UK Regulator Guides on Agreements Limiting Auditor Liability

Guidance has been issued on the use of agreements limiting auditor liability between companies and the outside auditors of their financial statements. The UK Companies Act now permits such agreements; and the Financial Reporting Council has offered guidance to help companies assess whether to enter into an agreement with their auditor, and to help them implement the agreement if they decide to do so. One of the key considerations when making that assessment will be the views of the shareholders, said the FRC, since they must approve any agreement.

While each company must make its own decision as to whether to enter into such an agreement with its auditors, the FRC believes that it would be desirable for companies to discuss with their leading shareholders the merits of entering into an agreement in their particular circumstances.

Effective April 2008, the Companies Act allow companies to limit the liability of their auditors by contract, provided that shareholder approval is obtained. Also, the resulting arrangements are effective only to the extent that they are fair and reasonable in
the particular circumstances.

The fair and reasonable standard is the key principle in the legislation. It means that a court can override any limits agreed to by the company and the auditor upon a finding that they are less than fair and reasonable. And a court can reach this conclusion even if the shareholders approved the agreement. In these circumstances, the agreement does not become null and void; instead the liability is amended to a level set by the court. Although the courts ultimately decide what is a fair and reasonable, the Act lists factors to be considered in making such a determination, such as the professional standards expected of the auditor.

Provided they obtain valid shareholder consent, directors will not incur personal liability in relation to the decision to enter into such an agreement if they act independently with
reasonable competence for the benefit of the shareholders. When deciding whether the company ought to enter into a liability limitation agreement, said the FRC, directors should understand the nature of the proposed agreement and its practical implications. By limiting the auditors’ liability, the company will necessarily accept that there will be an increased risk that it may be unable to recover part of the loss suffered.

There are a number of valid reasons for a company to enter such an agreement. For example, it may enable the company to obtain audit services from an audit firm of its choice at an acceptable price. A proposed agreement which uses the proportionality approach would ensure that the auditors potential liability in the event of a financial reporting failure is appropriately matched to their degree of responsibility for that financial reporting failure and their available resources.

The FRC also urged companies and auditors should consider how any agreement will interact with the audit engagement letter. One option is for the principal terms to be part of the audit engagement letter. Another option is to have a separate agreement just dealing with the limitation of the auditor’s liability, and which cross references the audit engagement letter.

When the company changes its auditor, the liability limitation agreement will not apply to the new auditor. Therefore, the incoming auditor will have to execute a new agreement, which will also be subject to shareholder approval.

A company must disclose the principal terms of the audit liability limitation agreement in a note to its annual financial statement for the financial year to which the agreement relates. Although there is no legal or regulatory obligation to do so, the FRC advises the company to consider whether any explanation or further disclosure would be appropriate in a report by the audit committee.