Assuming that management and the attorney’s assessments differ, how would you resolve such differences when assessing the potential for an unfavorable outcome associated with the claim? What are the pros and cons of relying on the attorney’s assessment versus management’s assessment?

Question

What will be an ideal response?

Answer 1

As a first step, the auditors should provide management with a copy of the attorney’s response letter.
Given that management is responsible for the financial statements, it is management’s responsibility
to resolve this financial reporting issue with its outside attorney. Perhaps management and their
attorney have failed to share relevant information with one another about the case, which might explain
differences in their assessments of the likely outcome. The auditor can help facilitate these discussions;
however, ultimately it is management’s responsibility to prepare the financial statements and related
disclosures.
The advantage of relying on the attorney’s assessment is that the auditor is able to rely on
evidence obtained from an external party who is an expert in assessing legal claims. Given the
subjective nature of evaluating loss contingencies, there is significant potential for management’s bias
to affect (either intentionally or unintentionally) their judgment about the likely outcome of the case.
Naturally, the potential negative effect on pretax earnings associated with accounting for and disclosing
loss contingencies provides an incentive for management to under assess the potential for loss. As a
result, seeking the advice of an outside legal expert offers tremendous advantage to the auditor since
the attorney’s assessment should be more objective than management’s. Additionally, outside attorneys
have extensive legal training and experience. So, the outside attorney is likely to be more objective and
more qualified to make loss contingency assessments than management.
One disadvantage of relying on the assessment of the outside legal counsel is that they may
be more conservative in making their assessment than management. An outside attorney may prefer
to err on the side of conservatism when providing legal assessments to external auditors to minimize
legal liability. Another potential disadvantage of relying on the outside attorney’s assessment is that the
assessment may not be completely reliable because the attorney has not received the most up-to-date
and complete information about the case from management. This disadvantage is most acute when
management and the outside attorney’s assessments are in agreement. For example, management
might have pertinent information that would lead one to conclude the likely outcome of a contingency
is reasonably possible or even probable. Management might withhold this information from both the
attorney and the auditor. In that case, the auditor may not obtain a reliable assessment of the likely
outcome of a contingency from the outside attorney.