Limiting Accountants' Liability through Engagement Letters

By Reinstein, Alan; Lobingier, Patricia G. et al. | The CPA Journal, November 2009 | Go to article overview

Limiting Accountants' Liability through Engagement Letters


Reinstein, Alan, Lobingier, Patricia G., Green, Brian Patrick, The CPA Journal


A Comparison of U.S. and European Policies

Many CPA firms use engagement letters containing clauses that seek to muiimize their exposure to legal liabilities for audits, reviews, compilations, and other professional services. Auditors have specifically used indemnification and liability limitation clauses and alternative dispute resolution (ADR) agreements to help control their insurance and other costs, especially for clients operating in high-risk business environments. While firms may view risk mitigation clauses from a cost standpoint, financial statement users and regulators have voiced concerns over impaired independence, auditor quality, and objectivity (Tim Bush, Shyam Sunder, and Stella Fearnley, "Auditor Liability Reforms in the U.K. and the U.S.: A Comparative Review," working paper, August 2007).

The AICPA recently abandoned Interpretation 101-16 (under the rules of independence), 'Indemnification, Limitation of Liability, and ADR Clauses in Engagement Letters," that would have claritied CPAs' ability to limit or minimize their Uabilities using engagement letters. Under this interpretation, an auditor's independence would have been considered impaired if an engagement letter contained clauses that indemnified or limited auditor liability for client, lender, or shareholder damages^ - including punitive damages - or would have indemnified or limited liability if a client knowingly misrepresented facts to die auditor. Interpretation 101-16 would also have reiterated that arbitration, mediation, and alternative dispute resolution clauses, as well as clauses diat require die unsuccessful party in the legal disputes to pay legal fees, do not impair auditors' independence.

The AICPA, instead, released Ethics Interpretation 501-8 (under die mies of discreditable acts). "Failure to Follow Requirements of Governmental Bodies, Commissions, or Other Regulatory Agencies on Indemnification and Limitation of Liability Provisions in Connection with Audit and Other Attest Services." The interpretation does not directly mention restricting auditors' ability to use limited liability clauses, but refers auditors to specific industry regulatory guidance that contains such restrictions. The European Union (EU) and the United Kingdom view this matter differently, allowing engagement letters to contain clauses limiting certain auditor legal liabilities.

Such differences could be troublesome for auditors of transatlantic entities containing parents or subsidiaries in each continent where legal recourse and allowable liability limits differ. The purposes of this article are to 1) discuss the abandoning of Interpretation 101-16; 2) describe some effects of Interpretation 501-8; and 3) compare and contrast global approaches to limiting accountants' liability tiirough die use of engagement letters.

This discussion is important because die United Kingdom and otiier EU countries have developed indemnification and limited liability clause policies that differ conceptually from those in die United States, where the courts and regulators generally oppose limiting auditor liability on independence and fairness bases. Nevertheless, EU members support limited liability agreements (LLA) between auditors and their clients, and favor similar clauses between auditors and third parties, often stemming from concerns over investor confidence.

Proposed AICPA Interpretation 101-16

In September 2006. the AICPA's Professional Ethics Executive Committee (PEEC) issued an exposure draft (ED) to interpret Rule 101 that updated a similar September 2005 exposure draft. Acknowledging the SECs stance that indemnification agreements remove a major stimulus to "objective and unbiased consideration of problems encountered in an engagement," die PEEC concluded that including such clauses in audit or other attest engagement letters could appear to compromise independence. The PEEC also noted that many industry groups and the Federal Financial Institutions Examination Council (FFIEC) do not favor clauses limiting auditor liability. …

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