How must an auditor and client agree to set a liability cap?

An agreement to set a liability cap between an auditor and a client must be formalized using a monetary amount or an agreed formula. This approach ensures clarity and precision in defining the extent of the auditor's potential liability, which is crucial for risk management in the audit engagement. By establishing a clear limit, both parties understand the financial risks involved, and this can help prevent disputes in the future.

The use of a structured approach, like a monetary limit or an agreed formula, allows for a mutually beneficial agreement that reflects the specific context of their relationship and the scope of the audit services to be provided. This technique is aligned with best practices in the auditing profession, where clear agreements help support ethical conduct and professionalism.

Informal discussions may lack the necessary legal precision and enforceability that a formalized agreement would provide. Additionally, referencing previous audit failures does not serve as a reliable basis for establishing a liability cap, as each engagement is unique in its circumstances. Lastly, any unilateral decision by the auditor would not respect the contractual nature of the relationship and could lead to misunderstandings or disputes. Thus, agreeing on a monetary amount or an agreed formula is the definitive method to appropriately manage liability in audit engagements.