Spell check underlines contractions of Verb + Not

BTW, do you see this same error in other applications or just Outlook?

Are you saying that a new User with all new blank preferences still showed this behavior? If yes, this is not only strange but indicates the problem is at the base level with the OS or with your Office install. Please verify you checked in a new User.  User and Identity get confused. There is nothing in the Office install that would cause this behavior so we need to look at how the Finder saves "learned" words.

Check System Preferences > Language & Text > Text

According to Apple Help....

If you accidentally add a misspelled word to the dictionary, type the misspelling in the Spelling and Grammar window and click Ignore, or Control-click the misspelling and choose Unlearn Spelling from the shortcut menu.

Other places where the misspelled word could have been added accidentally are:

Outlook > Preferences > Autocorrect

Dictionary file

User's Library/Preferences/Microsoft/Office 2011 (also check the Office 2008 folder) Dictionary file. You can drag to text editor like TextEdit or TextWranger to view and edit.

More info on editing your User's Dictionary file. Lion only directions:

 ~/Library/Spelling/LocalDictionary

Note that you’ll see this Spelling folder only if you’ve added at least one word to the spell checking dictionary via the Learn Spelling contextual command.

    Go to Edit menu --> Spelling and Grammar --> Show Spelling and Grammer.

    Enter your contraction into the top field and then click the Learn button.

In summary, you need to check the Dictionary file in the Microsoft folder in Preferences and the LocalDictionary in Library/Preferences/Spelling.

Thanks for all the info and help.

I'll try to answer all your questions as I'm still having this issue. (Not really an issue anymore as I'm using Mac Mail with Exchange now instead).

1. I do not see this issue in any other application. Not Word, not Mac Mail, not Firefox,e etc. Only Outlook thus far.
2. This issue occurs in a new user created in System Preferences and I switched to the user. (Just to let you know, I have worked for Apple and have a pc support background, unfortunately not a Microsoft Office on Mac support background). This happens on 2 separate computers that were set up independently of one another (no files were transferred in between them as far as preferences go, but they used the same Lion upgrade install and Microsoft Office discs as it's our University's copy).
3. It also happens in a new Identity.
4. I'm not misspelling the words, so I didn't add a misspelled word to the system (and if I did, the red dotted line wouldn't appear). Though I tried your suggestion anyways and opened it up and tried ignoring those words (I can't ignore it or learn it the usual way which is right-clicking it, as the option isn't there). Still no luck though.
5. I looked at both the LocalDictionary file (which I have) and the Custom Dictionary file in the Microsoft folder. Both contained words that I remember adding such as my last name. I tried adding the words that Outlook seems to think are "misspelled" and after saving both files with the words, Outlook still said they were wrong. Oddly enough, I realized Outlook is only underlining the first part in the words like Shouldn but not underlining the 't part. So I tried adding the words with the n but not the 't at the end. Thought it would work, but still no luck.

I'm out of ideas except a complete reinstall without backing up preferences, which I'm fine with. I usually only transfer personal files back and reinstall apps fresh. I may be willing to do that on my work computer when things slow down, but the beginning of every college semester is pretty busy.

Thanks again for your help, I'm willing to keep hacking at this, but as I said, maybe a reinstall of Office or even the OS may be in store.

Thanks,

Tony

Is there a fix for this yet.

I frankly do not understand why Outlook 2011 would have to learn a perfectly correct word. I am sorry to say that I find the whole experience with Outlook 2011 to be really disappointing - I honestly thought that I would be getting something that exceeded Outlook 2007 (windows) but I am astounded by the lack of functionality to be able to create well-designed e-mails (with tables, pictures, dynamically numbered bullet points, multi-lingual spell-check), flexibility to copy and paste either attachments or entire messages into another message, ability to drag e-mails to tasks or calendar entries etc.

I am new to Mac, so maybe I have been spoiled by the excellent Windows products ?