Legal claims can have a significant impact on a company’s financial position and financial performance. They can range from contract disputes, employment disputes, and environmental claims to product liability claims and intellectual property disputes.
Therefore, it is critical for auditors to understand the accounting treatment and disclosure of legal claims in financial statements.
The purpose of this article is to provide a comprehensive overview of audit procedures for legal claims under IFRS. The article will cover the accounting recognition, measurement, and disclosure of legal claims, as well as audit risks associated with these claims and audit procedures to mitigate these risks.
Accounting Under IFRS for Legal Claims
A. Recognition of Legal Claims
IFRS requires companies to recognize a liability for a legal claim when it is probable that an outflow of resources embodying economic benefits will be required to settle the claim, and a reliable estimate of the amount can be made.
In addition, legal claims should be disclosed in the notes to the financial statements if they are material.
B. Measurement of Legal Claims
IFRS requires that legal claims be measured at the best estimate of the amount that is required to settle the claim. This estimate should take into account the probability of different outcomes and the associated costs.
If the outcome of a legal claim cannot be estimated reliably, it should not be recognized as a liability.
C. Disclosure of Legal Claims
IFRS requires companies to disclose information about legal claims in the notes to the financial statements. This information should include a description of the nature of the claim, an estimate of its financial impact, and the expected timing of any settlement.
Audit Risks for Legal Claims
Audit risks in the context of legal claims involve the potential for an auditor to issue an incorrect audit opinion on the financial statements. These risks arise from the difficulties in assessing and evaluating the validity and accuracy of legal claims and their potential impact on a company’s financial position.
The following are some common audit risks associated with legal claims:
- Lack of understanding of the legal process and jurisdiction: Legal claims can be complex and difficult to understand, particularly if they involve different jurisdictions and legal systems. This can result in auditors having difficulty in accurately assessing the potential outcome and impact of a legal claim on a company’s financial position.
- Inadequate assessment of the likelihood of a claim being successful: The success of a legal claim can depend on many factors, including the strength of the evidence, the credibility of witnesses, and the interpretation of relevant laws and regulations. An auditor must assess the likelihood of a claim being successful and adjust the financial statements accordingly.
- Incomplete or unreliable information: Legal claims often involve large amounts of data and information, which can be difficult to obtain and assess. Auditors must ensure that the information they use is complete, accurate, and reliable, and that they have taken into account all relevant factors.
- Difficulty in estimating the potential financial impact of a legal claim: Legal claims can have a significant impact on a company’s financial position, but it can be difficult to estimate the amount of any potential damages or settlements. Auditors must exercise caution and use their professional judgement when making these estimates.
- Timing of legal claims and settlements: Legal claims can take many years to resolve and settlements can occur at any time. Auditors must consider the timing of any claims or settlements in their audit procedures and must make any necessary adjustments to the financial statements in a timely manner.
- Complexity of accounting for legal claims: The accounting for legal claims can be complex, particularly when the claims involve multiple parties or multiple jurisdictions. Auditors must have a good understanding of the relevant accounting standards and must exercise caution in making any necessary adjustments to the financial statements.
- Inadequate internal controls: The management of legal claims can involve many different departments within a company, and auditors must ensure that the internal controls in place are adequate and effective in managing these risks.
- Limited access to information: In some cases, legal claims may be subject to confidentiality agreements or other restrictions on the release of information. Auditors must consider these restrictions in their audit procedures and must ensure that they have access to all relevant information in order to carry out their work effectively.
- Potential for fraud and unethical behavior: Legal claims can be a source of fraud and unethical behavior, particularly in cases where there is a temptation to manipulate information or misstate the financial impact of a claim. Auditors must be vigilant in detecting and preventing these risks.
- Lack of specialist knowledge and expertise: Legal claims can involve complex legal, regulatory, and technical issues, and auditors must have the necessary specialist knowledge and expertise to assess these risks effectively.
When auditing legal claims, there are certain key assertions that must be considered to ensure the accuracy and completeness of the financial statements. These assertions include:
- Existence – The legal claim actually exists and is enforceable.
- Rights and Obligations – The entity has the right to recover amounts claimed and the obligation to pay amounts claimed against it.
- Completeness – All legal claims that should be recorded have been recorded.
- Valuation – The legal claims are recorded at the correct amounts, including any estimates and provisions made.
- Presentation and Disclosure – The legal claims are properly presented and disclosed in the financial statements.
Walkthrough testing is an important part of the audit process for legal claims. The objective of this testing is to gain an understanding of the processes and controls in place for recording, measuring, and reporting legal claims. During walkthrough testing, the auditor will typically:
- Review the documentation and processes for recording legal claims.
- Observe the recording and reporting of legal claims to ensure compliance with accounting policies and procedures.
- Review the legal claims recorded in the financial statements to ensure they are properly supported.
Test of Control
Test of control is another key component of the audit process for legal claims. The objective of this testing is to evaluate the effectiveness of the controls in place to prevent or detect material misstatements in the financial statements.
During a test of control, the auditor will typically:
- Evaluate the design and implementation of controls related to legal claims.
- Perform substantive procedures to test the controls in practice.
- Evaluate the results of the testing and determine if any additional substantive procedures are necessary.
- Document the results of the testing and any issues identified.
The audit of legal claims requires a thorough understanding of accounting principles and practices, as well as an evaluation of the relevant audit risks and controls.
The auditor must also perform appropriate substantive procedures and testing to ensure the accuracy and completeness of the financial statements.
Substantive Audit Procedures
Substantive audit procedures refer to the tests and procedures performed by auditors to gather evidence about the financial statements of an entity. The objective of these procedures is to obtain sufficient appropriate evidence to support the auditor’s opinion on the financial statements.
In the context of legal claims, the following are some of the substantive audit procedures that auditors can perform:
- Reviewing company’s legal claims policies and procedures
- Reviewing the company’s legal reserves, which are an estimate of the costs associated with settling claims and lawsuits
- Examining contracts and agreements related to the legal claims
- Reviewing the outcome of any legal proceedings related to the claims
- Performing analytical procedures on the claims, such as trends and fluctuations analysis, to detect any irregularities
- Obtaining an understanding of the company’s insurance policies and the coverage they provide for legal claims
- Evaluating the sufficiency and accuracy of the legal reserves set by the company
- Performing a review of the company’s communication with lawyers and other outside parties regarding legal claims
- Reviewing the company’s records and documentation for any settlements or payments related to legal claims
- Evaluating the company’s internal control procedures and processes related to legal claims to determine their effectiveness.
By performing these substantive audit procedures, auditors can gain a better understanding of the legal claims and their impact on the financial statements.
This can help auditors to provide a more informed opinion on the financial statements, which can improve the credibility of the financial statements for stakeholders.