AS 3407: Auditor’s Inquiry of a Client’s Lawyer
AS 3407 provides the framework for how auditors obtain crucial evidence from a company's lawyers to validate the accounting of legal contingencies.
Auditing Standard 2505, Inquiry of a Client’s Lawyer Concerning Litigation, Claims, and Assessments, from the Public Company Accounting Oversight Board (PCAOB), governs how an independent auditor examines a company’s legal entanglements. The standard outlines a formal process for auditors to gather evidence about potential losses from legal disputes. This process is designed to ensure a company’s financial statements accurately disclose material risks from litigation, claims, and assessments, to provide investors a clear picture of the company’s financial health.
The Client’s Role in the Inquiry Process
The process begins with company management, which is responsible for financial reporting. Management must identify, evaluate, and account for all Litigation, Claims, and Assessments (LCAs). This involves reviewing its operations to find legal issues with a potential financial impact, such as active lawsuits, contractual disagreements, or regulatory investigations.
Management must also consider unasserted claims. These are potential claims not yet formally made but are probable to be brought forward with a reasonable possibility of an unfavorable outcome. Management must then compile a detailed list of all identified LCAs, describing and evaluating each matter.
The Letter of Inquiry to Legal Counsel
After management prepares its list of legal issues, the auditor requests the client send a formal letter of inquiry to its legal counsel. The letter is from the client but instructs the lawyer to respond directly to the auditor, preserving the independence of the communication. This letter seeks to corroborate management’s assertions and must specify a response date, usually allowing a two-week window for review.
The inquiry letter asks the lawyer to comment on the completeness of management’s list of pending or threatened litigation and to provide a professional evaluation of those items. For unasserted claims, the letter requests the lawyer confirm their professional responsibility to advise the client on any such claims that require disclosure.
This distinction is important because of attorney-client privilege. For active litigation, the lawyer is asked to provide specific commentary. For potential claims that have not yet been filed, the inquiry is structured to respect professional boundaries while still ensuring the auditor is aware of the lawyer’s responsibility to inform their client about disclosure requirements.
The Lawyer’s Response to the Auditor
In the written response, the lawyer provides a professional opinion on the likely outcome of each listed claim. This evaluation uses specific terminology from accounting standards, classifying the probability of an unfavorable outcome as “probable,” “reasonably possible,” or “remote.”
Where feasible, the lawyer also provides an estimate of the potential financial loss or a range of loss for each claim. A loss is recorded in the financial statements if it is both probable and reasonably estimable. If a loss is only reasonably possible, it must be disclosed in the notes to the financial statements.
Lawyers are often cautious in their responses to avoid compromising their client’s legal position. Their responses may be guarded and use precise, non-committal language. Auditors are trained to understand the nuances of this legal language and its implications for the financial statements.
Auditor Actions Upon Receiving the Response
Upon receiving the lawyer’s response, the auditor compares the lawyer’s assessment of LCAs with the information provided by management. This helps determine if management’s accounting and disclosure for legal contingencies are appropriate and follow accounting principles.
The auditor uses the lawyer’s letter to judge the reasonableness of disclosures in the financial statement footnotes. If the lawyer’s response indicates a higher probability of loss or greater potential financial impact than what management has disclosed, the auditor will require the company to adjust its financial statements. This communication supports the fairness of the company’s financial presentation.
If a lawyer refuses to respond or the response is overly limited, it constitutes a “scope limitation” for the audit. If the auditor cannot obtain sufficient evidence regarding material legal contingencies, they may be unable to issue an unqualified, or “clean,” audit opinion. This can have serious negative consequences for a public company.