SRC Insights: Second Quarter 2006

Interagency Advisory on External Auditor Engagement Letters Issued

On February 9, 2006, the federal banking regulatory agencies (the agencies) issued a final advisory (advisory) to alert financial institutions’ boards of directors, audit committees, management, and external auditors to the safety and soundness implications of certain audit engagement letter provisions that limit external auditors’ liability. ¹

To be effective, external auditors must be independent in both fact and appearance, and they must perform the necessary procedures to comply with auditing and attestation standards. An external auditor’s objectivity, impartiality, and performance may be compromised if an agreement exists to limit the external auditor's liability. In conducting examinations of financial institutions, the agencies rely on audit results in making their assessments of safety and soundness, and audit results may be less useful when said agreements are in place.

The advisory applies to engagement letters executed for the following audits:

Audits of financial statements
Audits of internal control over financial reporting
Attestations on management’s assessment of internal control over financial reporting

The engagement letter provisions that the agencies deem unsafe and unsound generally consist of agreements between a financial institution and its external auditor to accomplish the following:

Indemnify the external auditor against claims made by third parties
Hold harmless or release the external auditor from liability for claims or potential claims that might be asserted by the client financial institution, other than claims for punitive damages
Limit the remedies available to the financial institution, other than punitive damages

Appendix A of the advisory contains several examples of unsafe and unsound limitation of liability provisions.

Under the advisory, provisions that waive the right of financial institutions to seek punitive damages from their external auditor are not considered to be unsafe and unsound. It should be noted that a provision that indemnifies an external auditor against third party claims, including punitive damages, would be considered unsafe and unsound under the advisory. Institutions that agree to waive claims for punitive damages may want to consider disclosing that arrangement in a proxy statement and other public reports.

The advisory is effective for audit engagement letters executed on or after February 9, 2006; it does not apply to previously executed engagement letters.

¹ The full text of the advisory, Interagency Advisory on the Unsafe and Unsound Use of Liability Provisions in External Audit Engagement Letters.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.

SRC Insights: Second Quarter 2006

Interagency Advisory on External Auditor Engagement Letters Issued

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