When a slew of Canadian organizations made the transition at the beginning of the year to an international financial reporting standard, lawyers faced almost overnight new ground rules that could prove to be burdensome, endanger solicitor-client privilege, and potentially prejudice defence in litigation cases.
Misgivings arise from the way that unresolved legal claims, or “contingencies” in accounting speak, must be reported under International Financial Reporting Standards (IFRS). IFRS, quite simply, imposes a higher threshold for identifying claims, takes a different approach to estimating the expected value of a claim, and has more extensive disclosure requirements.
“I don’t see lawyer’s lives getting any easier with IFRS,” remarked Stephen Kerr, a partner with Fasken Martineau Dumoulin LLP, who practices general corporate and commercial law. “Suddenly we’re going to be asked to do a lot more, with a lot more precision and a lot faster.”
On January 1, 2011, publicly accountable for-profit corporations, government business enterprises and other enterprises that chose to do so began using IFRS as the basis for preparing their financial statements. Under IFRS, unresolved legal claims are subjected to International Accounting Standard 37, Provisions, Contingent Liabilities and Contingent Assets (IAS37). In place for over a decade, IAS 37 differs significantly from the way that unresolved claims are interpreted by Canadian Generally Accounting Principles (GAAP).
The Canadian Bar Association (CBA) and the Auditing and Assurance Standards Board (AASB), the Canadian authority that sets generally accepted auditing standards (GAAS) for financial statement audits, have issued interim guidelines to assist lawyers with audit-related inquiries about unresolved legal claims but some questions will likely remain unanswered until either the courts themselves provide guidance or lawyers come to an understanding of how the rules should be interpreted, contend legal observers.
“There is going to be an evolution over the next little while as lawyers work together with their clients and as clients work with their auditors to find the best way to give auditors what they need to have while at the same time preserving the client’s position as best as possible,” said Mark Selick, a partner with Blakes who helped draft the interim guidance. “Most situations probably won’t be tough but there will be some, and I think there is going to have to be some dialogue to figure out the right way to deal with it.”
In both IFRS and GAAP, financial statements should recognize an obligation arising out of a past event when it is probable that a payment will have to be made to settle the legal obligation. The difference between both standards lies in the interpretation of when such legal claims must be reported. Under GAAP’s Section 39 rule, corporations would report legal claims when it is “likely” a payment must be made, something that has over time been interpreted as meaning there is a greater than 70 per chance that a payment may have to be made. IAS 37 uses a wider net and a lower threshold thanks to a “more likely than not” approach. Though there is no official interpretation, corporations would be expected to report legal claims when there is a greater than 50 per cent likelihood of being settled against the corporation.
As important, organizations no longer have the leeway GAAP provided them to report claims. Unlike GAAP’s section 3290, which allows corporations to avoid reporting legal claims when there is insufficient or conflicting evidence, IAS 37 does not grant such latitude.
“Lawyers are going to have to revisit decisions they made in the past about claims, and going forward they’re going to have to ask themselves questions about future claims, taking into account that it’s a different test, with a wider net,” said Kerr. “It’s going to be fascinating to see how lawyers and accountants interpret these rules.”
It’s going to be just as intriguing to see how the legal profession will tackle IAS 37’s requirement that clients be able to give a reliable estimate of the amount that might be owing due to the legal claim. Under IAS 37, corporations are required to provide a “best estimate,” a higher test than GAAP’s “reasonable estimate” approach. Organizations will likely have to perform complex measurement calculations in order to come to a “best estimate” and consult with their counsel to confirm their analysis, but it remains that outside counsel will shoulder much of the burden. Aside from likely approving the “best estimate,” a conundrum by itself, lawyers will have to ensure that the “best estimate” does not harm the interests of their client.
“It’s another conundrum lawyers face because it’s asking us to quantify something that we didn’t have to quantify with as much specificity in the past,” said Kerr. “Business people and auditors, who are closer to the numbers than lawyers are, are now going to be pressed into a situation to try to quantify what the potential impact is going to be if there’s an adverse judgment – and that just makes the lawyer’s job that much more difficult to try and figure out what these things are worth.”
Disclosure of the “best estimate” also can play into the hands of plaintiffs who have claims against entities reporting under IFRS, said Trevor Scott, a leading corporate commercial lawyer in British Columbia. Besides the inherent difficulties of trying to come up with a “best estimate” when so many different factors must be taken into account in a case involving litigation, such disclosure could potentially prejudice the defense of the defendants.
“There is a risk in describing a claim in your financial statement, describing the likelihood of that claim and its possible outcome that the plaintiff could look at that information and use it to their advantage,” noted Scott, a partner with Farris, Vaugh, Wills & Murphy LLP.
Coming up with a “best estimate” could also put in jeopardy solicitor-client privilege, particularly if the client and the auditor do not see eye-to-eye. The interim guidance provided by the CBA and the Canadian auditing authorities states that to protect privilege clients should communicate directly with the law firm without disclosing the communication to the auditor. Lawyers responding to audit inquiry letters should only confirm or deny the reasonableness of the client’s descriptions and estimates, adds the interim guidance. But it may not be that simple, observed Selick.
“In replying to audit inquiry letters, we always have to have in the back of our minds the risk that it might not be privileged,” said Selick. “Once you start talking to someone outside that tent, there is the potential of losing that privilege. So the goal is to keep the reply which would go to the auditor as short and succinct as possible, and not get into anything more than the bare essentials.”
In-house counsel too face new dilemmas, especially since the interim guidance appears to have been drafted with outside counsel in mind, said Fred Headon, who heads Air Canada’s in-house labour and employment law team. The interim guidance does not spell out the what in-house counsel should do when faced with an audit inquiry letter, a situation all the more vexing given that the entity is their client.
“We need to be thinking about it,” said Headon, who was part of the CBA committee that drafted the interim guidance. “When you read the guidance, it seems to presume that the lawyer will always be an external lawyer. We have not tackled the question of what may need to change in the underlying context for an in-house counsel. That’s still to come.”
In the meantime, entities reporting under IFRS risk facing a higher legal tab, says Kerr. “As the detail and disclosure becomes more extensive, as the job become more difficult in trying to estimate liability, I can’t believe it’s not going to add costs and complexity to our clients,” said Kerr.