Audit Threshold – A damaging grand gesture

The Tories become New Labour and so deregulation becomes betterthe audit threshold for SMEs are likely to prove ill-judged and costly, writes Peter Langard. regulation.

Or does it? Having had sufficient time to discover just how hard it is to come up with better regulation for small and medium-sized companies, the government, in the shape of Stephen Byers, the Trade and Industry secretary, has resorted to the principles of the Tory red tape cutters and is lining up a variety of obvious sacred cows for the slaughter. The statutory audit for small companies looks like being the first victim.

Is there some sense in Stephen Byers’ proposals or is he merely appeasing the small business community with a grand gesture which appears to offer immediate and lasting savings but which, with the advantage of hindsight, will not prove to be beneficial at all, but costly and ill-judged?

First, let’s look at the deregulatory possibilities that Byers is exploring.

Currently, companies with turnovers of £350,000 or less are exempt from the statutory audit requirement – although they can choose to have one if they wish. Corporate structure does not impact on this limit. Current definitions of small companies tend to focus on the £2.8m turnover threshold but the Department of Trade and Industry could increase that by nearly 50% if it wished – hence the possible exemption limit of £4.2m that has been discussed recently. The government could choose to stick with £350,000, or move to £4.2m or choose some point between.

There is talk that turnover might not be the only criteria the government uses in defining a new audit exemption regime. The ownership structure, in particular the presence of outside shareholders, might influence the decision.

Now let’s look at what end users make of the statu-tory audit at present.

In the second half of 1998, in a MORI survey of SMEs on behalf of ACCA, a large majority of companies (80%) surveyed saw the information being provided within the statutory audit as useful to the company audited; 83% of companies saw the information in audited accounts as useful to their bankers; and the percentage was 82% for companies’ perception of usefulness to the Inland Revenue. All the bank managers surveyed (17) considered the information provided within the statutory audit to be useful to all users.

The same survey found that 92% of companies and 94% of banks agreed with the statement that banks are more willing to lend to companies if they have seen audited accounts; 81% of companies and 88% of banks agreed that banks and other finance providers would require far more reassurance from a company that has not been audited. And 92% of companies plus 94% of banks agreed that there will always be a need for a reliable and independent statement of a company’s financial health.

So were the government to raise the exemption thresholds to the maximum permissible under EC rules, what are the options for small companies?

First, of course, a company could decide simply to replace the statutory audit with a voluntary audit. There is little doubt that, in view of the MORI findings reported above, many companies would choose to do just that – especially in view of the expressed needs of the Inland Revenue and their lending bankers for ‘a reliable and independent statement of (the) company’s financial health’.

No savings there then, Mr Byers.

Second, a company could replace its statutory audit with some form of tax audit or compilation/review exercise mainly undertaken to reassure the taxman.

Some saving in one direction perhaps, but a lessening in the level of assurance offered to shareholders, creditors and bankers alike.

Third, of course, a company could do nothing and pocket the audit fee.

This sounds attractive as long as there are no influential outsiders demanding financial reassurance or, if there are, if the company has the internal financial management skills to satisfy them. But, for most smaller companies the point of paying an independent accountant to prepare true and fair accounts and/or audit the books is that this option is less expensive than the opportunity cost of management’s own time or the direct cost or employing a full time (or even part time) finance professional.

Once again, it is hard to see where the savings will come from, especially if the decision to discard the audit results in financial mis-management. Over time, the social costs of such mismanage-ment and the potential for fraud could hugely outweigh the cost of external audit.

Supposing, a company took advantage of the new proposals and did away with an annual audit. Savings of up to £5,000 have been quoted in some reports. Is this likely? Given that companies will still have to prepare annual accounts for shareholders and file true and fair financial statements, projected savings for the majority of small companies would, we estimate, be a great deal less – often the audit fee accounts for only 10 or 20% of the annual accountant’s charges.

We believe the government should be encouraging the smallest stratum of companies to disincorporate completely. Company formation should be constrained by the imposition of a minimum capital requirement. Thereafter, those who choose to conduct their business activities through the medium of a limited company (and thus succeed in limiting their own personal liability) should be required to demonstrate their accountability via the audit.

We believe Byers has chosen an inappropriate target in spotlighting the external audit as a candidate for deregulation. We believe the statu-tory independent audit has value right across the board – to the owners and managers of small companies, to the Revenue, to bankers and to society as a whole. Encoura-ging companies to dispense with external audit would be a shortsighted move which, far from encouraging competitiveness, could well have a damaging effect on the UK economy in the long term.

Peter Langard is chairman of ACCA’s Small Business Committee

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