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Executive Summary

Over the past several months, a number of public companies have concluded that certain provisions in their outside auditors’ "standard form" of engagement letter raise issues which may affect auditor independence and which might be the proper subject for public disclosure.  These provisions in engagement letters run the gamut from those which the SEC believes clearly "impair independence" of the auditors and must be changed, such as dollar limits on auditor liability, to those which the SEC believes may "impair independence" of the auditors such as an agreement to use mediation or arbitration. 

The possible need for a company to publicly disclose issues affecting auditor independence arises under rules, regulations and policies of a number of regulatory bodies, including the Securities and Exchange Commission ("SEC").  In particular, Item 308(a)(3) of Regulation S‑K (the "Compensation Committee Report") and Section 2‑01 of Regulation S‑X ("Qualifications of Accountants") specifically address the independence issue.  As will be seen below, a number of companies have concluded that it is good practice to disclose potential independence issues in proxy statements for shareholder meetings in which the appointment of the auditors is approved or ratified by the shareholders. 

Discussion

On February 9, 2006, the Standing Advisory Group of the Public Company Accounting Oversight Board ("PCAOB") published a paper in which it set forth various views on the auditor independence consequences of certain provisions in auditor engagement letters (http://www.pcaobus.org/Standards/Standing_Advisory_Group/Meetings/2006/02-09/Indemnification.pdf).  The chart shown below, derived from the PCAOB’s paper, describes various audit engagement letter provisions and the effect of these provisions insofar as they may affect the auditors’ independence in the view of the American Institute of Certified Public Accountants ("AICPA"), the Federal Financial Institutions Examination Council ("FFIEC") and the SEC. 

On September 15, 2005, the AICPA published Proposed Interpretation 101‑16 (http://www.aicpa.org/download/ethics/2005_0915_ed_Indemn.pdf) which sets forth the AICPA’s position on the types of clauses shown below.  On May 10, 2005, the FFIEC published a proposed Interagency Advisory (http://a257.g.akamaitech.net/7/257/2422/01jan20051800/edocket.access.gpo.gov/2005/pdf/05-9298.pdf) that also analyzes these clauses.  It should be noted that certain of these engagement letter provisions, while not necessarily disabling under the PCAOB’s analysis, may impinge on the NYSE’s or Nasdaq’s auditor independence standards and also may raise independence issues with the SEC. 

Type of Clause	AICPA Proposed Interpretation	FFIEC Proposed Advisory
This table provides general information for discussion purposes only.  It does not provide guidance for interpreting the AICPA and FFIEC proposals.
Auditor indemnified against claims based on auditor’s negligence([1])	Impairs independence	Unsafe and unsound practice
Auditor indemnified against claims based on knowing misrepresentation by audit client’s management([2])	Does not impair independence	Unsafe and unsound practice
Auditor indemnified against claims based on audit client’s negligence	Impairs independence	Unsafe and unsound practice
Auditor’s liability limited to the amount of fees paid	May impair independence	Unsafe and unsound practice
Limitation of period during which audit client could otherwise file claim	Impairs independence	Unsafe and unsound practice
Limitation on audit client’s right to assign or transfer claim	Impairs independence	Unsafe and unsound practice
Exclusion of punitive damages	Does not impair independence	Unsafe and unsound practice
Agreement to use ADR	Impairs independence only if it also limits the auditor’s liability for actual damages or incorporates a provision that would impair independence	Presents safety and soundness concerns if it incorporates additional limitations of liability or if ADR rules may limit auditor liability
Unsuccessful party to pay adversary’s legal fees	Does not impair independence	Silent
Auditor’s liability limited to the amount of losses occurring during periods audited	May impair independence	Unsafe and unsound practice

The most common limitations found in auditor engagement letters include a waiver of punitive damage awards and the mandatory use of mediation and arbitration to settle claims.  The following are examples of what some public companies are disclosing about their auditor engagement letters in their proxy statements this season.  The logic behind making disclosure in the proxy statement, rather than in the Form 10K, 10Q or 8K, is apparently grounded in the belief that the most visible and proper place for disclosure of auditor liability limitations is in that section of a company’s proxy statement which solicits shareholder approval of the engagement of the independent auditor.

Fortune 500 Computer Company
"In connection with the audit of the 2005 financial statements, the company entered into an engagement agreement with an [independent auditor] which set forth the terms by which [the auditor] will perform audit services for the company. That agreement is subject to alternative dispute resolution procedures and an exclusion of punitive damages."

Computer Software Company
"In connection with the audit of the 2005 financial statements, we entered into an engagement letter with an [independent auditor] which set forth the terms by which [the auditor] will perform audit services for the Company. That agreement is subject to alternative dispute resolution procedures and an exclusion of punitive damages."

Transportation Holding Company
"In connection with the audit of the 2005 financial statements, the Company entered into an engagement agreement with an [independent auditor] which set forth the terms by which [the auditor] will perform audit services for the Company. That agreement is subject to alternative dispute resolution procedures and an exclusion of punitive damages."

It is expected that the PCAOB may have the ultimate word on this topic insofar as the PCAOB controls the registration of independent public accountants for public companies. 

Recommended Actions

Public companies may wish to review their auditor engagement letter to determine if any of the above-described liability limitation provisions are included.  Following the review, each company should, if clear limitations on liability exist, consider amending the auditor engagement letter or risk a later finding by the SEC, FFIEC or the PCAOB that the auditor is not independent.  If it is unclear whether limitations on liability exist or are prohibited, each company should consider whether to disclose questionable liability limitations in its proxy statement as suggested above.