Changed By Not Changing At All*: Accounting Regulators Continue to Limit Pending Litigation Disclosures


In 2010, when my co-authors and I published a piece in this journal (W. R. Koprowski, Steven J. Arsenault, and Michael Cipriano, Financial Statement Reporting of Pending Litigation: Attorneys, Auditors, and Difference of Opinions, 15 Fordham J. Corp. & Fin. L. 439 (2009)), I was hopeful that changes could be forthcoming regarding pending litigation in the financial statements of US public companies. At that time, both the Securities and Exchange Commission (“SEC”) Office of the Chief Accountant and Financial Accounting Standards Board (“FASB”) were considering ways to give financial statement users more useful and accurate information regarding pending litigation without asking attorneys to violate the American Bar Association’s 1975 Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information (known as “the ABA Treaty”).

Financial statement auditors are required to ask lawyers of their audit clients to provide various information about cases pending against their clients (i.e., likelihood of loss, potential size of loss, etc.) for purposes of auditing clients’ financial statements and related disclosures under State of Financial Accounting Standards (“SFAS”) No. 5 Accounting for Loss Contingencies (FASB, 1975). [1] The ABA Treaty, however, requires attorneys to be very limited in their discussion of pending litigation with good reason. Such disclosures could both breach Attorney-Client privilege and provide the adverse party with information that could be used against the client in court. The auditor is nevertheless left with the very undesirable position of needing evidence to support (or refute) its client’s compliance with FASB Accounting Standards Codification Topic (ASC) 450 but having a very limited amount of access to that evidence due to the ABA Treaty.

Auditing standards refer to an instance whereby the auditor cannot access adequate evidence to support a client’s assertion as a scope limitation (PCAOB AS 3101.20 – 3101.34). When a material scope limitation arises, auditing standards require auditors to render a qualified opinion, also known as an “except for” opinion, on their clients’ financial statements (PCAOB AS 3101.21). In our 2010 paper, we noted that the ABA Treaty makes it next to impossible for auditors to experience anything but a scope limitation with regard to pending litigation. As such, one would expect to see a considerable amount of qualified audit opinions because there are an undeniably high number of cases against US public companies of a material nature to those companies’ financial positions.

However, since 2000, other co-authors and I have scoured countless databases to discover only one (YES 1!) case of an auditor qualifying an opinion due to a scope limitation related to pending litigation. In 2001, Baum and Company, P.A. (Cedar Springs, FL) issued a qualified audit report to International Environment Management, Inc. (IEMI) with the following paragraphs:

We were unable to obtain a discussion or evaluation from the Company’s outside legal counsel of pending or threatened litigations.

In our opinion, except for the effects on the December 31, 2000 financial statements of such adjustments, if any, as might have been determined to be necessary have we been able to obtain a discussion or evaluation of pending or threatened litigation from the Company’s outside legal counsel as discussed in the preceding paragraph, the financial statements referred to in the first paragraph present fairly, in all material respects, the financial position of International Environmental Management, Inc. and Subsidiary as of December 31, 2000 and 1999 and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.

So, in the past 15 years either auditors have 1) received the evidence from attorneys they have needed to audit their clients’ pending litigation accounting and disclosures, potentially in violation of the ABA Treaty, OR, 2) issued unqualified opinions to clients without said evidence. I am a CPA with a Ph.D. in Accounting with experience working for a large international public accounting firm as an auditor; I am not an attorney. However, I know enough about attorneys to know that no attorney would risk disbarment to make an auditor happy. Since 2000, only 11 qualified opinions have been issued to US public companies, including the one above. [2] Why? Because the SEC only accepts annual financial statements included in registrants’ Form 10-K if they come attached to an unqualified audit opinion (SEC Codification of Staff Accounting Bulletins, Topic 1E2). [3]

This puts audit firms in an impossible position. They can’t get the access to audit evidence they need from attorneys due to the ABA Treaty and yet they also can’t issue a qualified audit opinion without running the risk of getting their publicly-traded clients’ securities delisted. As investors in US public companies, we would like to believe that we are getting financial statements prepared in accordance with GAAP if they are attached to an audit report saying they have been prepared in accordance with GAAP. Unfortunately, that just might not be the case given the current regulatory environment.

In 2010, I was not the only person to see this problem. Both the SEC and FASB were engaged in projects to improve the options for auditors without infringing on the ABA Treaty. FASB drafted its second exposure draft in three years related to updating the accounting for and disclosure of loss contingencies, including pending litigation. The draft called for significant increases in the amount of information disclosed by companies regarding pending lawsuits, including a tabular reconciliation of changes to accruals associated with each pending case and the reasons associated with the company’s inability to estimate a range of potential losses. [4] The 2010 exposure draft was met with nearly 400 comment letters and nearly all of them included arguments against the additional disclosures. One of the primary complaints included in the letters from public accounting firms was that the disclosure was already difficult to audit due to the ABA Treaty and that the additional disclosure requirements would exacerbate that problem substantially. I would like to report that FASB worked tirelessly to take the feedback from all of those stakeholders to produce an updated standard that gave financial statement readers better information, but I cannot. They killed the loss contingency project on July 9, 2012 via a vote of 5-2.

In our 2010 paper, we quoted former Chief Accountant of the SEC Scott Taub’s frustrations with registrants’ lack of disclosure and accruals regarding pending litigation. In 2010, one of Taub’s successors Wayne Carnall, expressed similar frustrations in various speeches, writings and presentation. One of Carnall’s primary “weapons” was to send formal comment letters from the SEC requesting additional information from companies that his staff felt were inadequately living up to the requirements of ASC 450. In his time with the SEC, Carnall published a sample letter sent to these registrants in October 2010. The number of letters sent to registrants regarding ASC 450 between 2008 and 2012 increased dramatically. Unfortunately for financial statement readers, Carnall’s crusade lost momentum with the FASB’s decision to kill the exposure draft in 2012 and we continue to be in the same situation we were in when our paper on this issue was initially published in 2010.

I started this piece by saying I was hopeful in 2010 that disclosures regarding pending litigation would improve. Six years later, am I still hopeful? I am definitely not as hopeful as I was, but I also know that FASB has a vision of converging US standards with International Financial Reporting Standards (“IFRS”) based on their published rationales behind several recent standard updates (formally known as Accounting Standard Updates). If that becomes true with their approach toward accounting for loss contingencies, then there is reason for hope that financial statement users will get enhanced information regarding pending litigation because the international standard for loss contingencies (IAS 37) requires a richer set of information than does ASC 450.

That said, auditors will still be handcuffed by both the ABA Treaty and the SEC ban on qualified opinions regardless of what changes FASB makes to ASC 450, if they ever do. We all know that the likelihood of the ABA Treaty being modified in any way is extremely remote. As such, the “answer” seems to be that the SEC consider rescinding its ban on qualified opinions, especially regarding pending litigation. While the scope of any audit is to opine on the financial statements as a whole (PCAOB AS 3101.04), many clients’ accounting and disclosures related to pending litigation often cannot be adequately audited and that fact should be specifically spelled out in a qualified audit opinion just as Baum and Company did in its 2001 audit report on IEMI. Unless the audit firm qualifies its opinion in instances when it cannot obtain the information it needs regarding a client’s pending litigation, the audit firm is effectively exposing itself to excessive liability for accounting of which the firm has little or no evidence to support the client’s accordance with ASC 450.


[1] SFAS No. 5 has since been codified by FASB in Accounting Standard Codification 450 (ASC 450).

[2] Cipriano, M., E. Hamilton and S. D. Vandervelde. 2016. “Has the qualified audit opinion become the “Rotten Kid” punishment threat?” Unpublished Working Paper.

[3] IEMI eventually had its securities delisted in 2005 largely due to their inability to get Baum & Co. (and subsequent auditors) to issue an unqualified audit opinion on their financial statements without getting evidence from their attorneys regarding pending litigation.

[4] Current GAAP (ASC 450) allows a company to avoid accruing a liability for a pending lawsuit if the a) loss is considered a remote possibility, b) the lowest end of the estimated range of possible loss is or c) the range of possible loss cannot be estimated.


*A line from Pearl Jam’s 1993 “Elderly Woman Behind the Counter in a Small Town”.

**Michael Cipriano is an Assistant Professor of Accounting at James Madison University and a licensed Certified Public Accountant.  Dr. Cipriano earned his PhD in Accounting from the University of South Carolina and has had his research related to financial information intermediaries (auditors and equity research analysts) published in various journals including Electronic Markets, Managerial Auditing Journal and the Journal of Prediction Markets.  He also serves on the Editorial Board of the Journal of Corporate Accounting and Finance and delivers significant hours of continuing professional education to accounting firms and state CPA societies. He can be reached at [email protected].


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