February 24, 2011

Clearing Up Confusion Over Audit Response Letters

Related to my recent blog drawn from a Willkie Farr memo covering comments made by Corp Fin’s Chief Accountant at a conference, here is a note from Stan Keller of Edwards Angell Palmer & Dodge (repeated from this memo):

There has been some confusion over the role of lawyer audit response letters under the ABA Statement and related AICPA auditing standard (together the so-called “Treaty”) and the relationship of those response letters to the accounting standards governing the accrual and disclosure of loss contingencies. This confusion is reflected in reactions to the FASB’s proposal to revise the accounting standard for loss contingencies and to a recent statement by Wayne Carnall, Chief Accountant of the SEC’s Division of Corporation Finance, warning companies against over-reliance on the Treaty in reporting litigation contingencies in financial statements. If the Treaty is properly understood, that statement should not, itself, be cause for concern.

The Treaty is an auditing standard designed to provide audit support for a company’s accounting for loss contingencies in accordance with applicable accounting standards, principally Accounting Standards Codification 450-20 (formerly Financial Accounting Standard No. 5). As an auditing standard, the Treaty addresses the lawyer’s response to the auditors and is just one part, though a key part, of the auditing process in which auditors gather and verify information. It does not address the disclosure requirements for the company’s accounting for loss contingencies, but rather deals with the information lawyers are to provide to the auditors. The Treaty was carefully constructed so that it provides audit comfort to the auditors, as a third party, while preserving the confidentiality of client communications and the fundamental protections of attorney-client privilege, thereby encouraging consultation by the client with counsel as critical to promoting voluntary legal compliance.

Thus, the information provided by lawyers in the audit response letter to auditors is more tailored than the information companies may be required to disclose pursuant to the accounting standards. The Treaty does not foreclose the auditor from obtaining additional information from the company consistent with the underlying purposes of the Treaty. Nor does the Treaty address the advice lawyers give their client companies regarding the company’s disclosure obligations. Significantly, audit response letters under the ABA Statement reaffirm the role of lawyers, when appropriate in connection with their engagement, in advising clients regarding disclosure.

The lawyer’s audit response letter provides meaningful information to the auditors by identifying overtly threatened and pending claims being handled by the lawyer and unasserted claims as to which the client specifically requests comment. In this way, the auditors are alerted to the existence of claims against the client. By confirming that the lawyer fulfills his or her professional responsibility, the audit response letter permits the auditor to rely on the continued involvement of the lawyer.

To illustrate the distinction between lawyer audit responses and company financial statement disclosures, lawyers in their audit response letter do not speculate on the amount of potential loss. Under the Treaty, they provide an estimate only if the risk of error in the estimate is “slight.” On the other hand, under ASC 450-20, a company may have to estimate the potential loss or range of losses and, if it cannot, explain why it cannot. The SEC has made this disclosure requirement clear as it seeks to ensure compliance with the existing accounting standard. Compliance with this requirement is the best way to convince the FASB that adoption of revised standards, which are likely to be more problematic, is not necessary.

The Battle Over the SEC’s Budget: Reaching a Crisis Stage

I’ve blogged frequently over the need for the SEC to be self-funded and the more recent efforts by Congress to limit the SEC’s budget (here’s one of many blogs on the topic). As noted in “The Hill” blog, House Democrats blasted Republicans recently in a hearing during which SEC Chair Schapiro testified as to the needs of the SEC. During the hearing, Rep. Barney Frank noted he will try to find $131 million from other sources to help fund the SEC.

As it stands, President Obama’s proposed budget would increase the SEC’s budget by 28%, to $1.428 billion from $1.118 billion. In comparison, the SEC would receive $1.069 billion under the House Republican’s plan – which is a reduction of over $70 million from the continuing resolution that the SEC presently is operating under (and a $337 million or 24% decrease, from what the SEC originally requested). As noted in, there is a letter-writing campaign by investors to maintain the SEC’s budget.

In its “2012 Congressional Budget Justification,” the SEC tells the story of how its budget has fared in recent years. From it, you can see that the SEC had 3748 full time equivalent staff last year – down 103 from 2005 (and in 2005, the SEC had received increased funding as a result of earlier financial scandals). Since 2005, the need for increased funding for the SEC has been highlighted in two separate GAO reports to Congress, including how the SEC has lost key staffers due to lack of funding. In fact, for many years during the 1990s – while the country experienced an economic boom – many SEC staffers went for years without a pay raise. When I left the SEC at the end of ’98 – then working for a Commissioner – I made an annual salary in the mid-70s. True.

After receiving an increase in funding in 2005, the SEC experienced three years of frozen and reduced budgets. This resulted in a forced reduction in SEC staff from the 3851 in 2005 to 3465 in 2007, as the turmoil in the markets was beginning to grip the nation. The SEC has also reported that its investments in IT systems underwent a forced decline of about 50% from 2005 to 2009.

If the House Republicans have their way and the SEC’s 2011 budget is reduced by $70 million – the SEC will have only 7 months to make its cuts since its fiscal year ends on September 30th. To do that, I imagine some drastic measures will have to be made. This sure seems like complete madness since Dodd-Frank was enacted less than a year ago. What financial crisis?

Here’s an interesting DealBook column commenting upon the possible ramifications on SEC enforcement cases if the SEC’s budget remains limited.

Recent Developments Regarding Fairness Opinions, Valuation Analyses and Related Topics

We have posted the transcript for our recent webcast: “Recent Developments Regarding Fairness Opinions, Valuation Analyses and Related Topics.”

My condolences to those that knew Joe Flom, one of the founders of Skadden Arps and beyond a giant in corporate law. As I understand it, Joe was working until near the end despite being the advanced age of 87. Amazing.

– Broc Romanek