A former employee files a $2.4 million wrongful termination suit three weeks before year-end. Management's counsel calls it "nuisance litigation" and books nothing. The auditor sends a letter to outside counsel and gets back one paragraph: "We decline to provide an evaluation." That single sentence, not the merits of the case, determines whether you can issue an unmodified opinion.
HIGH-FREQUENCY: AU-C 501 (Audit Evidence: Specific Considerations for Selected Items) requires the auditor to design procedures to identify litigation, claims, and assessments that may give rise to a risk of material misstatement. AU-C 501 treats litigation as a risk-of-misstatement question, not a legal question. The auditor is not deciding who will win, but whether the financial statements account for and disclose the matter correctly under FASB ASC 450.
HIGH-FREQUENCY: Five procedures are mandated:
- Inquire of management about policies for identifying, evaluating, and accounting for litigation. Obtain a list of pending and threatened matters with management's evaluation of each.
- Inquire of legal counsel through the attorney letter (below).
Common mistakes
- Treating inquiry of management as sufficient. AU-C 501 requires five procedures. Choices that stop at "ask management" skip the attorney letter, minutes review, legal expense review, and correspondence review.
- Substituting alternative procedures for the attorney letter. When counsel refuses to respond, candidates often pick "perform alternative procedures." That cannot supply a legal evaluation of likelihood and range of loss. A refusal is a scope limitation: qualified opinion or disclaimer.
- Confusing the FASB ASC 450 thresholds. Probable triggers accrual when estimable; reasonably possible triggers disclosure only; remote triggers neither. Trap answers accrue reasonably possible matters or disclose remote ones.
Bottom line
- AU-C 501 requires procedures to identify pending or threatened litigation, claims, and assessments that may give rise to a risk of material misstatement
- Five procedures: inquire of management, send an attorney letter, review TCWG minutes, review legal expense, examine attorney correspondence
- The attorney letter is the principal corroborating evidence: management lists matters; the attorney evaluates likelihood and range of loss
- The letter is prepared by management, sent under the auditor's signature, and the attorney replies directly to the auditor
Exam shortcut
When a question asks what procedures the auditor performs for litigation, the answer references all five AU-C 501 steps anchored by the attorney letter. Choices that list only one or two are incomplete. When the attorney declines to respond or replies so vaguely the auditor cannot conclude, the answer is scope limitation: qualified opinion or disclaimer, never "perform alternative procedures." When the cue gives a likelihood word and an estimability...
The full lesson (about 1,874 words, 12 min read) adds 1 worked example, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- III.E4
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