Best Practices: Responding to U.S. Audit Inquiries

  • September 07, 2016

By Marlene Kane and Robert Scavone

Introduction

Canadian lawyers who represent businesses are often asked to respond to audit inquiries from their cross-border clients, and in particular, their U.S. clients. The frequency of U.S. audit inquiries is increasing with the globalization of business and accounting standards. However, the revised Joint Policy Statement  on responding to audit inquiriesFootnote1 (the “Joint Policy”) deals only with Canadian lawyers’ responses to Canadian audit inquiries.

How, then, should Canadian counsel respond to U.S. audit inquiries in a way that will be most helpful to their American clients for U.S. financial reporting purposes? At the same time, what are Canadian counsel’s professional responsibilities in responding to U.S. audit inquiries?  What limitations on the scope and use of their audit responses should they express?

This article provides some answers to these questions, drawing on both the Joint Policy and the ABA Statement.Footnote2  A sample form of audit response for external Canadian counsel (Sample Response), incorporating the best practices discussed here, is also available.

Discussion of Best Practices

A Canadian client’s audit inquiry typically asks the law firm to provide information relating to “claims” and “possible claims” as defined in the Joint Policy. In contrast, an American client’s inquiry typically asks the law firm to provide information relating to “pending or threatened litigation” and “unasserted claims or assessments” which are “loss contingencies”Footnote3 as such terms are defined under the relevant accounting standards.Footnote4

Even though Canadian and American accounting standards differ, and the Joint Policy and ABA Statement ask somewhat different questions, there are enough similarities to allow Canadian lawyers to respond to U.S. audit inquiries in a meaningful way if some adjustments are made. 

1.  What does the U.S. audit inquiry ask the lawyer to address? Footnote5

  • With respect to pending or threatened litigation, a U.S.audit inquiry typically:  
    • sets out (i) management’s description of the nature of each matter, (ii) the progress of each matter to date, (iii) how management has responded or intends to respond (for example, to contest the case vigorously or to seek an out-of-court settlement), (iv) an evaluation of the likelihood of an unfavourable outcome, and (v) an estimate, if one can be made, of the amount or range of potential loss;
    • asks the law firm to (i) provide to the client’s auditors any explanation necessary to supplement the information provided by management in the letter, including an explanation of those matters on which the law firm’s views may differ from management’s and (ii) identify the omission of any pending or threatened litigation to make the list of matters complete; andFootnote6
  • Asks the law firm to provide the auditors with any explanation necessary to supplement the information provided by management in the letter with respect to unasserted possible claims or assessments “considered by management to be probable of assertion and which, if asserted, would have at least a reasonable possibility of an unfavourable outcome”,Footnote7 including an explanation of those matters on which the law firm’s views may differ from management’s.

The U.S. reference to “pending or threatened litigation,” is analogous to the Canadian term “claim.”   It means that a potential claimant has manifested to the client an awareness of and present intention to assert a possible claim or assessment, unless the likelihood of litigation is considered “remote.”Footnote8 

The U.S. term, ”unasserted claim or assessment,” is analogous to the Canadian term “possible claim.”   It means there has been no manifestation by a potential claimant of an awareness of, and present intention to assert, the possible claim or assessment.Footnote9 According to the ABA Statement, the client should request its lawyer to furnish information to the auditor only if the client has determined that (i) it is probable that a possible claim will be asserted, (ii) if asserted, there is a reasonable possibility that the outcome will be unfavourable, and (iii) the resulting liability would be material to the financial condition of the client.Footnote10

Although the Canadian and U.S. terminology addresses similar issues, the audit response letter should make it clear how “claims” and “possible claims” are defined to avoid any confusion. 

U.S. audit inquiries typically address only loss, not gain, contingencies.  Accordingly, they are concerned with litigation or claims only against, but not by, the client.  Canadian audit inquiries address both gains and losses and therefore litigation or claims against or by the client.   The audit inquiry response should make this difference clear as well.

2. What information regarding claims and possible claims  should be provided in the audit response? 

Consistent with the Joint Policy, the ABA Statement provides that when properly requestedFootnote11 by the client, it is appropriate for the lawyer to provide information to the auditor on (i) overtly pending or threatened litigation, whether or not specified by the client, and (ii) unasserted claims or assessments that the client has specifically identified and on which the client has specifically requested comment to the auditor.Footnote12

The information that lawyers may properly give to the auditor about these matters includes, to the extent appropriate, an identification of the proceedings or matter, the stage of proceedings, the claims asserted, and the position taken by the client. 

In a U.S. audit inquiry, the responding lawyer would normally refrain from expressing a judgment as to outcome except in those relatively few clear cases where it appears to the lawyer that an unfavourable outcome is either “probable”Footnote13 or “remote.”Footnote14 The ABA Statement anticipates that in most situations an unfavourable outcome will be neither “probable” nor “remote.” The ABA Statement also cautions that this standard applies with even more force in the case of unasserted claims.Footnote15

Where an unfavourable outcome is not viewed to be remote, the lawyer may also be asked to estimate the potential amount or range of loss in dollar terms.  However, the ABA Statement takes the position that the amount or range of potential loss will normally be impossible to ascertain with any degree of certainty.Footnote16  In most cases, therefore, the lawyer will not be able to provide any such estimate to the auditor.  The difficulty in estimating loss (or range of loss) is obviously even more compelling in the case of unasserted claims. 

3. What if the client omits unasserted claims or assessments from the inquiry?

On this issue, the Joint Policy and the ABA Statement are completely consistent with each other.  Lawyers have a professional obligation to their client to maintain the confidentiality of all lawyer-client communications and preserve solicitor-client privilege.  If the client’s inquiry letter omits unasserted claims, under no circumstances should the lawyer’s response identify for the auditor any unasserted claims that the client has omitted.Footnote17  The lawyer should confirm neither the completeness of management’s list of unasserted claims, nor the accuracy of management’s representation concerning disclosure of all unasserted claims.Footnote18  These issues should be dealt with between lawyer and client.  As noted in question 6 below, the Canadian audit inquiry response should expressly state that the law firm cannot respond to a general inquiry relating to the existence or absence of possible claims and cannot comment on the adequacy of the client’s listing of possible claims.

However, as both the Joint Policy and the ABA Statement acknowledge, lawyers do have a professional obligation to bring to their clients’ attention the existence of possible claims that have been omitted and to ensure that clients are aware of their own responsibility to bring those possible claims to the attention of their auditor.   It is the client who ultimately determines whether or not disclosure of an unasserted possible claim is required in its financial statements.Footnote19  Neither the Joint Policy nor the ABA Statement requires the lawyer to make any determination of what should be disclosed in the client’s financial statements; all that is required is a determination of what the client should disclose to the auditor. 

4. Should the Canadian lawyer give the requested undertaking about future advice to the client on unasserted possible claims?

U.S. audit inquiries ordinarily ask lawyers to confirm that under certain circumstances they will advise their clients about the clients’ obligation to make “disclosure” of unasserted claims or assessments in the context of financial statement presentation.Footnote20 The obligation is to advise the client as to whether the client must or should bring the unasserted claim to the attention of its auditor, not whether the client must or should disclose the unasserted claim in its financial statements.Footnote21 The ABA Statement refers to the requested confirmation from lawyers as the “Undertaking.”  Under the Joint Policy, no such undertaking is currently requested by, or given to, Canadian auditors by Canadian lawyers. 

The request for the Undertaking ordinarily appears in the audit inquiry as follow:Footnote22

We understand that whenever, in the course of performing legal services for us with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for financial statement disclosure, if you have formed a professional conclusion that we must disclose or consider disclosure concerning such possible claim or assessment, we, as a matter of professional responsibility to us, you will so advise us and will consult with us  concerning the question of such disclosure and the applicable requirements of Financial Accounting Standards Board Accounting Standards Codification 450, Contingencies. Please specifically confirm to our auditors that our understanding is correct.

For U.S. lawyers, the undertaking has been the source of some confusion and a great deal of commentary.  In fact, the ABA’s Second Report is devoted almost entirely to the issue. 

What does the undertaking mean? The ABA makes several important points on its scope.

First, the undertaking requires only that the lawyer not dismiss an unasserted possible claim without consideration, if, in providing legal services to the client, the lawyer in fact realizes that there is an unasserted possible claim and recognizes that it may call for financial disclosure. Footnote23

Second, once that threshold condition is met, the undertaking requires the lawyer to consider whether he or she can form a conclusion, as a lawyer, (i.e. a “professional conclusion”) that (i) it is probable the possible claim will be asserted, (ii) if asserted, there is a reasonable possibility that the outcome will be unfavourable to the client, and (iii) the resulting liability would be material to the financial condition of the client. Footnote24 

Third, if the lawyer has formed that conclusion, then his or her primary obligations are to: (i) bring the existence of the unasserted possible claim to the attention of a responsible officer or employee of the client (for example, in-house counsel), (ii) be satisfied that the client is generally aware of the disclosure requirements of ASC 450  with respect to unasserted possible claims and assessments, and (iii) ensure that the client understands the lawyer’s view that the possible claim is one which the client must disclose, or must consider disclosing, to its auditor. Footnote25

The ABA has made it clear that the undertaking does not require the lawyer to make determinations of what should be included in the client’s financial statements or to undertake an interpretation of ASC 450 or other accounting requirements as it may apply to a particular unasserted possible claim. Footnote26
Last, quite apart from issues of financial statement presentation, lawyers may have a role in advising clients about timely public disclosure of unasserted possible claims for press releases, securities reporting, and third party disclosure to lenders, for example. The undertaking is not intended to affect that role. Footnote27 

Should the Canadian lawyer give such an undertaking in the audit response? The short answer for most Canadian lawyers will be “no”, and in most cases, the undertaking should be strongly resisted. Why?

First and foremost, the undertaking is prospective (“will” advise and “will” consult). Giving such an undertaking does not make sense from either the lawyer’s or the auditor’s perspective where the Canadian lawyer has only a limited retainer from the U.S. client.Footnote28

Second, the ABA Statement makes it clear that no U.S. lawyer is obligated to enter into such an understanding with his or her client; nor is the lawyer obliged to confirm to auditors that such an understanding exists.  In fact, the ABA Statement goes on to say: “If no such undertaking by the lawyer is seriously intended, it would be entirely wrong for the lawyer to do either.” Footnote29

Whether or not a Canadian lawyer chooses to give the undertaking, he or she is not qualified to advise the client on ASC 450 or U.S. financial statement disclosure generally.   The lawyer should therefore expressly disclaim that responsibility, so there is no misunderstanding as to the nature of the advice the lawyer can give. Footnote30

5. What are best practices to ensure proper client consent to disclosure?

While the audit inquiry will have been signed by the client, that alone does not constitute consent to the disclosure of a confidence or the evaluation of a claim.Footnote31  To ensure client consent, the safest course is for the law firm to have the draft audit response reviewed by the U.S. client before releasing it to the auditor and request that the client confirm that it consents to the disclosure and evaluations set out in the response.Footnote32 

6. What are best practices to preserve privilege?

Concerns about waiver of solicitor-client privilege with Canadian audit inquiries apply with even more force in the American context.Footnote33  For example, an adverse party in the U.S. may assert that an evaluation of potential liability is an admission.Footnote34 Accordingly, to preserve privilege, we recommend that response to a U.S. audit inquiry should contain appropriate language, including an express statement that the client does not intend to waive privilege.Footnote35
U.S. auditors may ask the client for a representation about unasserted claims in the audit inquiry as follows: Footnote36

We have represented to our auditors that there are no unasserted possible claims that you have advised us are probable of assertion and must be disclosed in accordance with Financial Accounting Standards Board Accounting Standards Codification 450, Contingencies. 

In the ABA’s view, this particular language could constitute a waiver by the client of its privilege.  The ABA therefore counsels lawyers to err on the side of caution by including an express disclaimer in their response.  Accordingly, if that representation appears in the client’s audit inquiry, the Canadian lawyer should include the appropriate disclaimer in the response, based on the recommended ABA text: Footnote37

Please be advised that it would be inappropriate for us to respond to a general inquiry related to the existence of unasserted possible claims or assessments involving the Corporation.  We can only furnish information concerning those unasserted possible claims or assessments upon which the Corporation has specifically requested, in writing, that we comment.  Nor can we comment upon the adequacy of the Corporation’s listing, if any, of unasserted claims or assessments or its assertions concerning the advice, if any, about the need to disclose them.

7. What limitations on the scope and use of the response should be expressed? 

Both the Joint Policy and the ABA Statement contemplate certain limitations on the scope and use of the response. Since responses to U.S. audit inquiries cannot be made strictly in accordance with either policy statement, Canadian lawyers should expressly incorporate the necessary limitations in their response. 

To set the parameters of the response, the definitions of both “claims” and “possible claims” should incorporate a knowledge qualifier, defining knowledge as the current actual knowledge of lawyers in the firm who have performed services for the client in the relevant fiscal period.Footnote38

Both the Joint Policy and the ABA Statement recognize that it may be in the client’s interest to protect information contained in the lawyer’s response against unnecessary further disclosure or use beyond its intended purpose of informing the auditors. This limitation is incorporated in the Sample Response.  Both the Joint Policy and the ABA Statement contemplate that the lawyer’s response will not be quoted from or referred to in the client’s financial statements or otherwise without the law firm’s prior written consent.Footnote39 However, the ABA Statement goes further. It not only requires prior consent from the lawyer but also requires notice to the lawyer where, for example, disclosure is required by the court process or in defence of the audit.Footnote40 In responding to a U.S. inquiry, Canadian lawyers may wish to incorporate this limitation so they have an opportunity to consult with their client.

8. To whom should the response be addressed?

While Canadian audit responses are required to be addressed to the client with a copy to the auditors,Footnote41 American audit responses are typically addressed to the auditors with a copy to the client. Because the response will get into the hands of the auditor at the direction of the client, nothing turns on the addressee. The sample form response is addressed to the auditor, as directed by the client.

Summary of Best Practices

  • Provide “information” in your audit response only on:
    • Overtly pending or threatened litigation, whether or not specified by the client, and
    • Unasserted claims or assessments that the client has specifically identified and on which the client has specifically requested comment.
  • The “information” you provide should include only an identification of the proceedings or matter, stage of proceedings, the claims asserted, and the position taken by the client.  “Information” does not generally include a judgment as to outcome or an estimate of the potential amount or range of loss.
  • If your client’s inquiry letter omits unasserted possible claims, do not identify any of them in your response. 
    • Instead, advise your client of them and make sure that the client is aware of its responsibility to bring them to the auditor’s attention and to make appropriate disclosure in the financial statements.
    • Similarly, do not confirm for the auditor the completeness of management’s list of all unasserted possible claims or the accuracy of management’s representation to the auditor concerning disclosure of all unasserted possible claims.  Again, advise your client.
  • Expressly disclaim any responsibility to advise the client respecting financial disclosure in accordance with U.S. standards.
  • Forward a draft of the audit response to your client before releasing it to the auditor.  
  • Going forward, encourage your client to have you prepare, or assist in the preparation of, the description and evaluation of claims and possible claims (including materiality thresholds and exclusions) before the client issues the inquiry letter.
  • Take care to preserve privilege.  Incorporate the recommended language to preserve privilege, including an express statement to the effect that the client does not intend to waive privilege.

By Marlene Kane and Robert Scavone
McMillan LLP