORMATION TO ITS AUDITORS VS. THE NEED TO PRESERVE
ATTORNEY CLIENT AND WORK PRODUCT PRIVILEGES
Over the last decade, federal laws and policies have required ever increasing vigilance by
corporate officials, representatives, and agents, including its attorneys and auditors, to detect and
prevent wrongdoing, including financial statement fraud. A panoply of federal legislation and
policies, including the Sarbanes Oxley Act, 14 the Federal Sentencing Guidelines for
14
(Pub.L. 107-204, 116 Stat. 745, enacted July 30, 2002).
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Organizations, 15 Federal Acquisition Regulations, 16 the Federal Deficit Reduction Act (dealing
with Medicare and Medicaid and the False Claims Act), 17 the U.S. Health and Human Services
(HHS) Office of Inspector General Guidelines, 18 to name a few, have imposed new and
frequently rigorous requirements on organizations of all types to detect and prevent wrongdoing.
In response to these new rules, organizations frequently engage attorneys to design
internal controls and procedures, conduct confidential internal investigations, provide advice on
appropriate governance and management roles, and respond on occasion to government
investigations and civil and criminal litigation. All of these activities result in confidential
communications between attorneys and their organizational clients, as well as records reflecting
the attorneys’ work product.
Accountants and Auditors also face new oversight by the Securities and Exchange
Commission (SEC), the Public Accounting Oversight Board (“PCAOB”), as well as more
stringent accounting principles and auditing standards to help assure greater accuracy and
transparency in accounting controls, processes, and financial statements.
Colleges and universities in the United States are frequently organized as not-for-profit
corporations. While not-for-profits do not face all of the accounting and financial disclosure
requirements of corporations whose stocks are publically listed and traded, colleges and
universities nonetheless typically prepare an annual report, including audited financial statements
prepared in accordance with Generally Accepted Accounting Principles (GAAP) and their
external auditors’ activities are governed by Generally Accepted Auditing Standards (GAAS).
As described in Section I above, in evaluating a reporting entity’s compliance with Financial
Accounting Standard’s Board Statement No. 5 (SFAS No. 5), external auditors must obtain
information from college or university attorneys to ascertain whether the institution has appropriately
accounted for loss contingencies that accurately reflect possible future damages, penalties, and/or
fines arising out of existing and/or potential litigation.
15
United States Sentencing Commission, Guideline Manual, § 8B2.1 (Sentencing of Organizations). These
Guidelines set forth the requirements for organizations to establish and effective ethics and compliance program.
Organizations must establish internal controls to prevent and detect criminal conduct, investigate alleged criminal
wrongdoing and take appropriate disciplinary and corrective action. While the Federal Sentencing guidelines are by
their terms optional for organizations, as a matter of fiduciary responsibility, Colleges and Universities may be
required to have effective ethics and compliance programs as set forth in the Federal Sentencing Guidelines. See In
re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).
16
See 73 Fed. Reg. 67064, FAR Case 2007-006, Contractor Business Ethics Program and Disclosure Requirements
(November 12, 2008), which apply compliance program provisions (Subpart 3.10) and clauses (52.203-13 and
52.203-14).
17
The Deficit Reduction Act of 2005 provided that any entity that receives or makes annual payments under a
Medicaid State plan of at least $5,000,000 must, as a condition of receiving such payments, establish written policies
for employees, contractors, and agents that provide detailed information regarding the federal and state false claims
laws, including remedies and whistleblower protections. Pub. L. No. 109-171, § 6032(a)(3).
18
The HHS OIG alone has issued 14 compliance guidelines for recipients of Medicare and Medicaid funds. See
http://www.oig.hhs.gov/fraud/complianceguidance.asp
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Proposed amendments to SFAS No. 5, if adopted, will present critical challenges for
college and university attorneys, because these new and more rigorous standards may place
conflicting demands on college and university auditors and attorneys. If the institution’s attorneys
provide external auditors with the type and quantity of information the auditors may need about
pending or potential litigation, the attorneys’ disclosure may result in the loss of attorney client and
work product privileges that protect confidential client communications, information, and records.
If the attorneys refuse to provide the requested information, the auditors may be required to issue
qualified financial statements or may possibly refuse to certify their accuracy.
To fully appreciate this dilemma, an understanding of attorney client and work product
privileges is essential.
A.
The Attorney Client Privilege
It is widely recognized that the attorney-client privilege is “the oldest of the privileges for
confidential communication known to the common law.” 19 Wigmore, in his seminal treatise on
evidence, describes the attorney client privilege:
[W]here legal advice of any kind is sought from a professional legal advisor
in his capacity as such, the communications relevant to that purpose, made in
confidence by the client, are at his instance permanently protected from
disclosure by himself or the legal advisor except the protection be waived. 20
The purpose of the privilege is to “encourage full and frank communication between
attorneys and their clients and thereby promote broader public interests in the observance of law
and administration of justice.” 21 The privilege attaches not only to communications from the
client to the attorney, but also to confidential communications from the attorney to the client. 22
While the privilege has been criticized at times as a barrier to finding the truth, it has nonetheless
been upheld because the privilege, “promotes a public goal transcending the normally
predominant principle of utilizing all rational means for ascertaining the truth.” 23
The attorney client privilege applies to corporations 24 and other business organizations. 25
In Upjohn v. United States, the U.S. Supreme Court set forth the standards for establishing a
corporate attorney-client privilege:
1. corporate employees made communications to counsel;
19
Upjohn Co. v. United States, 449 U.S. 383, 389 (1981).
20
8 John H. Wigmore, Evidence in Trial at Common Law, § 2292 (John T. McNuaghten ed., 1961).
21
Upjohn Co., 449 U.S. at 389.
22
See, e.g., Metropolitan Life Insurance Company v. Aetna Casualty & Surety Co., 730 A.D.2d 61, 60 ( Conn.
1999); Byrd v State, 929 S.W.2d 151, 154 (Ark. 1996). See also, In re Sealed Case, 877 F.2d 976 (D.C. Cir. 1989).
23
Trammel v. United States, 445 U.S. 40, 50 (1980).
24
Upjohn, 449 U.S. at 394-395.
25
See, e.g., In re Bieter Co., 16 F.3d 929, 935 (8th Cir. 1994).
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2. corporate superiors directed the communications, so that the company could
obtain legal advice from counsel;
3. the employees knew that the purpose of the communications were to allow the
company to obtain legal advice;
4. the information was not available from upper management;
5. the employees spoke about matters within the scope of their corporate duties; and
6. the communications were confidential and the company kept the communications
confidential. 26 That is, the communication was not disseminated beyond those
persons who, because of the corporate structure, need to know its contents. 27
The attorney-client privilege belongs to the client. 28 However, when an attorney believes
that the attorney-client privilege applies, he or she has a duty to raise the claim of privilege in
order to protect any communication made in confidence. 29
B.
Lawyers Ethical Duty of Confidentiality
A lawyer has an ethical duty to preserve and protect clients’ confidences unless the client
gives informed consent. 30 This duty is very broad and includes not only to legally “privileged”
information but extends to all information relating to the client’s representation. 31 Indeed, the
attorney’s duty to hold client information confidential extends even to materials that are part of a
public record or that a third party is privy to it. 32
C.
Waiver of The Attorney Client Privilege
A client may waive attorney client privilege by disclosure of communications to third
persons, 33 either voluntarily or inadvertently. 34 Courts generally hold that disclosure of
26
Upjohn, 449 U.S. at 394-395.
27
In re Bieter, 16 F.2d at 936. See also, Diversified Industries, Inc. v. Meredith, 572 F.2d 596, 609 (8th Cir. 1977).
28
See, e.g., Klitzman, Klitzman & Gallagher v. Krut, 744 F.2d 955, 960 (3d Cir. 1984); Republic Gear Co. v. BorgWarner Corp., 381 F.2d 551, 556 (2d Cir. 1967).
29
Klitzman, 744 F.2d at 960; Republic Gear Co., 381 F.2d at 556.
30
See Model Rules of Professional Conduct, Rule 1.6(a). See also, Model Code of Professional Responsibility, DR
4-101(B)(1).
31
32
Id.
See e.g., Lawyer Disciplinary Board v. McGraw, 461 S.E.2d 850, 860 (W.Va. 1995).
33
Generally, in order for communications to be considered confidential attorney client communications in a
corporate setting, communications must be limited to persons on a “need to know” basis. That is, communications
are only privileged for those who must know of the communication, given the corporation’s structure, in order to
assure that the attorney is obtaining full and accurate information. See, e.g., In re: Grand Jury Proceeding v. Berkley
& Company, 466 F. Supp. 863 (D. MN 1979).
34
With regard to “inadvertent” waiver of attorney client privilege, corporations must ordinarily assure that documents
reflecting confidential attorney client communications are not intermingled with other unprivileged documents and are
clearly identified as privileged. When confidential communications are “inadvertently” revealed to third persons,
courts will typically look at the reasonableness of a corporation’s efforts to avoid inadvertent disclosure; the time taken
to rectify the error; the extent of the disclosure; and whether fairness and justice would be served by forgiving the
disclosure. See, e.g., Lois Sportswear, USA, Inc. v. Levi Strauss & Co., 104 F.R.D 103, 105 (S.D.N.Y. 1985).
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confidential attorney-client communications to accountants and/or auditors destroys the attorney
client privilege, 35 unless the communications with the accountant/auditor are made “in
confidence for the purpose of obtaining legal advice from the lawyer.” 36 Indeed, the work of
outside auditors is generally not considered protected by attorney client privilege because the
nature of the work performed for a corporation - auditing, accounting and advisory services - is
qualitatively different from legal services. 37
D.
Attorney Work Product Protection
The attorney work product doctrine is a qualified immunity from discovery that is applied
to materials created by lawyers and others in anticipation of litigation. 38 In federal courts the
doctrine is now codified in Rule 26(b)(3) of the Federal Rules of Civil Procedure. The purpose of
the doctrine is to protect unwarranted inquires into an attorney’s files and mental impressions. 39
It is important to note, however, that the work product doctrine does not apply to materials
created by attorneys for routine business purposes. 40
There are two kinds of attorney work product: tangible work product and opinion work
product. Tangible work product includes memoranda, notes, witness statements and other
tangible materials created or collected by attorneys in anticipation of litigation. The immunity
afforded to tangible work product is not absolute. An opposing party may obtain tangible work
product through discovery if it establishes that: (a) has a substantial need for the tangible work
product, and (b) it cannot produce or obtain its substantial equivalent by any other means without
undue hardship. Fed R. Civ. P 26(b)(3). Opinion work includes the attorney’s conclusions, legal
theories, mental impressions, and opinions. Opinion work product is generally immune from
discovery unless an opposing party demonstrates a compelling need, 41 and many courts have
held that the protection afforded opinion work product is almost absolute. 42
Either the lawyer or the client may assert the work product doctrine to protect the
attorney’s work product from disclosure.
35
Gutter v. E.I. Dupont De Nemours and Co., 1998 WL 201796, at *3 (S.D. Fla. May 18, 1998).
36
U.S. v. Kovell, 296 F.2d 918, 922 (2d Cir. 1961).
37
U.S. v. Adlman, 68 F.3d 1495, 1500 (2d Cir. 1995). It should be noted that under the laws of 15 states,
communications between certified public accountants and their clients are considered privileged. Ariz. Rev. Stat. §
32-749; Colo. Rev. Stat. §13-90-107; Fla. Rev. Stat. Ann. §90.5055; Ga. Code Ann. §43-3-32; Idaho Code §9-203A;
225 Ill. Comp. Stat. 450/27; Ind. Code §34-46-2-18; Ks. Stat. Ann. §1-401; LA. Code Evid. Ann. Art. 515; MD.
Code Ann., Cts & Jud. Proc., §9-110; Mich. Comp. Laws §339.732; MO. Rev. Stat. §326.322; N.M. Stat. Ann. §386-6; PA. Stat. Ann. Tit. 63 §9.11; Tenn. Code Ann. §62-1-116.
38
Hickman v. Taylor, 329 U.S. 495, 509-11 (1947).
39
Id. at 510.
40
Janicker v. George Washington University, 94 FRD 648, 650 (D.D.C. 1982).
41
Holmgren v. State Farm Mutual Auto Insurance Co., 976 F.2d 573, 577 (9th Cir. 1992).
42
See, e.g., In re Murphy, 560 F.2d 326, 336 (8th Cir.1977); In re Doe, 662 F.2d 1073, 1080 (4th Cir.1981).
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E.
Waiver of Attorney Work Product Protection
The waiver standard applied to attorney work product is less strict than the waiver
standard for attorney client privilege. While attorney client privilege is considered waived if
confidential communications are disclosed to third parties, the immunity from discovery afforded
to attorney work product is waived where the disclosure is made to an opposing party 43 or where
the disclosure substantially increases the opportunities for adversaries to obtain the
information. 44
The courts have issued inconsistent opinions with respect to whether disclosure of
attorney work product to outside auditors results in a waiver of the work product’s immunity
from discovery. Some courts have held that disclosure of work product to auditors does not
constitute a waiver. 45 Other recent court decisions have held that disclosure of work product to
auditors does not constitute a waiver. 46
The focus in some courts reasoning has been on the independence of the auditor and the
auditor's responsibilities to creditors and the investing public as explained by the Supreme Court
in United States v. Arthur Young & Co.:
By certifying the public reports that collectively depict a corporation's financial
status, the independent auditor assumes a public responsibility transcending any
employment relationship with the client. The independent public accountant
performing this special function 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. 47
Apply this reasoning, the court in Medinol, Ltd. v. Boston Scientific Corp., 214 F.R.D.
113, 116, 117 (S.D. N.Y. 2002) the court found that the attorney work product protection had
been waiver by disclosure of the work product to an outside auditor. The court reasoned that
while disclosure of attorney work product to auditor may not substantially increase the risk that
such work product would reach potential adversaries, the auditor's interests were not aligned
with company's and thus disclosure to auditor did not serve the privacy interests that the work
product doctrine was intended to protect.
Still other courts have held that whether disclosure of attorney work product to auditor’s
attorney should be waived must be decided on a “case-by case” basis. 48
43
In re Raytheon Securities Litigation, 218 F.R.D. 354, 359 (D. Mass. 2003).
44
See, e.g., In re Doe, 662 F.2d 1073 (4th Cir 1981); GAF Corp. v. Eastman Kodak Co., 85 F.R.D. 46
(S.D.N.Y.1979).
45
In re Pfizer Inc. Securities Litigation, 1993 WL 561125 (S.D. N.Y. 1993) at *6 (auditor shared common interests
with company, therefore the auditor is ‘‘not reasonably viewed as a conduit to a potential adversary’’).
46
In re Diasonics Securities Litigation, 1986 U.S. Dist LEXIS 24177, at *3-4 (N.D. Cal. June 15, 1986)
47
U.S. v. Arthur Young & Co., 465 U.S. 805, 817–818 (1984).
48
Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc., 2004 WL 2389822 (S.D. N.Y. 2004) at *5 to 8.
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Given the uncertainty in the case law, a cautious attorney representing a college or university
should clearly recognize that there is significant danger in releasing attorney work product to outside
auditors, following the guidance of the U.S. Supreme Court in Upjohn v. United States, in which the
Court concluded that “an uncertain privilege … is little better than no privilege at all.”49
F.
Implications of Proposed Amendments to SFAS No. 5
The Supreme Court in Upjohn v. United States made clear that there is a strong public
interest in protecting and promoting attorney client and work product privileges for corporations.
These privileges help assure that corporate executives will seek the advice and assistance of
counsel to help assure corporations, that their officers and employees will engage in legally
compliant conduct in their work. By protecting client confidences and thought processes of
counsel we facilitate the timely communication and resolution of problems. Moreover, as noted
above, the Court was equally concerned with ensuring that these privileges are predicable and
enforceable, because without these qualities, it is unlikely that corporate officers and employees
would avail themselves of the advice and assistance of counsel when it is needed.
Since 1975, attorneys and auditors have relied on ABA “Statement of Policy Regarding
Lawyer’s Responses to Auditors’ Requests for Information” and the AICPA Statement of Audit
Standards no. 12 (collectively the “Treaty”) to carefully balance the public interests between full
public disclosure in corporate financial statements with the need for confidential attorney client
communications and work product. As explained in the section below, the proposed amendments
to SFAS No 5 threaten to upset this carefully crafted balance and undermine the important public
policies supporting attorney client and work product confidentiality.
III.
THE “TREATY” BETWEEN THE ACCOUNTING AND LEGAL
PROFESSIONS: ABA STATEMENT OF POLICY REGARDING LAWYERS’
RESPONSES TO AUDITORS’ REQUESTS FOR INFORMATION AND AICPA
STATEMENT OF AUDIT STANDARDS NO. 12
A.
Background on The “Treaty.”
Working in tandem with the AICPA on the subject of responses to audit letters, the ABA
Statement of Policy Regarding Lawyers’ Responses to Auditors’ Request for Information (“ABA
Statement of Policy”) and accompanying Commentary was officially adopted by the Board of
Governors of the ABA on December 8, 1975. Within a month, on January 7, 1976, the Auditing
Standards Executive Committee of the AICPA adopted a counterpart statement, Statement on
Accounting Standards No. 12, entitled "Inquiry of a Client's Lawyer Concerning Litigation,
Claims and Assessments.”
B.
49
Developments Since Original Treaty (in 1975-1976).
Upjohn, 449 U.S. at 393.
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Since the adoption of the ABA Statement of Policy in 1975, the Committee on Auditors'
Inquiry Responses issued two reports regarding initial implementation of the ABA Statement of
Policy. (See First Report of the Committee on Audit Inquiry Responses Regarding Initial
Implementation of the Statement of Policy and Second Report of the Committee on Audit
Inquiry Responses Regarding Initial Implementation of the Statement of Policy, at Auditor’s
Letter Handbook pages 24 and 31). In addition, the Subcommittee of the Committee on Law
and Accounting (formerly the Committee on Audit Inquiry Responses) issued a report in
December 1989 regarding the ABA Statement of Policy (See 45 Bus. Law. 2245 (1990). The
Committee on Law and Accounting (through its Subcommittee on Audit Inquiry Responses) also
issued a report in 1996 regarding developments in audit inquiry letters and response thereto.
([Third] Report of the Committee on Law and Accounting, December 17, 1996). These reports
have not been approved by the ABA, and therefore, do not constitute official statements.
Also, since the adoption of SAS 12, the AICPA has issued auditing interpretations in
1977, 1983, 1990, 1997, 2004, 2005, and 2006. These interpretations are found in AU Section
9337 entitled "Inquiry of a Client's Lawyer Concerning Litigation, Claims, and Assessments:
Auditing Interpretation of AU Section 337.”
C.
The Lawyer’s Non-Exclusive Role.
The opinions and views of legal counsel are important, but they are not the sole source of
evidential matter considered by the auditor in making determinations about the accounting
treatment of litigation, claims, and assessments. Paragraph 36 of SFAS No. 5 specifically
instructs the preparer that other factors (including the views or opinions of non-legal advisors,
the experience of the company in similar cases, the experience of other companies in similar
cases, and the decision of management as to how to respond to the lawsuit, claim or assessment)
are to be considered in making a determination concerning loss contingencies involving
litigation, claims and assessments.
D.
ABA Statement of Policy: A Paragraph-By-Paragraph Analysis.
Analysis of Paragraph 1 – Client Consent to Response.
▪ A lawyer may provide information to the auditor in response to the auditor’s request
without the consent of the client (beyond the client’s letter constituting the initial consent) unless
(i) the information discloses a confidence or secret or (ii) requires an evaluation of a claim. Thus,
in the frequent case where there are no claims to report, the lawyer is free to respond to the auditor
without further consultation with the client. If, however, the response requires the disclosure of a
confidence or secret or the evaluation of a claim, the lawyer should consult with the client since the
client’s consent (to either of these disclosures) may only be given after full disclosure to the client
of the legal consequences of such action. (As discussed elsewhere in this outline, disclosure raises
waiver issues and the potential for a third party to assert that a disclosure concerning potential
liability constitutes an admission). In securing the client’s consent, it is generally not enough to
simply provide the client with a draft of the response since the client needs a full explanation of
the legal consequences of the consent in order to give proper consent.
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▪ For these purposes, a lawyer’s ethical obligation to preserve the client’s confidences
(defined as information protected by the attorney-client privilege) and the client’s secrets
(defined as other information gained in the professional relationship that the client has requested
be kept secret or the disclosure of which would likely be detrimental or embarrassing to the
client) include a much broader range of information than information protected by the attorneyclient privilege.
▪ The lawyer should satisfy him or herself that (i) the officer or agent of a corporate
client consenting to the disclosure understands the legal consequences of the disclosure and (ii)
the officer or agent has the requisite corporate authority to provide the required consent.
Analysis of Paragraph 2 – Limitation on Scope of Response.
▪ In responding to the auditor’s letter, it is appropriate for the lawyer to specify the scope
of his or her engagement and the date as of which the information is furnished (as well as to
disclaim any undertaking to advise the auditor of any subsequent changes). By incorporating by
reference in the response letter the limitations on scope specified in Paragraph 2 of the ABA
Statement of Policy (specifically contemplated by Paragraph 8 of the ABA Statement of Policy),
the lawyer confirms the following understandings with the auditor:
▫
the lawyer’s response is limited to those matters which have been given
substantive attention by the lawyer in the form of legal consultation;
▫
if the response is by a law firm or law department, the firm or department
has endeavored to determine from those lawyers in the firm/department who have rendered
services to the client during the fiscal period whether their services to the client involved
substantive attention to any overtly threatened or pending litigation; and 50
▫
beyond the inquiry of lawyers in the firm or department (as discussed
immediately above), the lawyer has not undertaken any review of the client’s transactions or
other matters for the purpose of identifying loss contingencies to be described in the response to
the auditor.
▪ Since the lawyer’s response can be properly limited to matters given substantive
attention, beware of audit inquiries that request information on matters of which the lawyer has
“knowledge,” which is extremely broad and potentially includes information from contexts
outside the professional relationship. 51
50
The ABA Statement of Policy recognizes that the internal procedures to be followed by a firm or department may
vary and that there is no prescribed set of procedures. The procedures undertaken should provide a reasonable basis
for the response. The policy states that “the evolution and application of the lawyer’s customary procedures should
constitute a reasonable basis for the lawyer’s response.” ABA Statement of Policy, Commentary for ¶2.
51
The Commentary explains that where the auditor’s request is addressed to a law firm, the firm may properly
assume that its response is not expected to include information that may have been communicated to a particular
individual in his or her capacity as a director or officer of the client.
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▪ Consistent with this limitation on scope, the work of a lawyer in providing preliminary
of passing advice or where the lawyer has not been asked to give studied attention to a matter
would be excluded. Similarly, where another lawyer or law firm is in charge of the matter for
the client, the other lawyer or law firm is the appropriate party to respond to that matter and the
lawyer need not respond. To avoid confusion, it may be appropriate in some cases to notify the
auditor that lawyer X or law firm Y is in charge of a particular piece of litigation or another
matter of which the lawyer is aware or had passing involvement.
Analysis of Paragraph 3 - Response May be Limited to Material Items.
▪ The lawyer may appropriate limit his or her response to items which are considered
individually or collectively material to the presentation of the client’s financial statements. If the
auditor has not defined materiality for purpose of the lawyer’s response and the lawyer decides to
limit his or her response to material items (individually or collectively), it is advisable for the lawyer
to specify the criteria used in making the materiality determination. If the lawyer does not expressly
limit his or her response to material items, the response will not be construed to be so limited. In
its First Report, the Committee on Audit Inquiry Responses recommends that the lawyer emphasize
to the client the desirability of establishing with the auditor realistic standards of materiality.
Analysis of Paragraph 4 – Limited Responses.
▪ If the lawyer intends to limit his or her response beyond the standard limitations
incorporated by reference by the language of Paragraph 8 of the ABA Statement of Policy), the
lawyer should expressly state that his or her response is limited in order to avoid any inference
that the lawyer has responded in all respects to the auditor’s inquiry (including all of the
unasserted possible claims or assessments or contractually assumed obligations specifically
identified by the client in its audit inquiry letter). If a lawyer does not expressly limit his or her
response, he or she may be assuming, unintentionally, more responsibility that intended.
▪ Paragraph 4 is designed to recognize that the auditor has an obligation to complete the
procedures necessary to satisfy him or herself as to the fair presentation of the financial statements in
order to render an unqualified audit opinion. If the procedures of an auditor are restricted, the auditor
may be required to issue a “subject to” or “except for” opinion.
Analysis of Paragraph 5 – Loss Contingencies.
▪ If the lawyer has devoted substantive attention to a matter, it is appropriate for the
lawyer to furnish to the auditor information concerning the following matters (subject to the
requirement, pursuant to Paragraph 1, to only disclose a confidence or secret or evaluate a claim
after full disclosure to the client of the legal consequences of such disclosure):
▫
overtly threatened or pending litigation (whether or not specified by the client); 52
52
Overtly threatened litigation means that the potential claimant has manifested to the client an awareness of the
possible claim and a present intention to assert it unless the likelihood of litigation is considered “remote.” ABA
Statement of Policy, ¶5. In the case of a pending governmental investigation, the Second Report of the Committee
on Audit Inquiry Responses Regarding Initial Implementation states that the situation does not involve overtly
threatened litigation where no charges have been made against the client or with respect to its conduct.
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▫ unasserted possible claims or assessments that the client has specifically
identified and for which the client has specifically requested, in the inquiry letter or supplement,
a response to the auditor. 53 In its First Report, the Committee on Audit Inquiry Responses
emphasizes that “under no circumstances will the lawyer be required to communicate with the
auditor concerning the existence or non-existence (i.e., negative assurance) of unasserted
possible claims other than those matters specified by the client in the audit inquiry letter.”
WARNING! Some inquiry letters will make a general inquiry regarding unasserted claims with
a request such as “Please confirm that there are no unasserted claims.” It is not appropriate to
respond to these general inquiries. Additionally, it is not appropriate to respond to broad
inquiries that in substance amount to a general inquiry.
▫ a contractually assumed obligation that the client has specifically identified and
for which the client has specifically requested, in the inquiry letter or supplement, a response to
the auditor.
These categories of “loss contingencies” relate to concepts of accounting accrual and
disclosure specified in SFAS No. 5. (See discussion elsewhere in this outline under the heading
“Accounting for Loss Contingencies: SFAS No. 5”).
▪ Expressing Judgments on Outcomes. In furnishing information to the auditor, the lawyer
should generally refrain from expressing judgments as to the outcome “except in those relatively few
clear cases where it appears to the lawyer that an unfavorable outcome is either “probable” or
“remote.” In this context, “probable” means the prospects of the claimant not succeeding (resulting
in an unfavorable outcome for the client) are judged to be extremely doubtful and the prospects for
success by the client in defending the claim are judged to be slight,54 and “remote” means the
prospects of the client not succeeding in its defense are judged to be extremely doubtful and the
prospects for success by the claimant in pursuing the claim are judged to be slight.55 The
Commentary accompanying Paragraph 5 recognizes that the estimated risks of a case may change
dramatically at different times during the case and that the total damages that ultimately might be
assessed will, in most cases, be subject to wide variance during most stages of the case. Per the
Commentary, “in most situations, an unfavorable outcome will be neither ‘probable’ nor ‘remote’
53
Where there has been no manifestation by a potential claimant of an awareness of and present intent to a assert a
claim or assessment, the client should request the lawyer to furnish information to the auditor only if the client has
determined that it is probable that a possible claim will be asserted, that there is a reasonable possibility that the
outcome will be unfavorable, and that the resulting liability would be material to the client’s financial condition.
54
The Commentary provides the following amplification of the term “probable.” An unfavorable outcome is
normally “probable” if it is extremely doubtful that the client will prevail after investigation, preparation (including
factual development and legal research), and progress of the matter has reached a stage where a judgment can be
made. IMPORTANT NOTE!: The ABA definition of “probable” differs from the FASB’s definition of “probable”
under SFAS No. 5, in which “probable” is defined to mean that the future event or events confirming the loss are
“likely” to occur.
55
The Commentary provides the following amplification of the term “remote.” An unfavorable outcome is
normally considered “remote” if it is extremely doubtful that the client will not prevail based on the lawyer’s
judgment that the client may confidently expect to prevail on a motion for summary judgment on all issues due to
the clarity of the facts and the law.
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as defined in the Statement of Policy.”56 In its First Report, the Committee on Audit Inquiry
Responses advises that a lawyer should not -- because of possible prejudice to the client in terms of
an admission or waiver of privilege – state that an unfavorable outcome is “reasonably possible” but
rather state that the lawyer cannot advise that the unfavorable outcome is “probable” or “remote.”57
▪ Providing Estimates of Loss. The ABA Statement of Policy emphasizes that estimating
an amount or range of potential loss will normally be impossible to ascertain with any degree of
certainty (in the words of the policy “the amount or range of potential loss will normally be as
inherently impossible to ascertain, with any degree of certainty, as the outcome of the
litigation”). Consequently, a lawyer is cautioned against providing an estimate of the amount or
range of potential loss unless he or she believes that the probability of an inaccurate estimate is
slight. In the case of unasserted claims, the policy states that in most cases an estimate will not
be possible given the additional challenges associated with unasserted claims.
▪ “Probable” Assertion of Unasserted Claims. With respect to unasserted claims, the
Commentary states that the judgment concerning whether the assertion of a claim is probable
will “infrequently be one within the professional competence of lawyers,” and therefore cautions
against treating unasserted claims as probable of assertion except where the judgment is
compelling. A lawyer should avoid any language that suggests that the unasserted claims
identified by the client represent all such claims of which the lawyer may be aware or that the
lawyer necessarily concurs with the client’s determination of those unasserted claims warranting
response by the lawyer. 58
Analysis of Paragraph 6 – Lawyer’s Professional Responsibility.
▪ A lawyer’s responsibilities may, depending on the nature of the matters as to which he
or she has been engaged, extend beyond the duty to respond appropriately to the auditor’s
request for information. For example, the lawyer has an obligation to not knowingly participate
in any violation by the client of the disclosure requirements of the securities laws, and the lawyer
may be required under the Code of Professional Responsibility to resign his or her engagement if
the lawyer’s advice concerning disclosures is disregarded by the client. The Commentary on
Paragraph 6 also explains that the lawyer may be responsible for assisting his or her client, if
requested by the client, in complying with the requirements of SFAS 5 to the extent such
assistance falls within the lawyer’s professional competence.
▪ Paragraph 6 expressly states that the auditor may properly assume that whenever the lawyer
has reached the professional conclusion that the client must either disclose or consider disclosure
concerning an unasserted possible claim or assessment the lawyer will advise the client of his or
her conclusion 59 and will discuss with the client the requirements of SFAS No. 5 and the
56
Commentary to ABA Statement of Policy at §5.2. In its First Report, the Committee on Audit Inquiry Reponses
explains that if a claim is not “probable” or “remote” it is by process of elimination “reasonably possible.” (See First
Report under heading “Evaluation of Outcome”)
57
58
See First Report under heading “Evaluation of Outcome.”
ABA Statement of Policy, Commentary at ¶5.2.
59
The form of response to the audit inquiry letter attached as Annex A to the ABA Statement of Policy is stated in
terms of the future (i.e., the lawyer “will advise” and “will consult”). While this undertaking may be appropriate for
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question of disclosure. 60 The typical audit request letter asks the lawyer to confirm this
understanding. 61 In its First Report, the Committee on Audit Inquiry Responses makes clear that
a lawyer’s obligation to consult with his or her client concerning unasserted possible claims does
not require the lawyer to search out or develop facts regarding such possible claims other than
those apparent to the lawyer from his or work for the client or to investigate matters beyond the
point desired by the client. Unless the lawyer has concluded as a matter of law that the
unasserted possible claim is probable of assertion and must be disclosed, which may require
withdrawal by the lawyer (see discussion below), a lawyer has discharged his or her
responsibilities to the client if he or she has notified the appropriately responsible officer or
employee of the client concerning the existence of the unasserted possible claim that the lawyer
has concluded must be considered by the client for disclosure, has satisfied himself that the
person so notified understands the need to consider disclosure under SFAS No. 5, and has
provided such person with the lawyer’s views on the matter. 62
▪ According to the ABA Statement of Policy, where in the lawyer's view it is clear that
(i) a matter is of material importance and seriousness, and (ii) there can be no reasonable doubt
that its nondisclosure in the client's financial statements would be a violation of law giving rise
to material claims, rejection by the client of the lawyer’s advice to call the matter to the attention
of the auditor would almost certainly require the lawyer's withdrawal in accordance with Rules
of Professional Conduct. 63 Since withdrawal might present a serious problem for the client,
clients should be urged to disclose to the auditor information concerning an unasserted possible
claim or assessment (not otherwise specifically identified by the client) where in the course of
the services performed for the client it has become clear to the lawyer that (i) the client has no
reasonable basis to conclude that assertion of the claim is not probable and (ii) given the
probability of assertion, disclosure of the loss contingency in the client's financial statements is
beyond reasonable dispute required.
▪ Does a Lawyer Have an Obligation to Confirm the Client’s Understanding Regarding
Unasserted Claims? In its Second Report, the Committee on Audit Inquiry Responses confirms
that a lawyer is under no obligation to enter into an understanding with the client regarding
unasserted claims in conformity with the ABA Statement of Policy, nor is the lawyer obligated to
the lawyer representing the client on a regular basis, it may not be appropriate for the lawyer engaged to act in a
limited capacity, such as special litigation counsel. In these circumstances, it would be appropriate for the lawyer to
qualify his or her ability to discharge this undertaking going forward. See Second Report of the Committee on
Audit Inquiry Responses, at ¶6, p. 35 of ABA Handbook.
60
Pursuant to SFAS No. 5, where there has been no manifestation by a potential claimant of an awareness of and
present intent to assert a possible claim or assessment, disclosure is required only if the organization concludes that
(i) it is probable that a claim will be asserted, (ii) there is a reasonable possibility that the outcome will be
unfavorable, and (iii) the resulting liability would be material to the organization’s financial condition.
61
Although this professional responsibility is to be confirmed to the auditor, the First Report by the Committee on
Audit Inquiry Responses indicates that this responsibility with respect to unasserted possible claims is to be on an
ongoing basis throughout the year. (See First Report under heading “Lawyer’s Procedures”)
62
See Second Report of the Committee on Audit Inquiry Responses, at ¶3, p. 34 of ABA Handbook.
63
See ABA Model Rules of Professional Conduct, Rule 1.16. MRPC Rule 1.16(a)(1) provides: “Except as stated in
paragraph (c), a lawyer shall not represent a client or, where representation has commenced, shall withdraw from the
representation of a client if: (1) the representation will result in violation of the rules of professional conduct or
other law; . . . ”
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confirm to the auditor that such an understanding exists. The ABA Statement of Policy was
developed to provide guidance to lawyers and is not a prescription for lawyer conduct. 64 Whether
or not the lawyer confirms to the auditor the client’s understanding, however, a response stated to
be in accordance with the ABA Statement of Policy permits the auditor to assume that the lawyer
will advise the client to disclose or consider disclosing an unasserted claim where the lawyer has
formed a professional conclusion that such action is required. Second Report at fn 2.
Analysis of Paragraph 7 – Limitation on Use of Response.
▪ Unless the lawyer’s response grants permission otherwise, the response may not be
quoted in whole or in part (or otherwise referred to) in the financial statements of the client (or
related documents), and the lawyer’s response is solely for the auditor’s information in
connection with its audit of the client. The response may be furnished to other parties in
connection with court proceedings or when necessary to defend the auditor against a challenge of
the audit, provided that in any case the lawyer is given at least 20 days advance notice (or as
much notice as is possible under the circumstances) of the proposed disclosure.
Analysis of Paragraph 8 – General (and Incorporation of ABA Statement of Policy by
Reference).
▪ Paragraph 8 states that the lawyer is free to supplement or modify the approach set forth
in the ABA Statement of Policy in particular cases and permits the lawyer to incorporate by
reference all of the limitations set forth in the ABA Statement of Policy by using specific language.
E.
Responding to Audit Inquiry Letters.
In responding to audit inquiry letters, it is important to understand the lawyer’s
responsibilities set forth in the ABA Statement of Policy (as discussed above) and to not go
beyond the scope of that policy. This will require that the lawyer carefully read each audit
inquiry letter so that the lawyer’s response does not unintentionally give rise to any
misunderstandings. A lawyer’s response letter may need to expressly disclaim responsibility for
commenting on any non-standard request.
A sample lawyer response letter is attached as Exhibit B.
In preparing response letters to audit inquiry letters, law firms should establish
procedures along the lines of those suggested in the “Proposed Law Firm Audit Letter Policies”
attached as Exhibit C.
64
See Second Report under heading “A Lawyer's Professional Responsibility to His Client with Respect to Matters
Recognized to Involve an Unasserted Possible Claim.”
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IV.
CALLS FOR “TRANSPARENCY” AND PROPOSED AMENDMENTS TO SFAS
NO. 5 BY FASB
A.
FASB Exposure Draft of SFAS No. 5 Amendments.
▪ On June 5, 2008, the Financial Accounting Standards Board (“FASB”) released an
“Exposure Draft” of a Proposed Statement of Financial Accounting Standards to amend SFAS
No. 5 and 141(R) (the “Exposure Draft”). 65 The Exposure Draft proposes significant changes in
the way in which loss contingencies are reported for financial statement purposes under GAAP.
In releasing the Exposure Draft, FASB requested comments on the amendments generally and on
a list of specific questions contained in the document. The list of questions itself suggests the
difficulty of improving financial reporting with respect to loss contingencies.
▪ The Exposure Draft offers the following basis for the proposed changes:
Investors and other users of financial information have expressed concerns
that disclosures about loss contingencies under the existing guidance in
FASB Statement No. 5, Accounting for Contingencies, do not provide
adequate information to assist users of financial statements in assessing
the likelihood, timing, and amount of future cash flows associated with
loss contingencies. This proposed Statement would expand disclosures
about certain loss contingencies in the scope of Statement 5 or FASB
Statement No. 141 (revised 2007), Business Combinations.
▪ The Exposure Draft leaves intact the standards for accrual of loss contingencies, but
proposes extensive changes with respect to disclosures of loss contingencies (that are not
accrued because the loss is either not “probable” or not capable of being “reasonably
estimated”).
▪ The Exposure Draft seeks to alter the current standards regarding the reporting of loss
contingencies by making the following changes:
▫ The types of loss contingencies that must be disclosed are expanded to include
even “remote” loss contingencies if (i) the contingency is expected to be resolved within a year
of the date of the financial statements or (ii) where the contingency could have a “severe impact”
on the entity’s financial position, cash flows, or results of operations.
▫ If disclosure is required, the information to be disclosed is expanded to include
specific quantitative information, including (i) the amount of the claim against the entity, including
damages, or (ii) the entity’s best estimate of the upper limit of loss exposure where there is no claim
amount. An entity may also disclose its best estimate of the possible loss or range of loss if it does not
believe that the amount claimed or maximum exposure disclosed reflects the entity’s actual exposure.
65
The full text of the Exposure Draft is available at http://www.fasb.org/draft/ed_contingencies.pdf.
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▫ If disclosure is required, the information to be disclosed is expanded to include
specific qualitative information, including information that is “sufficient to enable users to
understand the risks posed to the entity,” which must include – at a minimum – the following
information:
- a description of the contingency, including how it arose, its legal or
contractual basis, its current status, and the anticipated timing of its resolution;
- a description of the factors that are likely to affect the ultimate outcome
of the contingency along with their potential effect on the outcome;
- the entity’s qualitative assessment of the most likely outcome of the
contingency; and
- significant assumptions made by the entity in estimating the amounts
disclosed and in assessing the most likely outcome.
▫ If disclosure is required, the information to be disclosed must also include a
qualitative and quantitative description of the terms of relevant insurance or indemnification
arrangements that could lead to a recovery of the loss.
▫ The loss contingencies must be presented in a detail tabular reconciliation that
shows, at a minimum, the following information:
- increases for loss contingencies recognized during the period;
- adjustments (increases or decreases) resulting from changes in estimates
of loss contingencies previously recognized; and
- decreases resulting from any form of payment or settlement for loss
contingencies.
▪ The Exposure Draft provides an exception to disclosure where the disclosure would
prejudice an entity’s position in a pending matter. In these cases, the entity is permitted to
aggregate amounts at a higher level than by the nature of the contingency or, in “rare instances,”
not include certain information deemed prejudicial. Under no circumstances is the entity
permitted to not disclose the amount of the claim or assessment (or an estimate of the maximum
exposure to loss), a description of the loss contingency (including how it arose, its legal or
contractual basis, its current status, and the anticipated timing of its resolution), and a description
of the factors likely to affect the ultimate outcome of the claim or assessment
B.
ABA Response to Exposure Draft.
▪ On August 5, 2008, the ABA provided comments to FASB on the proposed
amendments contained in the Exposure Draft. The full text of the ABA response can be found at
http://www.abanet.org/poladv/priorities/privilegewaiver/ 2008aug5_privwaiv_fasb_l.pdf.
The National Association of College and University Attorneys
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▪ The ABA, and other commentators, were critical of the possible inequities in the
litigation process created by the proposed amendments. The potential problems stem from the
following requirements:
▫ A defendant would be required to report its "best estimate" and "maximum
exposure" to loss. This disclosure would be required even prior to the time, if at all, the plaintiff
had specified a damage amount.
▫ The litigation disclosures have been expanded to include detail quantitative and
qualitative information. These disclosures could potentially be admissible as evidence.
▫ The disclosures could potential waive the attorney-client privilege or work
product privilege.
▫ The requirement to provide estimated losses could potentially lead to greater
securities litigation if early estimates ultimately proved to be incorrect.
C.
Other Responses to Exposure Draft.
▪ There have been over 230 responses to the Exposure Draft by companies and
professional associations. Many of the responses echo the same concerns addressed in the
ABA’s response to the Exposure Draft. Some responses have voiced support for the changes.
The list of parties providing comments and links to their comments can be found at
http://www.fasb.org/ocl/fasb-getletters.php?project=1600-100.
D.
What’s Next for the Exposure Draft?
▪ On September 24, 2008, the FASB held a Board meeting and subsequently issued a
press release indicating that it had decided to conduct further deliberations with respect to the
Exposure Draft. The press release stated that the Board had instructed its staff to prepare an
“alternative model” in order to attempt to address various concerns raised about the Exposure
Draft and that the alternative model would be “field tested” along with the model contained in
the Exposure Draft. The Board also announced that any final Statement would be effective no
sooner than for fiscal years ending after December 15, 2009.
▪ On March 6, 2009, the FASB conducted two roundtable meetings with representatives
from the SEC, auditing standards setters (PCAOB and AICPA), auditors, lawyers, preparers of
financial statements (i.e., companies), and financial statement users (i.e., investors). The
meetings provided FASB with valuable input from the various stakeholders. The minutes of
these meetings may be found on the FASB project page for enhancing disclosure requirements
under SFAS No. 5. (See Section VI, Resources, for link to the FASB project page). Consensus
appeared to be reached on a number of items, including the understanding that litigation is
inherently unpredictable and that there is an important distinction between contentions made in
litigation and predictions, with the former being capable of verification by the auditors and the
later being in many cases unauditable.
The National Association of College and University Attorneys
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V.
PRACTICAL STEPS IN DEALING WITH AUDIT LETTERS
1.
Get a copy of the ABA Audit Letter Handbook. “Do not pass go, do not collect
$200!”
2.
For in-house counsel, be involved with your entity’s accounting personnel in
identifying the law firms to receive audit inquiry letters and in setting the materiality threshold
for the audit inquiry letters. Make sure that letters are not being sent to lawyers who have not
been engaged during the period under audit.
3.
For law firms, adopt audit letter procedures similar to those set forth in “Proposed
Law Firm Audit Letter Policies” attached as Exhibit C. 66
4.
For law firms, DO NOT RESPOND to non-standard requests from auditors! If
the audit inquiry letter requests you to “confirm there are no unasserted claims” or to “comment
on the legality of the ABC-XYZ merger,” which go beyond the scope of the ABA Statement of
Policy, do not respond to these inquires and expressly disclaim any comment on these inquiries.
5.
Review audit response letters with the client BEFORE releasing them to the
auditor. In obtaining the client’s consent to the disclosure of confidences, secrets, or the
evaluation of claims, a lawyer will in most cases need to explain to the client the legal
consequences of such consent (See ABA Statement of Policy, ¶1(d)).
VI.
RESOURCES
A. Current Legal and Accounting Standards.
▪ ABA Auditor’s Letter Handbook (published by ABA Section of Business Law)
(order online at www.ababooks.org or call (800) 285-2221). The ABA Auditor’s Letter
Handbook includes the following statements and reports:
▫ Statement of Policy Regarding Lawyer’s Response to Auditors’ Requests for
Information (approved by the ABA Board of Governors on December 8, 1975).
▫ Commentary to Statement of Policy
▫ First Report of the Committee on Audit Inquiry Responses regarding Initial
Implementation of the Statement of Policy (1976);
▫ Second Report of the Committee on Audit Inquiry Responses regarding Initial
Implementation (1976);
▫ Report of the Subcommittee on Audit Inquiry Responses (1989); and
▫ [Third] Report of the Committee on Law and Accounting (issued 1996)
66
Source: Boone, Michael M., Bulletin of the Section on Corporation, Banking & Business Law, "Lawyers'
Response to Audit Inquiry Letters-Practical Considerations Under the ABA-AICPA Understanding" (1977).
Reprinted with permission. Thanks to Michael M. Boone for his willingness to share this resource.
The National Association of College and University Attorneys
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▪ Statement of Financial Accounting Standards No. 5, Accounting for Contingencies
(March 1975) (SFAS No. 5) – full copy at www.fasb.org/pdf/fas5.pdf
▪ FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss (an
interpretation of FASB Statement No. 5), September 1976 – full copy at
http://www.fasb.org/pdf/fin%2014.pdf
▪ Statement on Auditing Standards No. 12 (approved January 7, 1976 by the AICPA
Auditing Standards Executive Committee) - full copy at
http://www.aicpa.org/download/members/ div/auditstd/AU-00337.PDF
▪ Additional auditing standards are available at
http://www.aicpa.org/Professional+Resources/Accounting+and+Auditing/
Audit+and+Attest+Standards/Authoritative+Standards+and+Related+Guidance+for+NonIssuers/auditing_standards.htm
B. Proposed New Disclosure Standards under FASB Exposure Draft and
Comments on Exposure Draft
▪ FASB Disclosure of Certain Loss Contingencies Project Page: Collection of
materials relating to proposed amendment of FASB Statements No. 5
http://www.fasb.org/project/accounting_for_contingencies.shtml
▪ FASB Exposure Draft of Proposed Statement of Financial Accounting Standards,
Disclosure of Certain Loss Contingencies, an amendment of FASB Statements No. 5 and 141(R),
dated June 5, 2008
http://www.fasb.org/draft/ed_contingencies.pdf
▪ ABA Comments on Exposure Draft titled “Disclosure of Certain Loss
Contingencies: An Amendment of FASB Statements 5 and 141(R) to Financial Accounting
Standards Board and International Accounting Standards Board, dated August 5, 2008
http://www.abanet.org/poladv/priorities/privilegewaiver/
2008aug5_privwaiv_fasb_l.pdf
▪ List of parties and comments on Exposure Draft
http://www.fasb.org/ocl/fasb-getletters.php?project=1600-100
The National Association of College and University Attorneys
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EXHIBIT A
SAMPLE AUDIT INQUIRY LETTER
Jane W. Lawyer
100 Maple Street
City, State, Zip
RE:
XYZ Enterprises, Inc. (“Company”)
Dear Jane:
TEXT OF LETTER
Our auditors, ABC Auditors, P.C., are concluding an
audit of our financial statements at December 31, 2008,
and for the period then ended. Please furnish to them the
information requested below involving matters as to
which you have been engaged and to which you have
devoted substantive attention on behalf of the Company
in the form of legal consultation or representation.
COMMENTARY
Be careful to understand the date of the
financial statements since loss contingencies
arising after the financial statement date,
even if “probable” and “reasonably
estimated,” are not required to be accrued
(although they may need to be disclosed).
Note the “substantive attention” reference.
Pending or Threatened Litigation (Excluding Unasserted
Claims and Assessments)
Please prepare a description of all litigation, claims and
assessments including civil rights violations (excluding
unasserted claims and assessments). The description of
each case should include:
a. the nature of the litigation;
b. the progress of the case to date;
c. how management is responding or intends to respond
to the litigation (e.g., to contest the case vigorously or to
seek an out-of-court settlement); and
d. 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.
Also please identify any pending or threatened litigation,
claims and assessments with respect to which you have
been engaged but as to which you have not yet devoted
substantive attention.
Note that an estimate is required only if
estimate can be made
Responding to this request is not required by
the ABA Statement of Policy. Paragraph 2 of
the ABA Statement of Policy provides that
unless the lawyer’s response indicates
otherwise it is properly limited to matters
which have been given “substantive attention.”
The National Association of College and University Attorneys
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Unasserted Claims and Assessments
We have represented to our auditors that there have been
disclosed by management to them all unasserted possible
claims that you have advised are probable of assertion
and must be disclosed in accordance with Statement of
Financial Accounting Standards No. 5 in the financial
statements currently under examination.
[or]
We have represented to our auditors that there are no
unasserted possible claims that you have advised are
probable of assertion and must be disclosed in accordance
with Statement of Financial Accounting Standards No. 5
in the financial statements currently under examination.
As a result of this request in many audit
inquiry letters, the Committee on Law and
Accounting in the [Third] Report
recommended, in erring on the side of
caution, to include the following paragraph
in the lawyer’s response letter: “Please be
advised that pursuant to clauses (b) and (c) of
Paragraph 5 of the ABA Statement of Policy
and related Commentary referred to in the
last paragraph of this letter, it would be
inappropriate for this firm to respond to a
general inquiry relating to the existence of
unasserted possible claims or assessments
involving the Company. We can only
furnish information concerning those
unasserted possible claims or assessments
upon which the Company has specifically
requested, in writing, that we comment nor
can we comment upon the adequacy of the
Company's listing, if any, of unasserted
possible claims or assessments or its
assertions concerning the advice, if any,
about the need to disclose same.”
Your response should include matter that existed as of
December 31, 2008, and during the period from that date
to the effective date of your response
Please specifically identify the nature of and reasons for
any limitation on your response.
This statement is consistent with paragraph 6
of the ABA Statement of Policy
Please also indicate the amount we were indebted to you
for services and expenses on December 31, 2008.
This is optional request, but most auditors
include it. The ABA Statement of Policy
indicates that this inquiry is appropriate.
The audit inquiry letter must be signed by
agent of client with apparent authority. See
¶1 of ABA Statement of Policy.
Very truly yours,
Lee David Murphy, Controller
The National Association of College and University Attorneys
27
EXHIBIT B
SAMPLE RESPONSE TO AUDIT INQUIRY LETTER
______________, 2009
Jane A. Auditor, CPA
ABC Auditors, P.C.
100 Main Street
City, State, Zip
Re:
XYZ Enterprises, Inc.
Ladies and Gentlemen:
TEXT OF LETTER
By letter dated March ___, 2009, Lee David Murphy,
Controller of XYZ Enterprises, Inc. (the "Company"),
has requested us to furnish you with certain information
in connection with the Company as of December 31,
2008, and during the period from that date to the date
of this response.
COMMENTARY
This paragraph recognizes that the lawyer is
responding at the client’s request (and
consent).
While this firm represents the Company on a regular
basis, our engagement has been limited to specific
matters to which we were consulted by the Company
This paragraph limits the scope of the lawyer’s
response (but only in a general way). The
alternative approach to responding (see
paragraph below) is preferable if the matters
handled by the lawyer are discrete.
[or]
We call your attention to the fact that this firm has
during the past year represented the Company only in
connection with a Vermont sales tax matter (as
described in the balance of this paragraph) and has not
been engaged for any other purpose. At the end of
August 2008, our firm was contacted by the Company
regarding a possible understatement of sales tax due to
the State of Vermont. Upon further investigation by
the Company and this firm, we determined that the
Company had not properly reported its sales tax
liability to the State of Vermont. Pursuant to the
Voluntary Disclosure Program operated by the
Vermont Department of Taxes, the Company
voluntarily disclosed its understatement of sales tax to
the Vermont Department of Taxes. That disclosure
ultimately resulted in the execution of an Installment
Agreement between the Company and the Department
This paragraph limits the scope of the lawyer’s
response to a specific matter. This limitation is
the better alternative when the lawyer has been
engaged on a specific matter or a few discrete
matters.
The National Association of College and University Attorneys
28
dated ___________, 2008, pursuant to which the
Company agreed to make monthly payments in the
amount of $_____ per month to the Vermont
Department of Taxes until the tax liability ($________)
is paid in full.
DISCUSSION OF UNASSESRTED CLAIMS
LISTED BY CLIENT
A lawyer should avoid any language that
suggests that the unasserted claims identified
by the client represent all such claims of which
the lawyer may be aware or that the lawyer
necessarily concurs with the client’s
determination of those unasserted claims
warranting response by the lawyer. ABA
Statement of Policy, Commentary at ¶5.2.
The information set forth herein is as of the date of this
letter, except as otherwise noted, and we disclaim any
undertaking to advise you of changes which thereafter
may be brought to our attention.
If you made an inquiry of the attorneys in your
firm involved with the client and the last
response was received on date X, your
response letter should indicate that it is
effective as of date X.
The Company has advised us that, by making the
request set forth in its letter to us, the Company does
not intend to waive the attorney-client privilege with
respect to any information which the Company has
furnished to us. Moreover, please be advised that our
response to you should not be construed in any way to
constitute a waiver of the protection of the attorney
work-product privilege with respect to any of our files
involving the Company.
This optional language is addressed in the
Report of the Subcommittee on Auditor
Inquiry Responses. The report states that this
language simply makes explicit what has
always been implicit, and that failure to include
this language does not constitute an expression
of intent to waive the privilege. In short, there
is no need to include this language.
Please be advised that pursuant to clauses (b) and (c) of
Paragraph 5 of the ABA Statement of Policy and
related Commentary referred to in the last paragraph of
this letter, it would be inappropriate for this firm to
respond to a general inquiry relating to the existence of
unasserted possible claims or assessments involving the
Company. We can only furnish information
concerning those unasserted possible claims or
assessments upon which the Company has specifically
requested, in writing, that we comment nor can we
comment upon the adequacy of the Company's listing,
if any, of unasserted possible claims or assessments or
its assertions concerning the advice, if any, about the
need to disclose same.
This paragraph was recommended by the
[Third] Report of the Committee on Law and
Accounting (December 17, 1996) as a result of
changes made by auditors in the language of
audit inquiry letters and its concern regarding
possible waiver of the attorney-client privilege.
This response is limited by, and in accordance with, the
ABA Statement of Policy Regarding Lawyers'
Responses to Auditors' Requests for Information
(December 1975); without limiting the generality of the
Paragraph 2 deals with the scope of the
lawyer’s engagement by the client and limits
the scope of the response to those matters
which have been given substantive attention by
If your standard form does not include this
language, it is out of date.
The National Association of College and University Attorneys
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foregoing, the limitations set forth in such Statement on
the scope and use of this response (Paragraphs 2 and 7)
are specifically incorporated herein by reference, and
any description herein of any "loss contingencies" is
qualified in its entirety by Paragraph 5 of the Statement
and the accompanying Commentary (which is an
integral part of the Statement). Consistent with the last
sentence of Paragraph 6 of the ABA Statement of
Policy and pursuant to the Company's request, this will
confirm as correct the Company's understanding as set
forth in its audit inquiry letter to us that whenever, in
the course of performing legal services for the
Company with respect to a matter recognized to
involve an unasserted possible claim or assessment that
may call for financial statement disclosure, we have
formed a professional conclusion that the Company
may disclose or consider disclosure concerning such
possible claim or assessment, we, as a matter of
professional responsibility to the Company, will so
advise the Company and will consult with the
Company concerning the question of such disclosure
and the applicable requirements of Statement of
Financial Accounting Standards No. 5.
the lawyer in the form of legal consultation
Paragraph 7 provides that the lawyer’s
response may not be quoted in whole or in part
(or otherwise referred to) in the financial
statements and the lawyer’s response is solely
for the auditor’s information in connection
with its audit of the client.
The Paragraph 6 confirms the lawyer’s
understanding of his or her obligation to advise
the company where he or he has formed a
professional conclusion that the Company must
disclose or consider disclosing an unasserted
possible claim or assessment.
The total amount of indebtedness to us for services
rendered to the Company as of December 31, 2008,
was $0.00. The total unbilled amount was $0.00.
Very truly yours,
DINSE, KNAPP & McANDREW, P.C.
Brian R. Murphy
The National Association of College and University Attorneys
30
EXHIBIT C
PROPOSED LAW FIRM AUDIT LETTER POLICIES 67
SUGGESTED INTERNAL PROCEDURES TO BE FOLLOWED BY LAW FIRMS IN
RESPONDING TO AUDIT INQUIRY LETTERS
A.
FIRST STEP: Approval of Inquiry Letter. Committee should review and approve all
Inquiry Letters received by firm.
1.
Check each Inquiry Letter to see if it is in acceptable form.
2.
Accept only Inquiry Letters which conform (at least substantively) to the ABA
suggested form.
3.
Do not accept an Inquiry Letter which:
(a)
asks something to the effect "please advise auditors of all claims against
client of which you have knowledge"; or
(b)
follows suggested form letter by indicating that the client has represented
to the auditor that the law firm has not advised the client of any unasserted
claim which is probable of assertion and must be disclosed, but then
states: "Please furnish to ABC Auditing & Co. an explanation, if any, that
you consider necessary to supplement the foregoing information,
including an explanation of those matters as to which your views may
differ from those stated"; or
(c)
makes reference in any manner, other than the exact words of the last
paragraph of the suggested form of Inquiry Letter attached as an exhibit to
the ABA Statement, to the client's representation to the auditor that there
are no unasserted claims which the attorney has advised are probable of
assertion; or
(d)
is not executed by a client representative with sufficient officer authority;
or
(e)
indicates client has been required to specify unasserted claims without
regard to FAS 5 standards (see paragraph (5) of ABA Statement); or
(f)
indicates that the client has been required to specify all unasserted claims
as to which legal advice may have been obtained (see paragraph (5) of
ABA Statement).
67
Source: Boone, Michael M., Bulletin of the Section on Corporation, Banking & Business Law, "Lawyers'
Response to Audit Inquiry Letters-Practical Considerations Under the ABA-AICPA Understanding" (1977).
Reprinted with permission. Thanks to Michael M. Boone for his willingness to share this resource.
The National Association of College and University Attorneys
31
4.
Without prior discussion with, and informed consent of, the client, do not prepare
Response Letters which would:
(a)
encompass matters intended to be covered by an attorney-client privilege;
or
(b)
involve disclosure of unasserted claims.
B.
SECOND STEP: Assignment of Drafting Responsibility for Response Letter. With
respect to each approved Inquiry Letter, the Committee should assign the responsibility
of preparing the Response Letter to an attorney ("attorney-in- charge") in the firm who
either (i) is the primary client contact for the firm, or (ii) primarily handles litigation filed
against the client.
C.
THIRD STEP: Internal Retrieval of Facts Needed for Response Letter.
Attorney-in-charge initially circulates Inquiry Letter to each attorney in the firm who has
had responsibility for any client matter since the prior year's Response Letter was
prepared or who supplied information utilized in the prior year's Response Letter (see
discussion under caption "Lawyer's Procedures" and "Retrieval" of First Report).
D.
1.
Point to Remember: Determination of attorneys who performed services for the
client can perhaps be done best by examining time or bookkeeping records.
2.
Active files pertaining to "asserted claims" against client should be reviewed by
attorney-in-charge as well as any litigation docket procedures maintained by firm.
3.
Attorney-in-charge should review prior year's Response Letter and check status of
information contained therein.
4.
Point to Remember: Law firm is not expected to make investigation to determine
existence of unasserted claims (see discussion under caption "Retrieval" of First
Report). However, if law firm has documented discussions with the client about
disclosure of an unasserted claim, review perhaps should be given to that
information.
5.
Point to Remember: With respect to asserted claims, SAS No. 12 contemplates
that the client may list and describe facts concerning asserted claims in the
Inquiry Letter and ask the attorney to comment thereon. This is not preferable.
FOURTH STEP: Preparing Draft of Response Letter.
1.
Follow carefully the ABA Statement in preparing Response Letter and, in
particular, ABA suggested form of Response Letter.
2.
Attorney-in-charge oversees other attorneys involved in preparing Response
Letter. Questions of interpretation of ABA Statement are directed to Committee.
The National Association of College and University Attorneys
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E.
3.
The Attorney who is attorney for same matter falling within scope of an attorney's
response under the ABA Statement should probably be the one to prepare an
appropriate description of such matter.
4.
Final draft of Response Letter should be circulated among and reviewed by all
attorneys who participate in the preparation of the Response Letter.
FIFTH STEP: Committee's Review and Approval of Final Draft of Response Letter.
1.
No approval by the Committee should be required of "plain vanilla" Response
Letter (i.e., no asserted or unasserted claims are described or mentioned therein
and letter otherwise conforms to firm's standard form of Response Letter).
2.
Committee review and approval should be required where a Response Letter
either:
3.
F.
(a)
Does not conform strictly to ABA recommended form or the guidelines of
the ABA Statement; or
(b)
Includes an evaluation of pending litigation or some other asserted claim;
or
(c)
Includes any disclosure or other treatment of an unasserted claim; or
(d)
Involves response to approved Inquiry Letter which does not satisfactorily
conform to ABA recommended form of Inquiry Letter.
Any Response Letter falling within one of the categories of subparagraph 2 above
should be presented to and discussed with the client before it is sent to the
auditor – probably constitutes required consent if full disclosure of legal
consequences are made to client.
SIXTH STEP: Execution of Response Letter.
1.
Attorney-in-charge should execute "plain vanilla" Response Letters and at least
one other attorney involved in the drafting of the Response Letter should initial a
copy of the final form to evidence their respective review and approval.
2.
In case of Response Letter requiring Committee approval as stated above,
Committee should execute and the attorney-in-charge should initial a copy of the
final form to evidence their respective review and approval.
3.
Copy of Response Letter (with the corresponding Inquiry Letter attached thereto)
should be kept in single client file.
4.
Observation: Often auditors will phone or otherwise orally confer with attorneys
for the purpose of obtaining information which they might otherwise not obtain
via the Response Letter, e.g., off-the-cuff evaluation of claims. Auditor will then
The National Association of College and University Attorneys
33
prepare a memo to his file of such conversation with the attorney. SAS No. 12
recommends that the auditor sometimes confer orally with the attorney (see
paragraph 10 of SAS No. 12). However, with limited exceptions, communications
with auditor should be limited to Response Letter.
(a)
Point to Remember: Consideration should be given by the law firm to
adding a sentence to the ABA recommended form of Response Letter to
the effect that "This letter represents the only authorized communication
from this firm, and is the only communication from this firm upon which
you may rely, regarding 'loss contingencies' of XYZ corporation and the
other matters discussed herein" unless the law firm intends otherwise.
(b)
Point to Remember: Standard form of Response Letter might also request
that auditor provide law firm with copies of any memos which they may
have prepared concerning oral conversations with the attorney or confirm
that no such memo exists.
5.
Any special oral discussions with auditors concerning matters covered by or
relating to the Response Letter should be documented by the attorney for later
reference if matter is sensitive in nature.
6.
Response Letters involving evaluations, special legal considerations, treatment of
unasserted claim or some other special matter should be kept in a master file for
later reference by the Committee.
7.
The ABA recommended form of Response Letter might also be expanded to
indicate the attorney's reliance upon the First Report and the Second Report. This
would be helpful in making sure the auditor understands the law firm's view of its
professional responsibility covered by paragraph 6 of the ABA Statement.
The National Association of College and University Attorneys
34