The Audit Inquiry Letter: Purpose and Process

An audit inquiry letter is a formal request from a company’s management to its legal counsel, initiated at the request of an external auditor during a financial statement audit. Its purpose is to obtain independent evidence regarding litigation, claims, and assessments (LCA) that could materially impact the company’s finances. The lawyer’s response helps the auditor verify management’s information about legal contingencies, ensuring potential losses from legal matters are properly accounted for and disclosed.

Information Required in the Inquiry Letter

The client’s management is responsible for drafting the audit inquiry letter for its legal counsel. Management must prepare a comprehensive list of all pending and overtly threatened legal actions. For each matter, the letter must describe the issue, its current progress, management’s planned response, and an evaluation of the likelihood of an unfavorable outcome. This evaluation must also include an estimate of the potential financial loss or a range of loss, if one can be reasonably determined.

The letter must also address unasserted claims and assessments (UCAs), which are potential claims that have not yet been made. Management must identify and list any UCAs it believes have a reasonable possibility of being asserted and resulting in an unfavorable outcome. This determination is based on criteria for disclosure under accounting standards like Accounting Standards Codification (ASC) 450.

The letter must request that the lawyer evaluate management’s descriptions and assessments of the pending and threatened litigation. The lawyer is asked to comment on whether they agree with management’s evaluation or if their professional opinion differs. This request for confirmation corroborates the information management has presented to the auditors and asks the lawyer to affirm the completeness of the provided lists.

Finally, the letter must authorize the lawyer to communicate directly with the auditor, which permits a response without violating attorney-client confidentiality for the audit’s purpose. The letter will specify the period under audit to ensure the lawyer’s response covers the relevant timeframe. The complete inquiry is prepared on the client’s letterhead and signed by management.

The Lawyer’s Response to the Inquiry

A lawyer’s reply to an audit inquiry letter is guided by the American Bar Association’s (ABA) Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information. This framework balances the auditor’s need for information with the lawyer’s duty to protect attorney-client privilege. The policy outlines what a lawyer can and cannot disclose to avoid waiving legal protections for the client.

When addressing pending or threatened litigation, the lawyer confirms the existence and status of the matters listed and may offer comments on case progress. They will corroborate factual information but will avoid making definitive predictions about the ultimate outcome of the litigation. Because legal results are inherently uncertain, lawyers are professionally cautious about forecasting them, and their response will reflect this.

The treatment of unasserted claims and assessments (UCAs) is a sensitive area. According to ABA policy, a lawyer will not give an opinion on the completeness of management’s list of UCAs or confirm its evaluations. This avoids compromising the client’s legal position by acknowledging unclaimed potential liabilities. If a lawyer concludes a UCA will likely be asserted and have an unfavorable outcome, their ethical duty is to advise the client to make the necessary financial statement disclosures.

The response letter will state that it is limited to the matters identified in the client’s inquiry. It will also include a paragraph reminding the auditor of the lawyer’s professional responsibility regarding unasserted claims. This ensures the auditor understands the response’s boundaries and does not misinterpret a lack of comment on UCAs.

The Audit Inquiry Process

The audit inquiry process begins when the auditor, after assessing risks from legal contingencies, requests that management prepare and send an inquiry letter to its legal counsel. This request is a standard part of audit planning and risk assessment.

Following the request, management drafts the inquiry letter, compiling the list of LCAs and their evaluations. Once prepared and signed, the letter is given to the auditor. The auditor then controls its delivery to the legal counsel to ensure the correct version is sent.

Upon receiving the inquiry, the lawyer prepares a written response adhering to ABA guidelines. The lawyer must send the response directly to the auditor, not back to the client. This direct communication channel provides the auditor with independent, external corroboration of management’s assertions. The primary response must go to the auditor to be considered valid audit evidence, though a copy is often sent to the client.

Audit Implications of the Response

The lawyer’s response is important audit evidence used to corroborate management’s information on litigation and claims. The auditor compares the lawyer’s response with management’s assessments. This comparison helps the auditor evaluate the reasonableness of the company’s accounting and disclosure for contingencies under ASC 450.

If the auditor cannot obtain a satisfactory response, a scope limitation occurs. This can happen if the client refuses to prepare the inquiry letter, the lawyer refuses to respond, or the lawyer’s response is significantly restrictive, such as refusing to comment on material litigation. A scope limitation prevents the auditor from gathering sufficient evidence to form a conclusion on the potential impact of legal matters.

A scope limitation directly impacts the auditor’s report. If the potential effect of the unresolved legal matters could be material, the auditor cannot issue an unqualified (“clean”) opinion and must modify it instead. This could result in a qualified opinion, stating the financial statements are fairly presented except for the possible effects of the unresolved matter.

In severe cases where the potential impact is pervasive, the auditor may issue a disclaimer of opinion. A disclaimer states that the auditor could not obtain sufficient evidence to provide any opinion on the financial statements. This outcome signals significant uncertainty to investors and creditors, potentially damaging the company’s credibility.