Disclosure of limitations in auditor engagement letters

By:  Cydney Posner

As previously discussed (see my posting of 2/13/06), there has been substantial controversy in regulatory circles about the propriety of various forms of auditor indemnification and limitations on liability that accounting firms have been serving up recently in their form engagement letters.

The topic was debated at a recent meeting of the PCAOB's Standing Advisory Group, with generally mixed results, aside from the fairly uniform agreement that indemnification of auditors would violate the SEC's independence rules. On the other hand, ADR and limitation-of-liability provisions were the subject of some debate. Among the related topics addressed was disclosure of the terms of the engagement letters, both to the public and to the audit committee itself. Apparently, some in the Group expressed concern that audit committees and board members were not fully aware of these provisions, calling into question whether committee members could fully consider the possible detrimental effects on their companies and whether, as a result, they could properly fulfill their fiduciary obligations.

With respect to disclosure to the public, some companies have been adding disclosure about the terms of their auditor engagement letters to their proxy disclosure in the sections concerning auditors. A number of companies, such as Sun and Silicon Graphics, have included disclosure about the terms of engagement letters, and provides a sampling of the auditors' various defenses of their adhesion contracts (that must have been a typo-- I'm sure I meant to write "engagement letters"). As an illustration, the most recent proxy statement from Sun includes, as an introduction to the "Audit Fees" table, the following language: "In connection with the audit of the 2005 financial statements, Sun entered into an engagement agreement with Ernst & Young LLP which set forth the terms by which Ernst &Young LLP will perform audit services for Sun. That agreement is subject to alternative dispute resolution procedures and an exclusion of punitive damages." More expansive disclosure may make sense, depending on the provisions.

This proxy season, we should make a practice of reviewing auditors' engagement letters and consider adding appropriate proxy disclosure with respect to material provisions of this kind.

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