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Audit ResponsesWhat You Need to Know in 2017

Thursday, January 12, 2017| 1:00 PM EasternSponsored by

Audit Responses Committee

www.americanbar.org | www.abacle.org

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Panelists

• Thomas W. White—WilmerHale, Washington, DC

• Miranda K. Mandel—ALAS, Inc., Chicago, IL• Noël J. Para—Alston & Bird, New York, NY


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Today’s Topics

• What are audit responses and why do we do them?

• What should we and should we not include in an audit response?

• What procedures should be followed for preparing audit responses?


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What Are Audit Responses?

– An audit response is a response to a client’s request that a lawyer provide certain information to its auditor in connection with an audit (or “examination”) of its financial statements

– As part of the audit, the accountant must assess the company’s reserves and disclosures regarding the potential impact of litigation and other contingencies

– Auditing standards require that the accountant obtain confirmation of management’s accounting for contingencies, which includes obtaining information from counsel

– The audit response process is the means by which the accountant obtains that confirmation


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When Do We Do Audit Responses?

– Annual audits of financial statements• Annual reports on 10-K• Private company audited financials

– Securities Offerings• Audited financial statements included in or incorporated by

reference in registration statements such as S-1 or S-3• Updates may be required each time accountants consent to use of

their audit report (in IPO can be with every amendment)– Reviews

• Some auditors request in conjunction with reviews of quarterly financials and 10-Qs


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Background: Accounting Standards

• ASC 450-20 (formerly FAS 5)– Accrual for pending or overtly threatened litigation is required if

loss is probable and the amount of loss can be reasonably estimated

• If range, accrue best estimate within range or, if no best estimate, bottom end of range

– Footnote disclosure of contingencies required if a loss is reasonably possible (more than remote)

• In general, no disclosure of unasserted claims is required unless it is probable that a claim will be asserted and an unfavorable outcome is reasonably possible


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• Key definitions:– Loss contingency—“an existing condition, situation or set of

circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when one or more future events occur

– Probable—“the future event or events are likely to occur”– Remote—”the chance of the future event or events occurring is

slight”– Reasonably possible—“the chance of the future event or events

occurring is more that remote, but less than likely”


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• ASC 450-20 Disclosure– Where there is an accrual for a loss contingency, disclosure of

the nature of accrual, and “in some circumstances” the amount of the accrual, may be required

– Disclosure where loss is reasonably possible shall• Indicate nature of contingency• Give an estimate of possible loss or range of loss or state that such

an estimate cannot be made


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The Auditor’s Responsibilities

– Decision about accounting for contingencies is management’s, not accountant’s or lawyer’s

– Auditing standards require accountants to• obtain management’s explanation of contingencies, assessment of

likelihood, estimates of loss• corroborate management’s assertions through inquiry to outside

and in-house counsel• document the work they perform, including any oral communications

with company counsel– Auditors increasingly seek as much information as possible

about legal contingencies


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The Lawyer’s Concerns

– Waiver of privilege• Disclosure of attorney-client communications to accountants

probably waives privilege• Disclosure of work product as part of audit may not be a waiver• Audit response requests and accounting literature sometimes

disclaim any intention to require privilege waiver, as may some responses

– Prejudice to client’s litigation position• Disclosing information about lawyer’s assessment of merits of case

and/or potential damages would be useful to plaintiff’s counsel, particularly for settlement purposes

• Disclosure of “unasserted claims” might reveal claims that plaintiffs might otherwise never learn about or assert


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The “Treaty”

– Since 1975, the scope of a lawyer’s responsibility to auditors has been established by a so-called “treaty” between legal and accounting professions

• AICPA/PCAOB SAS 12 (Now AICPA AU-C § 501.16ff, PCAOB AS 2505)

• ABA Statement of Policy– The treaty seeks to strike a balance between an auditor’s need

to confirm management’s assertions and a lawyer’s need to preserve privileges and protect client’s litigation position

– The treaty ties a lawyer’s disclosures to the recognition/disclosure standards in ACS 450-20 (FAS 5)


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Basic Premises of the Treaty

– Only the client can request/instruct the lawyer to provide information to the auditors

• Client signs or authenticates a request letter and transmits a letter to lawyers requesting they provide information to the auditors

• In practice request letters are prepared by the auditors• Auditing standards prescribe the form and contents of request,

though auditors often vary the form– Lawyer only reports pending or overtly threatened claims, unless

client specifically requests otherwise– Lawyer confirms professional responsibility to advise client about

disclosure of unasserted claims


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Elements of Lawyer’s Response

– Lawyer responds by a form letter that incorporates the ABA Statement of Policy

– Only “material” matters covered• Request letter often specifies a dollar materiality threshold• Lawyers usually reluctant to make materiality judgments

– Covers only matters to which lawyer has been engaged to give substantive attention, or represent the client

• During period covered by financial statements and through date of letter

• Many letters only cover period as of and since end of fiscal period– Case descriptions typically include name of case, court, nature

of claims and defenses, procedural status


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– In general, lawyer’s response only covers “pending” or “overtly threatened” claims

• “Overtly threatened” means a potential claimant has manifested awareness of and a present intention to assert a claim, unless likelihood of litigation or settlement is remote

• Usually means express demand or threat, e.g., draft complaint or letter; saber rattling not necessarily “overt”

– Government investigations• Fact that government has initiated investigation, including seeking

documents or testimony, does not imply the existence of pending or threatened litigation

• SEC “Wells Notice” or equivalent is usually considered to constitute overtly threatened litigation


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– Lawyers do not predict outcomes in audit responses, unless they conclude that the outcome of a claim is either “probable” or “remote”

• “Probable” = claimant’s prospects of not succeeding are “extremely doubtful” and client’s prospects of success in defense are “slight”

• “Remote” = client’s prospects for not succeeding in defense are “extremely doubtful” and claimant’s prospects of success are “slight”

– Note that these definitions differ from ASC 450-20– “We cannot predict the outcome” means only that the lawyer

has not determined that an outcome is either probable or remote

– Settlements can be “probable” in some circumstances


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– Lawyers do not comment on unasserted claims, unless client specifically requests

• Regardless of what the request letter says• Watch out for “We’ve disclosed all unasserted claims to the client”

request• Increasingly, clients do request that we comment on pending

government investigations– Response letter specifically disclaims any comment on

unasserted claims (as well as “contractually assumed liabilities, which are beyond the scope of this presentation)


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– Duty to advise client regarding disclosure• Audit request letter from client requests lawyer to confirm that if, in

the course of performing legal services with respect to unasserted claim, lawyer concludes that disclosure is required or that client should consider disclosure, lawyer will so advise client and consult regarding requirements of ASC 450-20

– Request letter asks lawyer to confirm this understanding and lawyer expressly confirms this in the response

– Note that this confirmation is tied to ASC 450 standards, not general securities law disclosure standards


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Duty to Advise on Disclosure

– Depending on the nature of the engagement, counsel may have a duty to advise clients on the need to disclosure information

– Counsel may not knowingly participate in a client’s violation of securities laws requiring disclosure and, therefore, may have to resign if the client disregards advice about required disclosure


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Consulting With the Client

– The audit letter authorizes disclosure of routine, nonconfidential information

– A negative evaluation should be provide only with the client’s informed consent

– Care should be taken when responding to client concerns about disclosure

– Many clients now ask to see drafts of responses before the lawyer submits the response to the auditor


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When Should I Not Respond?

– When the firm has not substantively represented the client in the matter

– When the client hasn’t consented– When the auditor asks for information that is outside the Treaty– When the auditor asks for an oral update


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What Can Happen If I Get It Wrong?

– Claim by auditor investors that the response was misleading– SEC claim under Rule 13b2-2 for misrepresentations to auditors– Claim by client (after claim by opposing party) that response

waived the attorney-client privilege or undermined client’s position


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How Can I Make Sure to Get It Right?

– Understand the Treaty and the disclosure rules and stay abreast of changes and trends

– Establish and follow firm procedures for responses– Review the request letter for nonstandard requests– Respond in accordance with the Treaty


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Updates

– Accounting standards require companies and auditors to consider the impact of events that occur subsequent to end of fiscal period through date of issuance of financials

– This can include initiation of new litigation or claims or developments in pending litigation

– Many auditors therefore ask for an “update” or “bring-down” of audit letter response

• Changes in accounting standard have made this more frequent• Request needs to be confirmed by client• Request letter can include standing request to provide updates• Response should be in writing• No standard form of response


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Process

– Law firms should maintain appropriate procedures to ensure that the responses are complete and accurate

– Common procedures include:• Centralized process: Request letters are referred to

designated persons, and responses are prepared by lawyers or legal assistants with appropriate training and expertise

• Request to all lawyers who billed time during period covered by the request; affirmative lawyer response required even if nothing to report (may exclude de minimis hours from questionnaire)

• Review and revision of draft responses by staff and lawyers


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Resources

– ABA Business Law Section, Audit Responses Committee, AUDITOR’S LETTER HANDBOOK (2d. ed. 2013)

– Audit Responses Committee, ABA Business Law Section, Statement on Updates to Audit Response Letters, 70 Bus. Lawyer 489 (2015)

– Audit Responses Committee Webpage and Listserve: http://www.americanbar.org/groups/business_law/committees.html

Documents

Audit Responses - American Bar Associationapps.americanbar.org/dch/thedl.cfm?filename=/CL965000/otherlinks... · reserves and disclosures ... – Lawyers do not predict outcomes in