Confirming litigation and claims with lawyers
How an auditor identifies litigation and claims under ISA 501, when to write to the client's external lawyers, and how replies feed provisions and notes.
By Achekam · · 5 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
A former employee has taken the client to the labour court. A customer is withholding payment and threatening to sue over defective goods. The client has been served with a summons over a boundary dispute and passed it to its attorneys. Management mentions none of this at the planning meeting, not out of dishonesty, but because nobody asked the right question. The lawyers' invoices in the general ledger tell a different story.
Litigation and claims are one of the areas ISA 501 picks out for specific attention. The auditor must design procedures to identify them and, where there is a risk of material misstatement, seek direct communication with the client's external legal counsel.
Inquiries of management and reading minutes
Identification comes first. ISA 501 requires procedures to identify litigation and claims that may give rise to a risk of material misstatement, including:
- inquiry of management and others within the entity, including in-house legal counsel where there is one;
- reviewing minutes of meetings of those charged with governance, and correspondence between the entity and its external legal counsel;
- reviewing legal expense accounts.
The legal expense review is often the most productive. List every firm of attorneys paid during the year and after year end, with the amounts and a brief description of the matters from the invoices. A firm paid modest sums every month for a year is probably acting in something more than routine contract work.
Ask the client for that list, and for a schedule of matters with their status, through the RFI console. Staff create, send and track requests for documents, answers and confirmations there, whichever screen the request was raised from, and the timeline records what was asked and when it was answered.
When to write to external lawyers
If the auditor assesses a risk of material misstatement relating to litigation or claims, or audit procedures indicate that other material litigation or claims may exist, ISA 501 requires the auditor to seek direct communication with the entity's external legal counsel, unless law, regulation or the relevant professional body prohibits it, in which case the auditor performs alternative procedures.
The communication is through a letter of inquiry, prepared by management and sent by the auditor, asking the lawyer to reply directly to the auditor. Two forms are common:
| Form | How it works | When it suits |
|---|---|---|
| General inquiry | Asks the lawyer to list and comment on all matters they are handling | Where management's list may be incomplete |
| Specific inquiry | Management lists the matters and its assessment; the lawyer comments on each and confirms the list is complete | Where lawyers in the jurisdiction respond only to specific questions |
In practice, many lawyers will respond only to a specific inquiry, and may limit what they say to protect privilege. That is why management's schedule of matters, prepared carefully, matters so much.
Preparing and approving the letter
The letter should identify each matter, ask for the lawyer's view of the likely outcome and an estimate of the financial implications, including costs, and ask whether there are matters not listed. It should be addressed to the specific lawyer responsible, at an address the auditor has checked, and signed by management authorising the lawyer to respond to the auditor.
In Achekam, a legal letter can be handled as an external confirmation. Staff plan the confirmations and prepare the requests, and a different person approves each request before it goes. Use that approval to check the points that most often go wrong: the right firm and the right person, every matter on management's schedule included, and the authorisation from management attached.
Sending it and recording how
Achekam does not send confirmation requests itself. Staff send them and record how, and each respondent answers through a single-use link. A lawyer who prefers to reply on the firm's letterhead by e-mail or post may do so; the team records the reply's arrival and attaches it.
Timing matters. A letter sent at the start of fieldwork may be out of date by the time the report is signed. If the gap is long, ask the lawyer for an update close to the report date, or obtain management's written confirmation that nothing has changed and corroborate it with legal invoices after year end.
If management refuses permission for the auditor to communicate with its lawyers, or the lawyer refuses to respond appropriately, and the auditor cannot obtain sufficient appropriate evidence by alternative procedures, ISA 501 requires the auditor to modify the opinion under ISA 705. A non-reply should never simply be left on the file; the alternatives for non-replies in other confirmations are similar in spirit to those in debtor confirmations: when nobody replies.
Using the replies for provisions and disclosures
The lawyer's reply is evidence about outcome and amount, but the accounting judgement remains management's, and the audit judgement the auditor's. Under IAS 37 and Section 21 of IFRS for SMEs, a matter where an outflow is probable and can be estimated reliably needs a provision; one where an outflow is possible needs disclosure as a contingent liability unless it is remote.
A worked example in words: the lawyer confirms that the former employee's claim is likely to succeed and estimates the award and costs within a range. Management has provided nothing. The team asks management for its best estimate, proposes a provision on that basis, and checks that the uncertainty is disclosed. The boundary dispute, which the lawyer describes as defensible with a low chance of loss, is disclosed as a contingent liability, or not at all if the lawyer considers the risk remote.
These judgements can be contentious, especially when a provision would breach a covenant. Staff can take a technical consultation from question to conclusion and closure, and record a difference of opinion with each party's position, escalation and resolution. How provisions and contingencies are presented is covered in provisions and contingent liabilities. The IFRS Foundation's summary of IAS 37 explains how provisions, contingent liabilities and contingent assets are defined and accounted for, and what must be disclosed.
On the litigation work item, each procedure is marked done only with a written response and its documents, or set aside with a reason; steps are never deleted. Record the list of lawyers, the matters identified, the letters sent and replies received, and the conclusion on each matter.
A litigation checklist
- List every law firm paid during the year and after year end.
- Obtain management's schedule of matters and read minutes for others.
- Decide whether a letter is needed, and which form.
- Have the request approved by someone other than its preparer, then send it and record how.
- Update the position close to the report date.
- Conclude on provision, disclosure or neither for each matter.
Start with the ledger
On your next file, before the planning meeting, run a report of payments to attorneys for the year. Take it into the meeting and ask management about each one.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
