Coming clean about small company audits.

When it was first suggested that the small company audit be abolished over 20 years ago, there were howls of protest.

The Inland Revenue insisted it would be quite impossible to collect taxes properly if companies were allowed to prepare their accounts any old how. The professional bodies, fearful that one of their main sources of income would dry up, insisted the audit was essential to banks and creditors as well as minority shareholders. And all this in spite of the fact that the UK was almost alone in the developed world in requiring an audit for companies of all sizes.

But a number of recessions and the need for successive governments to be seen to be reducing red tape eventually resulted in the lifting of the blanket audit requirement.

Very small companies with a turnover of under #350,000 were first exempted in 1993 and now, as of 26 July this year, eligible companies with turnovers of under #1m are exempt (ineligible companies, however small, are still required to have an audit – and most companies in the financial services sector are ineligible). It is suggested the turnover limit should be raised to #4.8m, the maximum permitted under EU directives.

So what has happened? Apart from the pressures of political expediency, very little. Those in the Revenue who initially dug in their heels and refused to contemplate change have retired, and the accountancy profession, which no longer has the same level of respect it once had, has come under pressure to be more commercially oriented and less self-serving.

The reality is very small company audits always were a nonsense. It is not much of an exaggeration to say the average brown-paper-bag job, requiring the preparation of accounts from scratch, typically involved the firm preparing the accounts and stapling an audit report on the front. There was no real distinction between accountancy and audit work.

The more diligent had a quick look at stock and bad debts to see whether there was anything that really wouldn’t stand up to investigation, but often, the stock figure was used as a balancing figure to provide the right profit figure for the year. Too many high street bank managers (now almost extinct) thought a qualified audit report was better than an unqualified report, in the same way that an qualified accountant is better than an unqualified one. And they rarely relied on the accounts for lending purposes in any case. Most preferred to take charges over directors’ personal assets instead.

Few continue to maintain that an audit, or any sort of review, is essential for these very small companies, particularly where there is no distinction whatsoever between ownership and management. And few qualified accountants appear to have been driven out of business as a result of audit exemption up to now.

For small companies that are big enough to need their own bookkeeper the position is less clear. An accountant is often still needed to finalise the statutory accounts, but once again, the audit work rarely represents a significant proportion of the total fee. Over the next year or so some of these ‘larger’ small companies will decide that they can dispense with the services of their registered auditor because there is no longer any requirement for a statutory audit, forgetting that banking covenants often require an audit opinion. Only when lenders start to query the fact that there is no audit opinion on this year’s accounts, and the fact that the accounts appear to have been prepared by some unqualified person they have never heard of, will the problem come to light. Auditors need to remind their clients of this.

But is a full blown audit really necessary for these companies? The Company Law Review has suggested that an Independent Professional Review (IPR) might be less burdensome for companies with a turnover of between #1m and #4.8m, but still provide sufficient assurance to satisfy minority shareholders, banks, and other interested third parties.

We’ve been through this loop before. The old ‘audit exemption’ report applied to companies with a turnover of between #90,000 and #350,000.

It stated the accounts were ‘properly prepared’ and agreed with the accounting records. It was dropped in 1997 as unworkable.

The APB’s consultation paper on the IPR suggests the new report should provide ‘negative assurance’ to the effect that the accountants are ‘not aware of any material modifications that should be made to the financial statements in order for them to be in accordance with the Companies Act 1985 and the FRSSE’. Technical departments and academics may be able to distinguish between an audit, an audit exemption report and an IPR, but will anyone else?

To impose a statutory requirement to provide this type of assurance, in the absence of any accepted framework is to invite confusion.

While some of the professional bodies have given a cautious thumbs-up to the IPR proposal, partly to protect their members’ income, the prospect of going through the time-consuming and expensive exercise of obtaining consensus, issuing and implementing guidance is less than inspiring, particularly given the intention to drop the requirement in due course and permit full exemption for all companies with a turnover of under #4.8m.

And it seems inevitable that when the banks do respond they will do so inconsistently by continuing to require an audit for some clients but accepting an IPR for others, without properly understanding the distinction.

The Company Law Review is a golden opportunity to simplify matters and company law needs simplifying. It would be a great shame if that rare opportunity were missed.

Either companies need an audit, or they don’t, and if ministers aren’t sure, they should retain it until they are. The current proposals are a mess.

It is tempting to look overseas when we are unsure as to how to proceed.

In the US, there has never been any mandatory audit requirement, except for SEC-listed companies, but the profession there seems to be doing fine.

The APB’s consultation paper on the IPR is partly based on US guidance.

In other countries in the developed world, including Europe, audit exemption limits are higher than in the UK. But such comparisons need to be put into context. The UK has more companies (about 1.2m) than any other European country, mainly as result of 1970s fiscal policy. Some countries have high minimum capital requirements, others have complex registration requirements.

Many have company law regimes that are historically more closely tied to tax legislation than in the UK, and the mechanisms for financing companies differ across the world. Decisions made in respect of company audits are for us to decide. It would be a mistake to impose or lift an audit requirement based on the experience of countries whose regimes are dissimilar to ours.

Research suggests up to 40% of exempt companies in the UK continue to file an audit report. Some companies are unaware they are exempt or regard the cost of the audit as marginal. But some consciously choose to retain the audit. It seems likely that a higher proportion of companies will do so under the new regime, particularly if reminded the Revenue has recruited a substantial number of accountants to advise inspectors over the last two years.

Several DTI consultation documents on audit exemption have been at pains to point out audits have value for a wide range of stakeholders.

It is only mandatory audits that are in question. On the one hand, it must surely be better for the profession to provide services, including audits, that clients actually want, need and, more importantly, are willing to pay for, than routine compliance work that clients perceive as little more than red tape. It is also likely many companies will seek to reduce costs by dispensing with the audit and using unqualified accountants to prepare accounts and tax returns.

By the time directors realise the quality of service they are receiving is way below that provided by their former, qualified accountant, it will be too late, and they will find they are paying all manner of penalties exacted by Companies House, the Revenue and Customs.

In the short-term, it seems qualified accountants will lose out. Soon, the market will decide as it becomes clear the extra cost of engaging a properly qualified accountant, in whatever capacity, saves companies money in the long run.

– Elizabeth MacKay has worked for the Big Five and for regulators both in the UK and abroad. She writes and lectures on global audit and regulation.

More on the audit exemption

Links to Byer’s announcement

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