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FRC issues auditor liability guidance

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1st Jul 2008
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This week the Financial Reporting Council (FRC) issued the guidance to the auditor liability clauses contained in the Companies Act 2006. The clauses came into force on 6 April.

Directors wishing to enter into auditor liability agreements will need to win approval from their shareholders, “and will not incur personal liability” for the decision “if they act independently with reasonable competence in what they honestly believe to be most likely to promote the company’s success”. Nevertheless the FRC admits that by limiting the auditors’ liability the company stands less chance of recovering any loss suffered should audits go awry.

Outlining why directors might want to limit their auditor’s liability, the FRC says it might help secure firms a better class of auditor – not an argument that indicates auditor choice has been improved. It also suggests such agreements may decrease audit costs. The guidance then goes on to imply that without such an agreement auditors currently face disproportional liability, and reminds directors that “companies regularly enter into agreements with suppliers… which contain limitations of liability” – so why not enter into one with their audit firm?

While shareholders’ authorisation must be south, private companies that have not yet entered into such an agreement (which will be all of them, one imagines) can seek a resolution waiving the need for approval. Similarly, public companies that have not yet limited auditor liability may seek a resolution approving only the principal terms.

As the law currently stands, negligent auditors are liable to the company for all the loss it suffers as a result of that negligence. The new agreements may limit this to a “proportionate share”, where the company would not be able to recover any losses from the auditor which may be attributable to the acts of another party, such as a company director. Alternatively, liability could be determined purely by reference to the “fair and reasonable test” (that is to say, left to the courts, where such cases generally end up anyway). A third option would be the fixed cap, be it a monetary amount or determined by an agreed formula.

“Each company must make its own decision as to whether to enter into such an agreement with its auditors,” said FRC chairman Sir Christopher Hogg. “However, the FRC believes that it would be desirable for companies to discuss with their leading shareholders and with their advisers the merits of entering into an agreement in their particular circumstances”.

In its guidance, the FRC said that concerns shareholder interests were being prejudiced should be offset against “the efforts being made by the audit profession
to improve audit quality”. It did not specify what these efforts were.

John Hutton, secretary for the Department for Business, Enterprise and Regulatory Reform welcomed the guidance.

“Its potential contribution to greater stability and certainty in the business world is very welcome and timely,” he said.

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