Why Does the Auditor Ask About Legal Matters?

An important responsibility of the accountant in an audit engagement for community associations is the determination of whether there are legal matters that must be disclosed in the financial statements. Often, determining if the association is involved in any litigation, then, deciding what type of disclosure is required, if any, is a complicated matter for the accountant. Sometime, the volunteer boards of directors or the community association managers do not understand the various compliance reporting issues regarding legal actions; thus, they may not supply the appropriate information to the auditor. It is then left up to the auditor to develop tactics to discern the existence and extent of litigation.

There are several audit procedures that assist in the discovery of litigation. The most helpful are 1) inquiry of management – preferably at the onset of the audit, 2) reading of the board meeting minutes, 3) examining attorney bills and 4) obtaining a representation letter from the association’s attorney. The auditor is looking for both pending and threatened litigation.

When legal matters are found, the auditor must use judgment and take extra precautions to ensure that litigation matters and other contingencies are properly disclosed and reported in the audit. Also, the boards of directors and managers should review the footnotes closely to ensure that the auditor has correctly stated the current position of the Association with regards to legal matters. It is important that current owners as well as prospective owners be properly notified of the nature of the litigation.  Generally, the outcome of the litigation cannot be ascertained and this statement in generally included in the footnote also. An example of a basic footnote is as follows:

            The Association is in litigation with the developer of the project over alleged construction defects. Some of these defects include…. Discovery proceedings are in progress. (e.g. or, a trial date has been set for July, 200X. There is court ordered mediation which is currently in progress.) The ultimate outcome of the litigation cannot presently be determined. 

This disclosure is an important item in the audit report. Boards of directors should remember that the financial statements, including the footnotes, are ultimately their responsibility. Before the board authorizes an audit report to be issued, especially when there are pending or potential legal matters, the board should take the time to discuss the matter with their attorney, and ensure that the auditor has properly disclosed the current status of the litigation. This is a requirement of generally accepted accounting principles and of generally accepted auditing standards for the CPA. The board’s and/or manager’s input in the matter is critical. This is a responsibility which must be taken seriously.