Legal letters: litigation, claims and assessments under AU-C 501

• List the procedures AU-C 501.17 requires to identify litigation
• Identify the required contents of a letter of inquiry under AU-C 501.23
• Set the effective date and due date for a lawyer response
• Determine the report effect of a refusal under AU-C 501.25

Finding the matters first

The legal letter is corroboration, not discovery. AU-C 501.17 requires procedures to identify litigation, claims and assessments that may give rise to a risk of material misstatement:

• Inquiry of management and others in the entity, including in-house legal counsel.
• Obtaining from management a description and evaluation of litigation, claims and assessments at the balance sheet date and through the date the information is furnished, including which matters were referred to counsel.
• Reviewing governance minutes, management's documents on the matters, and correspondence with external counsel.
• Reviewing legal expense accounts and invoices from external counsel.

The legal expense review is where most unknown lawyers turn up. Read the invoice descriptions, not only the vendor list. A firm billed for "employment matter" work in October is a lawyer you write to.

For each matter you find, AU-C 501.18 requires evidence about when the cause of action arose, the probability of an unfavorable outcome, and the amount or range of loss. Those three points map directly to ASC 450 recognition and disclosure; see ASC 450 loss contingencies.

The letter of inquiry

Unless your procedures show no actual or potential litigation that could cause a material misstatement, AU-C 501.19 requires you to seek direct communication with external legal counsel through a letter of inquiry prepared by management and sent by you. If in-house counsel is responsible for litigation, AU-C 501.20 adds a similar letter to in-house counsel, which does not replace the external letter. If you decide not to send a letter, AU-C 501.21 requires you to document why.

AU-C 501.23 lists the minimum contents. The letter includes:

1. Identification of the entity, its subsidiaries and the date of the audit.
2. Management's list of pending or threatened litigation, claims and assessments on which counsel has been engaged and devoted substantive attention, or a request that counsel prepare the list.
3. Management's list of unasserted claims that management considers probable of assertion and that would have at least a reasonable possibility of an unfavorable outcome.
4. For pending and threatened matters, a request that counsel describe the matter, evaluate the likelihood of an unfavorable outcome, estimate the loss or range if possible, and identify any omissions from the list.
5. For unasserted claims, a request that counsel comment where its views differ from management's.
6. Management's statement that it understands counsel will advise it when an unasserted claim may call for disclosure, and a request that counsel confirm that understanding.
7. A request that counsel identify the nature of and reasons for any limitation on the response.
8. A request that counsel specify the effective date of the response.

The legal letter template follows that list.

Timing

Ask for a response with an effective date close to the report date. AU-C 501.A55 says a two-week period between the specified effective date and the latest date the response is to be sent to you is generally sufficient. If the report date slips, the response may need to be updated, because the gap between the lawyer's effective date and your report date is a gap in your evidence.

AU-C 501.24 requires you to consider asking why counsel resigned or was replaced when you learn of a change.

Refusals and limitations

AU-C 501.25 requires a modified opinion if counsel refuses to respond appropriately and alternative procedures do not give you sufficient appropriate evidence, or if management refuses permission for you to communicate or meet with external counsel. Management's refusal is a scope limitation imposed by management, so AU-C 705.11 through .13 also apply.

Not every limitation is a refusal. Responses commonly limit themselves to matters given substantive attention, and that is consistent with the request. Evaluate the response against the matters you know about: a material matter that counsel declines to evaluate is a gap you must close another way.

Common file findings

• No letter sent to a firm that appears in the legal expense account.
• Response effective date weeks before the report date with no update.
• Management's list attached to the letter omits a matter in the minutes.
• The file holds the response but no evaluation of how each matter was accounted for and disclosed.

The loss contingency evaluation log closes that last gap.

Cedar Point Logistics, LLC: lining up the letters