What it means
The process starts with management rather than the auditor. The company writes to each law firm it uses, lists the matters it believes are outstanding and asks the lawyer to confirm or correct that list, and the lawyer then replies directly to the auditor, which is what makes the evidence independent.
What the auditor needs is an assessment of two things for each matter: how likely a loss is, and roughly how large it might be. Those two answers determine whether the company must record a liability in the accounts, merely disclose the matter in a note, or say nothing at all.
Lawyers reply carefully because anything they write could later be used against their own client. Professional guidance allows them to decline to estimate an outcome where a matter is genuinely too uncertain, so phrases such as an inability to express an opinion on the likely outcome are common rather than evasive.
Accounting rules translate the lawyer's language into numbers. Where a loss is probable and can be reasonably estimated, the company accrues it as an expense and a liability; where it is only reasonably possible, the matter is disclosed but not accrued; where it is remote, neither step is required.
A refusal to respond, or a reply that omits a matter the auditor already knows about, is a serious problem. It counts as a limitation on the scope of the audit, and in bad cases it leads to a qualified opinion or the auditor resigning from the engagement.
In practice
Real-world examples.
Example
A medical device manufacturer is defending fourteen product liability claims. Its auditors will not sign off until the company's three law firms each confirm the list of matters and give a view on likely outcomes. Two firms respond fully, and the third takes six weeks, delaying the audit report and the group's results announcement.
Example
A retailer is in dispute with a landlord over dilapidations at a closed store. The attorney's letter states that a loss is remote because the lease wording clearly favours the tenant, so nothing is accrued and nothing is disclosed. The auditor keeps the letter as evidence supporting that decision.
Example
A software business is being acquired and the buyer's team reviews the last audit file. The attorney's letter reveals a customer claim that never appeared in the vendor's own due diligence pack, and the buyer negotiates a $600,000 escrow to cover the risk before completion.
Formula
Calculation
Accrued legal liability = the sum of all matters that are both probable and reasonably estimable, taken at the best estimate, or at the low end of a range where no single point in the range is more likely than another.
A manufacturer's lawyers reply on three matters at the year end:
Matter A, a breach of contract claim. Loss is probable, best estimate $320,000.
Matter B, an employment claim. Loss is probable, estimated between $80,000 and $140,000 with no point more likely than any other.
Matter C, a patent claim. Loss is only reasonably possible, potential exposure $1,500,000.
Accrual: Matter A at $320,000 plus Matter B at the low end of its range, $80,000.
$320,000 + $80,000 = $400,000 recorded as a liability and an expense.
Disclosure only: the additional possible exposure on Matter B of $140,000 - $80,000 = $60,000, plus the full $1,500,000 on Matter C.
$60,000 + $1,500,000 = $1,560,000 of reasonably possible loss described in the notes but not recorded.
Matter C changes nothing in the profit figure this year, yet a reader of the accounts still learns that a $1,500,000 claim exists.Case study
Seen in the real world.
Corbell Plastics is a fictional packaging manufacturer created to illustrate this concept. In the year under review, Corbell's management prepared its usual list of legal matters for the auditors and included only two items: a small supplier dispute and a routine employment grievance. Both were assessed internally as trivial.
Corbell's external law firm replied to the auditors with a third matter management had left off the list, an environmental claim from a regulator relating to a site the company had closed four years earlier. The lawyers described a loss as probable and estimated the clean-up contribution at between $700,000 and $1,100,000, with no figure within that range more likely than another.
Under the accounting rules Corbell accrued $700,000, the low end of the range, and disclosed the further $400,000 of possible exposure in a note. The finance director's initial reaction was that the lawyers had created a problem, but the audit partner's point was the opposite: the obligation already existed, and the attorney's letter simply made it visible before the accounts were published rather than afterwards.
Watch out
Common mistakes.
- Treating the letter as an optional formality. It is a primary source of audit evidence over contingent liabilities, and a missing reply can stall a whole reporting timetable.
- Sending the request to only the company's main law firm. Every firm handling any material matter, including specialist employment or intellectual property counsel, needs to receive one.
- Assuming a probable loss with a wide range means nothing is recorded. Where no point in the range is more likely, the low end is accrued and the remainder is disclosed, so something is always recognised.
Questions
People also ask.
Who writes the letter, management or the auditor?
Management writes the request and lists the matters, the lawyer writes the reply, and the reply goes straight to the auditor rather than back through the company.
What happens if the lawyer refuses to answer?
The auditor treats it as a scope limitation, and if the exposure could be material the result is usually a qualified or disclaimed opinion.
Does the letter cover matters that arose after the year end?
Yes, it should cover unasserted claims and matters arising up to the date of the auditor's report, because those can still require disclosure as subsequent events.
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