Audit: Representation letters for clients and their auditors are a continuing challenge for lawyers, writes Stewart Peters.
Ideally, the governing body would adopt policies and procedures to identify, evaluate, record and report on the outcome of any material legal matter (as ASA 508 Enquiry Regarding Litigation and Claims contemplates). The auditor would in turn review and discuss with management the procedures and obtain a list of legal matters. This would include a description of the matters and an estimate of their likely financial consequences.
Helpful management would in turn enable the auditor to prepare letters from the client entity to the entitys lawyers, properly naming the company and all relevant subsidiaries or divisions, and containing appropriate descriptions of the matters and estimates in relation to any relevant entity. The audit request letters would also seek, in appropriate terms, responses in order to evaluate the reasonableness of managements estimates and to corroborate the completeness of legal matters identified by management.
Ideally, the obligations imposed by the Corporations Act or the general law relating to fulfilment of duties of officers, including preparation of accounts and not misleading auditors, would assist the auditors. Unfortunately, this is not a perfect world.
Auditing standards have been generally tightened. In particular, since 1 July 2006, ASA 508 imposes certain mandatory obligations on auditors. But it recognises that auditors may not receive the responses they seek from lawyers. The obligation imposed on auditors is to endeavour to obtain written representations from all lawyers with whom management has consulted on material legal matters. ASA 508 recognises that the 'completeness of the response obtained is likely to depend on the individual lawyer and the size and complexity of the lawyers firm'.
ASA 508 contemplates what an auditor would ordinarily consider if a response is not received from the entitys lawyers or the response received is incomplete and recognises some understandable circumstances, including litigation at an early stage, material uncertainties and information relating to legal professional privilege, which might be discoverable in litigation.
In 2005, in the 789 TEN case in NSW, the audit letter of request and the solicitors' response commenting on litigation were required to be disclosed to the other party. The present position on privilege is unsatisfactory as it inhibits auditors performing their duties and unfairly prejudices the position of entities concerned in litigation legislative change to reverse this position is desirable.
Band-aid solutions, such as lawyers' letters to the entity alone, may be subject to attack because the letter was not for the purpose of obtaining legal advice. There may well be a waiver of privilege in relation to a lawyers letter if a copy is provided to the auditors. There may also be a waiver of privilege in relation to initial information provided by the entity to the auditors needed for the audit request letters to be prepared.
Confidentiality undertakings by auditors about information or documents received may still be subject to a possible challenge on a discovery application. Justice Bergin in the 789 TEN case made remarks at first instance suggesting that such undertakings arguably conflict with the auditors duty of independence.
In practice, there can be further difficulty for auditors in obtaining responses from lawyers, who may think that a very narrow request is being made of them in relation to the matters specified, or may only respond if litigation has actually commenced or has been threatened in writing.
Lawyers may think this even if the request made of them contains a definition of 'legal matters' of the kind referred to in paragraph 6 of ASA 508.
Auditors have referred to an audit expectation gap to explain the difference between what they do in practice (generally seek to understand the entity, make enquiries and perform various tests) and what some people think they do (that is, check everything). There may also be something of a lawyer understanding gap as to what lawyers are being asked to consider or do. Lawyers may know only so much about a clients affairs and may not appreciate the relevance of what they do know. A lawyer may not comprehend that a matter may be material. For example, the solicitor may be handling a small claim without appreciating that it is the tip of the iceberg that leads ultimately to the sinking of the ship.
The present position regarding privilege is helping to maintain an environment which encourages less-than-candid responses to auditors.
A passage from Auditing in Australia was quoted in the 789 TEN case, which indicated that for various reasons, including privilege, many lawyers believe that despite a clients request that they provide the auditor with information they should be less than candid in letters to auditors. Putting privilege aside, lawyers may be able to say only so much in relation to a particular matter or they may be encouraged to advocate the clients case in an unreasonably optimistic manner. They, however, have obligations to comply with their clients retainer as well as to not provide answers that are simply wrong or false or misleading and deceptive. A rogue in management could potentially manipulate what is provided to the auditors on the management side, and could in turn prevail upon a lawyer to make no reference to a material matter which might ultimately lead to the collapse of the entity, and great loss.
Additionally, a matter could simply be overlooked by a lawyer as a result of an honest misunderstanding of the request being made or some other simple oversight. In circumstances such as this, in future collapses, the recently introduced proportionate liability legislation will lead to those against whom claims are made for loss pointing actively to others they might consider to have caused or contributed to the loss.
Law firms adopting appropriate procedures and terminology in responding to audit requests can provide more meaningful responses. They can also effectively limit the extent to which any complaint might be made regarding these responses, especially in a worst-case scenario.
