The key principle behind agreements between companies and their auditors to limit the auditor’s liability must be that the agreements are “fair and reasonable”.

That’s what we’ve learned from draft guidance on liability limitation agreements that has been published for consultation by the Financial Reporting Council.

Auditors now have the option to limit their liability by contract under the Companies Act 2006.

The draft guidance sets out what’s allowed under the Companies Act and some of the factors that will be relevant when assessing the case for an agreement, and explains what matters should be covered in an agreement and the process to be followed for obtaining shareholder approval for a liability limitation.

It has been produced by a working group chaired by Sir Anthony Colman, previously a Judge of the Commercial Court, and including representatives of companies, investors and the accountancy profession.

Colman says: “The working group recognises that identifying generally acceptable approaches could reduce the need for extensive negotiation among auditors, companies and shareholders, and the time and costs associated with implementing an agreement.”

Liability limitation agreements cannot cover more than one financial year and must be approved by a resolution of the company’s shareholders.

The Act also states that any arrangements to limit liability will not be effective except to the extent that they are “fair and reasonable” in the particular circumstances. The draft guidance warns this is the key principle in the legislation.

“It means that the Court can override any contractual limits agreed between the company and the auditors if it considers that they are less than “fair and reasonable”. The Court may reach this conclusion notwithstanding the fact that the agreement had been approved by the company’s shareholders. In these circumstances the agreement does not become null and void; instead the liability is amended to a level set by the Court,” the guidance states.

The FRC will accept comment on the guidance until 14 March 2008. It’s expected that final guidance will be published in the first half of next year.

Read the whole draft guidance here

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Related tags: draft guidance, liability limitation agreements, companies act, financial reporting council, auditor liability, anthony colman, business law,