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Consultation Document on Proposals to Increase the Audit Exemption Threshold and Threshold Defining Medium-Sized Companies
Issued by the Department of Trade and Industry

Comments from ACCA
30 September 2003

Executive Summary

ACCA believes that the independent external audit is a valuable managerial discipline and an essential aspect of good internal financial housekeeping. The audit provides the most effective source of comfort for independent (i.e. non-family or non-director) shareholders. It also gives indirect assurance for other, potentially vulnerable, groups of stakeholders such as employees and unsecured creditors.

Raising the audit exemption threshold has a number of implications. These include:

• a heightened probability of deliberate fraud perpetrated by the owner-managers
  
  
• an increased risk of financial statements being misstated through undetected error
  
  
• an increased risk that the quality of financial statements will suffer through being prepared by unqualified accountants
  
  
• a consequent (and potentially undetectable) deterioration in the quality of financial information held on the public record
  
  
• a potentially damaging conflict between tightened regulatory intentions in respect of money laundering and a liberalised regime for small company accounting and reporting
  
  
• the removal of a vital practical element in the training and professionalisation of future generations of accountants
  
  and
  
  
• an inevitable reduction in the number of firms holding registered auditor status, leading to a reduction in the availability of audit services to the non-exempt part of the small business community, viz SMEs which wish to have voluntary audits and other small entities, such as charities and firms of solicitors, which will continue either to need audits or to require the services of a qualified professional.

For the reasons stated above, and in the absence of any signal that the Government is prepared to consider alternatives to quantitatively based exemption criteria (such as audit being triggered by the presence of independent shareholders), we would prefer to see the audit exemption threshold remain at or close to the current £1m level.

In the event that the threshold is eventually raised, however, we have also considered how best to protect independent shareholders and other stakeholders. Our thoughts on how this protection might best be achieved are set out in paragraphs 17 to 24 and summarised immediately below.

While banks and regulatory authorities are in a privileged position to demand audited financial reports, employees, unsecured creditors and shareholders who are neither directors of a company nor involved in its day to day management (i.e. �independent shareholders�) are not. It can also be argued that some minority directors also fall into this category. A reduction in the filing period for small company accounts and the abolition of abbreviated accounts will go some way to providing enhanced protection for employees and creditors. However, unless tempered by an additional protective layer, proposals to increase the audit exemption threshold will impact most severely on the interests of the independent shareholders and minority directors.

We recommend, therefore, that UK companies legislation should be amended so as to provide more explicit protection for these particular shareholder groups. In our view, a company should only be exempt from independent audit if:

1. it meets two of the three quantitative conditions already specified in (and subject to periodic review by) UK company law (i.e. turnover, balance sheet assets and employee numbers)
   
   and
   
   
2. shareholders vote unanimously to opt out of the audit regime.

Even with this additional layer of protection for independent shareholders and minority directors, we are not convinced that, taken as a whole, the financial benefits of a reduction in audit costs will be sufficient as to outweigh the risks inherent in a significantly raised exemption threshold. From a broader economic perspective, the total turnover of companies affected by the proposed threshold increase, assuming a average turnover of £2m, would be £132 billion (66,000 companies x £2m). It follows that the projected savings of £66m (£1K per company) would result in an overall saving of one twentieth of one percent of total turnover, hardly a convincing statistic given the potentially negative consequences of the change.

As a result, unless the Government determines to take into account factors other than purely quantitative criteria for assessing the reasonableness of "exempt status", ACCA does not believe that it is appropriate to raise the audit exemption threshold significantly above the current £1m turnover level without addressing in detail both the assurance needs of affected user groups and the wider implications of such an action for the small business community, for the fight against organised crime and for the need to maintain an orderly and reliable company registration system.

General Comments

RAISING THE AUDIT THRESHOLD

1. ACCA welcomes the opportunity to respond to the DTI Consultation Document Raising The Threshold. Over half of ACCA�s 98,000 members work in or service SMEs (Small and Medium-size Enterprises) and ACCA itself acts as a voice for small businesses.
   
   

2. ACCA believes that the independent external audit is a valuable managerial discipline and an essential aspect of good internal financial housekeeping. The audit also provides the most effective source of comfort for minority directors and independent shareholders. It also gives indirect assurance for other, potentially vulnerable, groups of stakeholders such as employees and unsecured creditors.
   
   

3. In general terms, ACCA would prefer to see a regulatory environment where audit exemption was not based on purely quantitative threshold criteria. In our view, quantitative criteria are often poor proxies for organisational and stakeholder complexity. Paragraphs 21 to 24 below set out our suggestions as to how the law might be changed to recognise the shortcomings of the current threshold approach by providing an additional layer of protection for minority directors and independent shareholders. Before that, however, we make some comments regarding the dangers inherent in any attempt to deregulate the audit process and the need for greater protection of stakeholders.
   
   
   The dangers inherent in audit de-regulation
   
   

4. For several years the Department of Trade & Industry has mooted the idea of raising the turnover threshold, below which companies are not required to have audits. Two years ago, the Company Law Review Steering Group, a body appointed by the DTI, backed such a move, as part of a wider deregulatory analysis of the small company sector.
   
   

5. There is an obvious superficial attraction in removing the audit requirement from a substantial number of businesses. The audit is, however, there for a reason.
   
   

6. One of the main dangers in abolishing the statutory audit is a distinctly higher risk of fraud. In 2001, the ACCA surveyed 1250 of its own practising firms, to determine the incidence of fraud they had encountered. On average, these firms had 215 clients, so the report covered over 260,000 UK companies.
   
   

7. The principal cause of fraud was found to be personal gain by management and often involved the manipulation of financial records to disguise, suppress or alter transactions. In these cases, management often over-rode financial controls to allow the fraud to be effected. But, in 45% of cases, it was the external auditors who detected the fraud.
   
   

8. A large increase in the small audit threshold is very likely to lead to increased levels of deception and lower standards of compliance, governance and financial management generally. In addition to independent shareholders and minority directors, employees and unsecured creditors are also vulnerable to these dangers. The widespread use of accounts preparation software packages may lead to the eventual non-involvement of any qualified professional in the preparation and filing process and there is a danger that unqualified accountants will begin to compete for business at a much higher level of turnover than has hitherto been the case, with all that that implies for the quality of filed accounts and client value for money.
   
   

9. ACCA is also concerned that the Government is considering such a move at the same time as new Money Laundering regulations come into effect. From later this year, accountants, auditors and other professionals will face the risk of jail they fail to report suspicions of money laundering. The audit is a key mechanism for uncovering such activities. Similarly, in the wider context of global terrorism, reducing checks on companies� finances seems an unwise move.
   
   

10. Another issue flowing from any decision to increase exemption thresholds relates to the supply and pricing of auditing services. Much has been made of the potentially adverse economic consequences � at the top end of the audit market � of both auditor liability and the concentration of audit activity. The real impact of a significant rise in the small audit threshold is, however, unknown. Likely impacts include: a reduction the number of firms retaining registered auditor status; a thin coverage of audit supply to SMEs outside major urban conurbations; increases in the cost of audit; and a reduction in training opportunities. This last point is significant since the practical aspect of auditor training traditionally develops and reinforces the ethical and professional attitudes which examination syllabi can only influence indirectly. The impact here will be on the next generation of auditors.
    
    
    Research results
    
    

11. In May 2003, ACCA conducted a survey of Practising Certificate holders. The survey covered a range of issues including their views on whether or not the audit exemption threshold should be raised to £4.8m (which was then the EU�s official upper limit to the threshold).
    
    

12. The results of our 2003 survey showed that 53% of respondents felt that the threshold should be increased to £4.8m and 36% thought it should remain at £1m. The remaining 11% took the view that the threshold should be raised but not as high as £4.8m. The response rate, however, was only 18%, and we do not, therefore, feel that the above results can be interpreted as providing unequivocal support for an increase in the audit exemption threshold of the magnitude suggested by the consultation document.
    
    

13. Another finding of the 2003 ACCA survey was that 57% of respondents were of the opinion that, if the threshold were to be increased to £4.8m, one or more of their clients would continue to have an audit. We note that DTI-funded research on company directors, carried out by Kingston University, revealed a similar pattern of responses.
    
    

14. ACCA members believe that their clients will continue to want audits because:
    
    

    • banks, other providers of finance and regulatory authorities, e.g. ABTA, require audited accounts
      
      and
      
      
    • independent shareholders often expect there to be an audit.
      
      
15. It should be noted that our members believe that their clients see three main benefits in the external audit. These are:
    • providing assurances to banks and other lenders
      
      
    • providing checks on accounting records and systems
      
      and
      
      
    • improving the credibility of financial information.
      
      
16. Similar benefits were identified by the 2003 Kingston University study referred to in paragraphs 4.2 and 4.3 of the consultation paper. These research findings confirm previous published research on the benefits of the small company audit from a number of user perspectives. This means that, in addition to being a useful managerial control mechanism, the demand for the small company audit is largely being driven by the interests of outsiders such as bankers, regulatory authorities and non-director shareholders.
    
    

    Protection of outsiders
    
    

17. We accept that, from the perspective of timeliness, annual financial statements, on their own, will never be entirely satisfactory as a means of protecting the employee or the unsecured creditor. However, changes mooted as part of the Company Law Review process should go some way towards increasing the timeliness and relevance of accounts filed on the public record. In our responses to the Company Law Review consultative papers, we have supported the proposals both to shorten the filing periods for annual accounts purposes and to abolish abbreviated accounts. It would be a retrograde step immediately to undermine these forthcoming improvements by simultaneously eliminating the assurance provided by the external audit.
    
    

18. The consultation paper uses the 2003 Kingston University research to argue that the size of a company is influential in creating demand for the audit. ACCA believes that this is a case of �stating the obvious� because, the larger a company is, the more likely it is to have loans outstanding and to have shareholders who are not involved in the direct management of the company. The larger the company, so too the larger the number of employees and unsecured creditors.
    
    

19. There are also, however, a significant number of smaller companies, with turnovers less than the proposed threshold of £5.6m, which share the above characteristics. And, while banks and regulatory authorities are in a privileged position to demand audited financial reports from these smaller companies, employees, unsecured creditors, minority directors and shareholders who are neither directors of the company nor involved in its day-to-day management (i.e. �independent shareholders�) are not.
    
    

20. Although there is no research evidence of which we are aware to support the argument that better run companies will always opt for a voluntary audit and that poorly managed enterprises will generally seek to benefit from the exemption option, these outcomes must represent very plausible scenarios. A significant increase in the audit exemption threshold will simply present poorly managed companies with more opportunities to dispense with external professional advice and avoid external scrutiny.
    
    A proposal to amend existing audit exemption legislation
    
    

21. ACCA believes that, seen in the light of the forthcoming legislative changes referred to in paragraph 17 above, proposals to increase the audit exemption threshold by a significant amount are likely to impact most severely on the independent shareholders.
    
    

22. The proposal set out below moves away from the entirely quantitative criteria which currently form the basis for audit exemption. We believe that such quantitative measures frequently fail to reflect the needs of independent shareholders.
    
    

23. While shareholder protection is currently recognised under section 249B(2) of the 1985 Companies Act, it only provides that shareholders with 10 per cent or more of the shares can require an audit of the company�s accounts. To ensure that minority directors and those shareholders who are not directors and who do not enjoy access to the financial records of the company are fully protected, we propose that UK company law should remove the 10% rule in section 249(2) and, instead, make the audit compulsory in situations where shareholders of qualifying (in size terms) companies do not vote unanimously to opt out of the audit regime. Effectively, ACCA is proposing an �opt out� provision rather than the current �opt in� approach currently embedded in UK company law.
    
    

24. In summary, whatever quantitative thresholds are deemed appropriate, a company should only be exempt from independent audit if its shareholders have unanimously elected to opt out of the audit regime.
    
    Conclusion
    
    

25. In the event that the Government decides to ignore the arguments in favour of the status quo presented in paragraphs 4 to 11 above, and commits instead to an immediate increase in the audit exemption threshold, we recommend that any increase should be limited in extent, with the new threshold level being no higher than £2m.
    
    

26. A more appropriate outcome of this consultation exercise would be for the Government to acknowledge that quantitative threshold criteria are inappropriate for determining whether or not an audit should take place. It would be preferable, we believe, for UK companies legislation to be reinforced (so as better to protect the interests of employees and unsecured creditors) and amended as described in paragraph 24 above (so as to provide more explicit protection for the interests of the minority directors and independent shareholders).
    
    

27. We note that it would also be possible to combine these recommendations so that a company would only be exempt from independent audit if:
    
    it meets two of the three quantitative conditions already specified in (and subject to periodic review by) UK company law
    
    and
    
    its shareholders have unanimously elected to opt out of the audit regime.
    
    

28. We shall be happy to discuss the details and implications of this proposal with the DTI.
    
    
    Questions Raised in the Consultation Paper
    
    
    Costs of the Audit - Can you:
    (a) identify any cost savings for your business, or more generally, resulting from an increase in the audit exemption threshold to the maximum permissible under EU Law?�

29. In ACCA�s 2003 survey, members holding Audit Practicing Certificates were asked if their fees had materially changed for their clients who used the exemption not to be audited since the last increase in the threshold to £1m (the current UK maximum). Just under a third said that clients� fees had materially decreased.
    
    

30. The cost of the audit is likely to be proportionally higher for companies with a turnover of less than £1m vis-à-vis those exceeding £1m. In terms of costs and benefits, the costs are likely to exceed the benefits at turnover levels less than £1m. This is supported by previous research at Kingston University in 2000.
    
    

31. In terms of extending the audit exemption threshold to the maximum permissible under EU law (currently £5.6m), ACCA believes that costs will not play a significant part in a company�s decision to elect to be exempt from the statutory audit. For most such companies it is likely that the benefits of the audit will exceed the costs. Research from Kingston University in 2000 supports this position.
    
    
    (b) quantify those costs or savings?
    
    

32. Using data from the consultation paper, the potential total cost saving will be £66m for all those additional companies which will be able to use the exemption.
    
    

33. In terms of the individual company, the measurable saving resulting from an increased exemption threshold is likely to be immaterial bearing in mind the benefits which the audit brings to the credibility of financial reports from a users perspective. A saving of £1,000 for a company whose turnover is £1m represents 0.1% . From a broader economic perspective, the total turnover of these companies, assuming a average turnover of £2m, would be £132 billion. (66,000 companies x £2m) and a saving of £66m would result in an overall saving of one twentieth of one percent of turnover.
    
    
    THE THRESHOLD DEFINING MEDIUM-SIZED COMPANIES
    
    The Government welcomes comments from respondents on the proposal to increase the threshold defining medium-sized companies to the maximum permissible under EC law.
    
    

34. As far as accounting and reporting are concerned, the main significance of the medium-sized company category is to regulate exemption from standard Companies Act reporting and filing requirements. The Company Law Review recommended that the provision for small and medium-sized companies to file abbreviated annual accounts be abolished. The DTI�s White Paper Modernising Company Law subsequently endorsed this recommendation. The Review proposed additionally that, in the light of its proposal to increase substantially the thresholds which define the small company, the current exemption for the parent companies of �medium sized� groups from the obligation to prepare consolidated accounts should be abolished.
    
    

35. If both these measures are to be carried through in the new Companies Bill, then ACCA believes that the rationale for re-shaping the quantitative eligibility criteria for medium sized companies at this stage would appear to have limited usefulness, at least for company law purposes.
    
    

36. We do, however, accept that the category of medium-sized company is materially useful in respect of determining companies� rights to capital allowances on plant and machinery and would support its retention, at least for this purpose. Extending the thresholds as proposed in the document would be beneficial to businesses since it would entitle more firms and groups to qualify for first year allowances.
    
    

37. Assuming that the category is retained, and the thresholds are raised, the remaining issue is whether the UK should exempt medium-sized companies from the requirement, which will have to be introduced into UK law in due course via the Modernisation Directive, to disclose in their annual reports non-financial key performance indicators.
    
    

38. It is our understanding that the proposals for UK company law reform envisage a movement towards two distinct reporting regimes � one for small private companies and another for all other companies. In our view, it would be inconsistent with this approach to retain isolated disclosure exemptions for medium-sized companies. In any case, we consider that it would be reasonable for companies with turnover in excess of £5.6 million to be expected to disclose the information concerned. We would therefore argue against taking advantage of the exemption.

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