Inquiries generally should be sent to all lawyers who have devoted substantive attention to a matter on behalf of the client in the form of legal consultation or representation.

Evaluating the Lawyer's Response

When evaluating a lawyer's response, the auditor needs to pay particular attention to responses that are unclear about the potential outcome of a case. Examples of such unclear responses include the following:

It is our opinion that the company will be able to assert meritorious defenses to this action. (The assertion of "meritorious defenses" does not necessarily indicate that they will prevail.)

* We believe the action can be settled for less than the damages claimed.

* We are unable to express an opinion as to the merits of the litigation at this time.

* The company believes there is absolutely no merit to the litigation.

* In our opinion, the company has a substantial chance of prevailing in this action.

* 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. Nevertheless, if the plaintiff is successful, the award may be substantial.

Instead, responses should clearly indicate that an unfavorable outcome is remote, such as in the following responses:

* 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.

* We believe that the plaintiff's case against the company is without merit.

* We believe the company will be able to defend this action successfully.

* 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 a nominal amount.

SAS No. 12 was issued in January 1976, and included the American Bar Association approved policy statement entitled, Statement of Policy Regarding Lawyer's Responses to Auditor's Request for Information. The ABA Statement and SAS No. 12 memorialize a compromise between the legal and accounting professions and acknowledge the importance of maintaining public confidence in financial statements. The ABA Statement recognizes that the lawyer has an ongoing responsibility to assist his or her client, at the client's request, and encourages responses with the same precision that is sought by FASB Statement No. 5 on contingencies.

Lawyers, however, do not typically quantify "odds" in numerical terms. Rather, lawyers apply judgmental factors to evaluate cases without any intention to assess probability in a statistical, scientific, or empirically-grounded sense. Auditors are, therefore, admonished in the ABA Statement that "it should not be anticipated that meaningful quantifications of 'probability' of outcome or amount of damages can be given by lawyers in assessing litigation." Even without this admonition, significant differences in the definition of the key terms associated with loss contingencies would discourage the lawyer from expressing a judgment except in "relatively few clear cases." For example SFAS No. 5 defines probable as "the future event or events that are likely to occur." On the other hand, the ABA Statement defines the same term as "an unfavorable outcome for the client is probable if the prospects of the claimant not succeeding are judged to be extremely doubtful and the prospects for success by the client in the defense are judged to be slight." The ABA Statement concludes that "it is appropriate for the lawyer to provide an estimate of the amount or range of potential loss. . . only if he believes that the probability of inaccuracy of the estimate of the amount or range of potential loss is slight."

Similarly, the ABA Statement recognizes that compliance with SFAS No. 5 should not intrude upon the confidentiality of the lawyer-client relationship. Lawyers are cautioned that in responding to an auditor's inquiry letter, the lawyer must be guided by his ethical obligations as set forth in Canon four of the Code of Professional Responsibility, which enjoins the lawyer to preserve his client's confidences. Lawyers must be aware that giving auditors access to privileged statements may waive the lawyer-client privilege. In addition, an adverse party may claim that any evaluation of potential liability is an admission of that liability. In fact, some clients prefer to add a statement such as the following to emphasize the retention of attorney-client and attorney work-product privileges:

We do not intend either this request or your response to our auditor to constitute a waiver of the attorney-client privilege or the attorney work-product privilege.

The tension between the auditor's inquiry and the lawyer's response is graphically illustrated in the area of unasserted claims or assessments. Like SFAS No. 5, the ABA Statement distinguishes between actions that are pending or that an adverse party has manifested an intention to commence and "other contingencies of a legal nature or having legal aspects," i.e., unasserted claims. As to the latter, the ABA Statement places the burden on the client to request the lawyer to furnish information if the client has determined that it is probable that a claim will be asserted and would be material to the client's financial condition.

The ABA Statement provides that an attorney is authorized to disclose information to his clients' auditors only where the client has both "specifically identified" in the audit inquiry letter or supplement thereto" a particular unasserted claim or assessment, and has "specifically requested" comment by the attorney on that unasserted claim or assessment. This places the burden on the client, in the first instance, to identify and report material unasserted claims.

If the client does not request the lawyer to furnish information relating to unasserted claims, information will not be volunteered by the lawyer. To the extent that the lawyer's knowledge of unasserted possible claims is obtained by means of confidential communications from the client, any disclosure would violate the lawyer-client privilege and constitute a waiver as fully as if the communication related to a pending claim. Moreover, the ABA Statement recognizes that an attorney has no duty to investigate legal problems of the client, even if advised of some facts that might conceivably constitute a legal problem.

This is a source of great frustration for many auditors, but a properly designed inquiry letter alleviates most problems. in this regard, the ABA Statement assures the auditor that while performing legal services for the client, ". . . if the lawyer concludes that an unasserted claim calls for financial statement disclosure, he will so advise the client and will consult with the client concerning the question of such disclosure and the applicable requirements of SFAS No. 5." Accordingly, the auditor may draw some measure of comfort by obtaining a representation from the lawyer that he has discharged this obligation, usually contained in the lawyer letter.

Effect on Auditor's Report

Once the auditor is satisfied that the attorney's response is complete, a determination must be made whether an appropriate accrual has been made or disclosure is required of a loss contingency based on the likelihood of an unfavorable outcome, and the effects, if any, on the standard auditor's report. SAS No. 58, Reports on Audited Financial Statements states that if the likelihood is more than remote, an auditor must consider whether to modify the standard report with an explanatory paragraph emphasizing the uncertainty.

FASB Interpretation No. 14 (an interpretation of SFAS No. 5) requires the use of a reasonable estimate if the conditions noted earlier for accrual are met, but the ultimate amount of a loss contingency is unknown. That is not to say that it is appropriate to delay accrual of a loss until only a single amount can be estimated. SFAS No. 5 requires that, where information is available, this estimate may fall within a range of amounts. If TABULAR DATA OMITTED some amount within the range appears to be a better estimate, that amount should be accrued. If not, the minimum in the range should be accrued. Though the minimum amount in the range is usually not the same as the ultimate loss, it is unlikely that the ultimate loss will be less than the minimum amount. In one case where a large public company disclosed that the estimated total cost of environmental cleanup ranged from $151.3 million to $4.5 billion, SFAS No. 5 would require the company to accrue the $151.3 million.

However, if the outcome of future events is not susceptible of reasonable estimation by management, no determination can be made whether the financial statements should be adjusted or in which amount. Such events are regarded as uncertainties and require consideration by the auditor in fulfilling his reporting obligation. Not all loss contingencies require modification of the standard auditor's report. In fact, some do not even lead to a disclosure requirement. Loss contingencies that exist due simply to the nature of ongoing business operations require no disclosure or consideration in the auditor's report. For instance, absence of coverage may represent a potential exposure to a company because company's net income and financial position could be adversely affected if uninsured losses in excess of amounts provided were to be incurred. However, the lack of adequate insurance coverage is not, by itself, grounds to accrue a liability nor disclose the details, since the event requiring recognition--the loss-- has not occurred.

In deciding whether to add an explanatory paragraph to the report because of a matter involving an uncertainty (other than a going concern matter), the auditor considers the likelihood of a material loss resulting from the resolution of the uncertainty. When the outcome of future events may affect the financial statements but reasonable estimates cannot be made (which is usually the case), consideration should be given to the following:

* Remote Likelihood of a Material Loss. If management believes and the auditor is satisfied that there is only remote likelihood of material loss--no explanatory paragraph is required.

* Probable Chance of a Material Loss. If management believes and the auditor is satisfied that a material loss is probable for which a reasonable estimate cannot be made, the auditor should add an explanatory paragraph.

* Reasonable Possibility of a Material Loss. If management believes and the auditor is satisfied that a material loss is more than remote, but less than probable, the auditor should consider the following:

a. The magnitude of loss in excess of materiality.

b. The likelihood of occurrence.

As the amount of reasonably possible loss becomes larger or the likelihood of occurrence of a material loss increases, the auditor is more likely to emphasize the matter in his report.

Explanatory Paragraph Added to The Report

If the auditor has concluded that he should include an explanatory paragraph in his report, he should describe the matter leading to the uncertainty in a separate paragraph (following the opinion paragraph) and indicate that its outcome cannot presently be determined. The separate paragraph(s) may be shortened by referring to disclosures made in a note to the financial statements. However, no reference to the uncertainty should be made in the introductory, scope or opinion paragraphs, thus the standard report remains unqualified.

An example of an explanatory paragraph (following the opinion paragraph) describing an uncertainty follows:

As discussed in Note X to the financial statements, the Company is a defendant in a lawsuit alleging infringement of certain patent rights and claiming royalties and punitive damages. The Company has filed a counteraction, and preliminary hearings and discovery proceedings on both actions are in progress. The ultimate outcome of the litigation cannot presently be determined. Accordingly, no provision for any liability that may result upon adjudication has been made in the accompanying financial statements.

The financial community is still getting acquainted with this form of reporting on uncertainties. Although an emphasis paragraph does not result in a qualification, users generally frown on any modification to the standard report. On the other hand, the absence of emphasis when a material uncertainty is properly disclosed in the footnotes, could be construed by users as an opinion on the outcome of the uncertainty by the auditor. The auditor should take extreme precaution when considering modifying the standard report for uncertainties and, in those instances when the auditor wishes to emphasize a matter involving litigation, auditors should consult with and have the client's attorney review the language contained in both the footnotes and auditors report prior to release. In extreme cases, the auditor might wish to consult with his or her attorney. The accompanying checklist outlines points to be considered in evaluating lawyers' responses to letters or audit inquiry.