TALKING TO THE AUDITORS: ETHICAL PITFALLS IN COMMUNICATING WITH AUDITORS

TALKING TO THE AUDITORS: ETHICAL PITFALLS IN COMMUNICATING WITH AUDITORS NACUA 49th Annual Conference Erin Stewart Robert Roach Brian R. Murphy {B044...
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TALKING TO THE AUDITORS: ETHICAL PITFALLS IN COMMUNICATING WITH AUDITORS NACUA 49th Annual Conference Erin Stewart Robert Roach Brian R. Murphy

{B0447693}

Major Changes Taking Place In Accounting World • Codification of GAAP • AICPA has launched “Clarity Project” to rewrite auditing standards • Convergence of GAAP and international accounting standards • Stay tuned! Next 2-4 years will involve significant accounting changes

Regulatory Environment Imposing Increased Vigilance • Increased vigilance required to prevent and detect financial wrongdoing. Requirements imposed by • SOX • Federal Sentencing Guidelines • HHS OIG Guidelines • FAR • Calls for increased financial statement “transparency” increases potential for conflicting attorney-auditor roles. • Increasing “transparency” places pressure on attorney client and work product privileges. Auditors will be demanding more information from attorneys. 3

Users Dissatisfied With Current Disclosure Standards • Users demanding more information about loss contingencies arising out of litigation. • FASB is sympathetic to the concerns of financial statement users and has proposed changes to SFAS No. 5 governing financial statement disclosures. • There is just one problem . . .

How Does Anyone Know What’s Beneath the Surface?

Roles in Financial Statement Preparation • Colleges/companies prepare financial statements • Auditors perform tests and gather evidence to corroborate management’s assertions for the purpose of expressing an opinion • Lawyers are engaged as experts to provide corroborating evidence to the auditors. • Lawyers are not the exclusive source of evidential matter

SFAS No. 5: Accounting for Loss Contingencies • Under GAAP, losses fall into three categories: – “Probable, “reasonably possible”, or “remote”

• Disclosure rules differ for each category “Remote” No disclosure required

“Reasonably Possible” Disclosure of possible loss required

“Probable” Accrual required if loss can be estimated

Asserted v. Unasserted Claims • Very important distinction under rules between asserted claims and unasserted claims • For an unasserted claim, unless assertion of claim is “probable,” there is no obligation to accrue or disclose loss contingency • Client makes the determination of whether assertion is “probable” (with possible input from counsel)

Poor Disclosure Under Current Rules Provides Ammunition to Users • “The Company is involved in a number of legal proceedings, including class actions, concerning matters arising in connection with its business. The Company believes it has meritorious defenses to each of these actions and intends to defend them vigorously. The Company believes that it is not a party to any pending proceeding that would have a material adverse effect on the Company’s financial condition. However, it is possible that the outcome of any such proceeding could have a material impact on results of operations in any particular reporting period as proceedings are resolved.”

FASB SFAS No. 5 Project • In September 2007 FASB opened a project to enhance disclosure requirements for loss contingencies under SFAS No. 5. • Board issued an Exposure Draft, Disclosure of Certain Loss Contingencies, in June 2008. • Comment period ended in August 2008. • Roundtable meetings with all stakeholders took place in March 2009. • Trying to wrap up project by early fall.

The Attorney Client Privilege • Oldest of the privileges for confidential communication known to the common law. • Encourages full and frank communication between attorneys and their clients. • Promotes broad public interests in the observance of law and administration of justice.

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Upjohn v. United States • • • • • • •

Employees made communications to counsel; Made so that the company could obtain legal advice from counsel; Employees knew that the purpose of the communications were to allow the company to obtain legal advice; Information was not available from upper management; Employees spoke about matters within the scope of their corporate duties; Communications were confidential; Communication was not disseminated beyond those persons who, because of the corporate structure, need to know its contents 12

Attorneys’ Ethical Duties A lawyer has an ethical duty to preserve and protect clients’ confidences unless the client gives informed consent

Waiver of Attorney Client Privilege Attorney client privilege may be waved by disclosure of communications to third persons • Waiver may be voluntarily or inadvertent. • Waived by disclosure to anyone except those with whom the attorney must communicate in order to assure full and accurate information to give legal advice. 14

Waiver- Communication with Auditors ▪ Disclosure of confidential attorney-client communications to accountants and/or auditors destroys the attorney client privilege, unless made “in confidence for the purpose of obtaining legal advice from the lawyer.” ▪ Auditing, accounting and advisory services is qualitatively different from legal services.

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Attorney Work Product Protection (Qualified immunity from discovery) • Applies to materials created by lawyers and others in anticipation of litigation; • Protects unwarranted inquires into an attorney’s files and mental impressions; • Does not apply to materials created by attorneys for routine business purposes. 16

Two Types of Work Product •

Tangible: memoranda, notes, witness statements and other tangible materials created or collected by attorneys in anticipation of litigation.



Opinion: attorney’s conclusions, legal theories, mental impressions, and opinions.

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Nature of Immunity • Tangible: May be obtained if opposing party it establishes that: • It has a substantial need for the tangible work product, and • It cannot obtain its substantial equivalent by any other means without undue hardship. • Opinion: Generally immune from discovery unless • an opposing party demonstrates a compelling need, • many courts have held that the protection is almost absolute 18

Waiver of Attorney Work Product Protection • Less strict than Attorney Client privilege • Waived where the disclosure is made: – to an opposing party, or – where the disclosure substantially increases the opportunities for adversaries to obtain the information 19

Waiver Decisions Inconsistent! Concern: Auditor's interests are not aligned with company's and thus disclosure to auditor did not serve the privacy interests that the work product doctrine was intended to protect.

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“The Treaty” • “Treaty” refers to two coordinated pronouncements, ABA Statement of Policy and SAS No. 12, that established a common understanding between the professions regarding lawyer responses to audit inquiry letters • Treaty is now over 30 years old (1975-1976) • Proposed amendments to SFAS No. 5 threaten to upset carefully crafted balance reflected in the Treaty

ABA Statement of Policy: Client Consent • ¶ 1 - Must counsel client on consequences of lawyer’s disclosure to auditor in order to obtain client’s informed consent (unless there is nothing to report) • Lawyer should be review draft of proposed response to auditor with client before it is sent • Obligation of lawyer to preserve confidences broader than just information protected by attorney-client privilege

ABA Statement of Policy: Limitation of Scope • ¶ 2 – Appropriate for lawyer to specify scope of engagement for client and date on which information furnished • Lawyer’s response limited to matters given “substantive attention” • Beyond inquiry of lawyers who have rendered services to client, lawyer is under no obligation to undertake review of client’s transactions or matters. Watch out for inquires that request information on all matters of which the lawyer has “knowledge” or other broadly worded requests!

ABA Statement of Policy: Response May be Limited to Material Items • ¶ 3 - Lawyer may appropriate limit response to items which are considered “material” to presentation of client’s financial statements • If lawyer does not expressly limit response to material items, response will not be so limited. • Lawyer should emphasize to client the desirability of establishing realistic standards of materiality with auditor.

ABA Statement of Policy: Limited Responses • ¶ 4 – If lawyer intends to limit response beyond the standard limitations incorporated by reference by language of Paragraph 8 of the ABA Statement of Policy), lawyer should expressly state that response is limited in order to avoid any inference that the lawyer has responded in all respects to auditor’s inquiry If non-standard inquiry is made by auditor, lawyer should expressly state that he or she is not responding to the non-standard inquiry.

ABA Statement of Policy: Loss Contingencies • ¶ 5 – After discussion with client, lawyer may appropriately disclose to the auditor information concerning: – All pending or overtly threatened litigation – Unasserted claims that have been specifically identified by the client and for which client has requested a response to the auditor in the letter Under NO CIRCUMSTANCES is lawyer required to communicate to auditor existence or non-existence of unasserted possible claims EXCEPT FOR those specified by client in audit inquiry letter

ABA Statement of Policy: Loss Contingencies (cont’d) • ¶ 5 – With respect to predicting outcomes, statement contains strong language that expressing judgments limited to “few clear cases” • Sets high bar for a loss being “probable.” Prospects of claimant not succeeding “extremely doubtful” and prospects of success by client judged to be “slight.” • ABA definition of “probable” not the same as FASB definition!

ABA Statement of Policy: Loss Contingencies (cont’d) • ¶ 5 – Lawyer cautioned against providing estimate of amount or range of loss unless probability of inaccurate estimate is “slight.” • Lawyer should avoid language that suggests unasserted claims identified by client represent all such claims or that lawyer concurs with client’s listing of unasserted claims. • Judgment concerning whether assertion of claim is probable will “infrequently be one within the professional competence of lawyers.”

ABA Statement of Policy: Lawyer’s Professional Responsibility • ¶ 6 – Responsibilities to client may, depending on nature of matters handled by lawyer, extend beyond duty to appropriately respond to audit (e.g. securities law compliance) • Responsible for advising client to disclose loss if it meets criteria of SFAS No. 5! Standard audit response letter confirms this responsibility.

ABA Statement of Policy: Limitation on Use of Response • ¶ 7 – Unless lawyer’s response grants permission otherwise, the lawyer’s response may not be quoted or referred to in client’s financial statements • Auditor will provide advance notice to lawyer in event of proposed disclosure of lawyer’s letter in connection with court proceedings.

ABA Statement of Policy: Incorporation by Reference • ¶ 8 – Lawyer is free to modify or supplement the approach set forth in ABA Statement of Policy • All of the limitations and understandings set forth in ABA Statement of Policy may be incorporated by reference by use of model language.

Proposed Amendments to SFAS No. 5 • Exposure draft of proposed amendments proposed extensive changes with respect to disclosures of loss contingencies. Rules regarding accrual left intact. • New disclosures problematic. Potential for serious prejudice to disclosing entity. • Subject to serious criticisms.

Aftermath of Exposure Draft • FASB roundtable meetings produced consensus on number of issues. • Recognition that predicting litigation outcomes hazardous. Big differences in case evaluation depending on stage of case (early v. late), level of publicity, and number of claimants (single v. class action or multiple claimants) • Recognition that big difference between “contentions” and “predictions.” Seemed to be acceptance that disclosing “contentions” would be better model for disclosure framework. • Stay tuned. Project to wrap up soon!

What to Do Now • Buy ABA Auditor’s Letter Handbook. • Learn parameters of ABA Statement of Policy. Not likely to change significantly. • Carefully read incoming audit inquiry letters. Do NOT RESPOND to non-standard requests. • Review drafts of audit responses with clients and discuss consequences of proposed disclosures. • Recommend to clients that appropriate materiality thresholds be set.

Questions & Answers