Audit Exemption, Raising the Thresholds
Comments from ACCA
April 2005
ACCA is pleased to comment on the above consultation paper. We are disappointed that the consultation paper presents the issue of whether or not small companies in the Isle of Man should be legally required to have an audit mainly in terms of bringing IOM legislation into line with that of the UK. Further, and apart from referring to the Government’s promise to revise the exemption rules, the paper fails to explain the rationale for this promise and does not explore the merits and possible weaknesses of the Government’s case.
We consider that the Government needs to take a wider view of the issue, taking into account not only the financial cost of an audit to the client company but the actual benefits of the audit. Whatever decision is taken for IOM companies also needs to be based on what is best for IOM companies and their various stakeholders, and not on an attempt to recognise some international benchmark.
In considering what, if anything the law, should say about the audit of limited liability enterprises, it is important at the outset to understand what the purpose of the audit is intended to be. The main purpose of the audit is as follows:
to give an expert, independent opinion to the members of a company on the extent to which a company’s financial statements comply with the requirements of law and technical standards.
Essentially, therefore, the audit is intended to provide reassurance to the company’s members, who ultimately own the company and who in the case of a commercial company will have invested money in it, that the company’s directors are presenting a faithful record of the company’s financial performance and position.
We accept that the rationale for having an audit becomes disputable where a company’s owners and directors are one and the same. If there is no separation of ownership and management, then – it can be argued - the owners cannot learn anything as a result of the audit process which they did not know already. The core logic of the audit process therefore becomes a matter of fair debate.
But there are other, tangential purposes of the audit which must not be overlooked in the process of setting an appropriate exemption regime.
Firstly, the audit should not be seen solely as a retrospective check on the accuracy of the financial statements. As part of the audit engagement, the auditor will consider whether the client company’s record-keeping and accounting procedures are adequate. Where he considers that they are not adequate, he will make appropriate recommendations to the client for future action. There will be no additional charge for this – it will take the form of an add-on service to the audit. Also as an integral part of the audit function, the auditor will take steps to detect and report fraud – research has found that the audit process is particularly successful in this respect in the small company environment.
More generally, it can be argued that, if a company has formally appointed an auditor to serve a fixed period in office, it will be more prepared to approach him for ad hoc professional advice than would be the case if the company did not have an auditor in place to whom they could look for essential advice. Those small companies which have no or limited in-house expertise in the fields of accounting or financial management therefore stand to benefit in practical terms from the appointment of an auditor.
Secondly, an audit report is of practical benefit to addressees, and in some cases third parties, in that they may have grounds to claim damages against the auditor where he conducts his work negligently and they suffer loss as a result. Members of companies which have not been audited do not have this comfort
Thirdly, there are the public interest implications. The consultation paper states that the tax authorities make use of audited accounts in determining an individual company’s tax liability (although they will normally look for information additional to the accounts before finalising their calculations). But there are implications too for the overall quality and reliability of the financial information prepared by companies. The paper cites research from the UK which suggests that over 90% of complaints about the content of published accounts relate to audit exempt entities. If non-compliance is or may be occurring at this level, surely there is a risk that a message will be sent out to small companies that the authorities will not be concerned about the quality and reliability of the accounts that they prepare. Such an outcome needs to be avoided not only for the sake of good public administration but for the sake of business confidence in the whole system of financial reporting. These public interest implications suggest that the interests of a company’s shareholders alone are not the only valid criteria to take into account in considering the future of the statutory audit.
Fourthly, and leading on from the foregoing point, auditors can be (and are under IOM and EU law) used by the authorities to perform a ‘gatekeeper’ function in respect of vital public interest issues such as the reporting of suspicions and evidence of money laundering. With regard to the latter, we consider that it would potentially be very dangerous for the authorities to allow the creation of a situation whereby companies with substantial levels of turnover were subject to neither a publication requirement nor an audit requirement.
The Government also needs to be clear about what it hopes to achieve from any reform. If, as seems to be the case, it considers that small companies will be able to save money by not having to pay audit fees, it needs to quantify what it thinks those savings are likely to be. If those savings are not likely to prove material, it should re-consider the rationale of its plans.
We believe also that the Government needs to acknowledge the probable consequences of its proposals for competition. Raising the exemption threshold to £5.6 million would almost certainly ensure that the number of firms conducting audit work would reduce to the Big 4 and a small number of medium-sized firms. Client choice, and fee competition, would be severely affected. If smaller firms left the market as a result of the change, non-profit-making bodies, such as charities, which traditionally use the professional services of smaller firms, would be forced to use, and pay the fees of, the large firms. There would also be unhealthy long-term implications for those wishing to train to become auditors – those who could not find positions with the handful of remaining audit firms would have no choice but to leave IOM to train and work in the UK.
As for the specific proposal made in the paper to raise the exemption threshold from £45,000 to £5.6 million, there are two obvious points to make on this proposal. First, it represents a huge increase on the current threshold. Second, the figure proposed has been based on the revised exemption threshold recently introduced in the UK, which is itself based on the maximum exemption threshold provided for in EU law.
In our view, the UK threshold should not be seen as the natural benchmark for the IOM. The threshold of £5.6 million was only brought into effect last year and its effects have yet to be properly analysed (although we understand that the APB in the UK is already considering filling the void left by audit exemption by a new, intermediate-level assurance report). If research predictions are borne out, and the majority of exempt UK companies continue to have an audit, the question must be asked whether the reform actually does serve the interests of small companies and their shareholders. When the new threshold was introduced in the UK, it constituted a radical - and controversial - change from the previous threshold of £1 million, an exemption level which banks and other lenders were reported as viewing as being already in excess of the turnover level at which they would normally seek the reassurance of an audit. The UK reform was also widely seen as a political gesture on the part of a Government which had come in for widespread criticism from small business organisations for the extent and cost of the regulatory burdens which it had imposed on businesses. Further, the £5.6 million audit exemption threshold is by no means standard among EU countries – where states have audit exemption arrangements at all (and not all do), most opt for a figure below £5.6 million.
Since the IOM already has an audit exemption regime, we would not argue for the restoration of an all-audit regime. We appreciate in any case that the Government has already made a decision albeit in principle to make certain reforms. The point at issue is where to pitch any reform of the current rules.
ACCA considers that any new basis of exemption should aim to strike a balance between financial materiality and the rights of shareholders as the ultimate stakeholders in a company. On the first point, we believe that an exemption threshold of between £250,000 and £500,000 would be more appropriate than the threshold being proposed. Companies with turnover of several millions will be often be substantial enterprises with relatively sophisticated internal structures which should not be lumped together with the very simple enterprises which have modest levels of turnover.
We also believe that, since the shareholders are the parties to whom the audit report is addressed, they should always be entitled to determine whether their company has an audit or not. Regardless of the size of a company’s turnover, therefore, the agreement of the shareholders should be a pre-requisite for audit exemption. Ideally, this agreement should be manifested through a requirement for a unanimous positive resolution to approve the exemption, though it could alternatively be done by making audit exemption standard at the set level of turnover but with provision for any single shareholder to formally demand that the company has its accounts audited.
We also have some practical points on the specific proposal now being made and some questions which need to be resolved. First, it appears that the Treasury would regulate the audit threshold on the basis that it is the only organisation entitled to receive accounts of a limited company, there being no requirements for the publication of accounts under IOM company law. The FSC can only take regulatory action in respect of company accounts submitted to them by entities which are regulated by them by virtue of conducting a licensed activity. The technical question we would raise here is - does existing legislation give the Treasury the right to disclose accounting information to a third party? Would it constitute a breach of data protection or an infringement of human rights legislation against the directors and/or shareholders of the company for it to do this? And where a company is exempt from the audit, what would be the basis for the Treasury insisting on the production of audited accounts for the purpose of assessing a company’s tax liability?
Obviously, any grounds for requesting an audit would have to be disclosed to a company, but would the Treasury be forthcoming in divulging the basis of its investigation? We would remind the Treasury that there is existing precedent on the IOM for the Assessor accepting unaudited accounts that breached the existing audit threshold of turnover in excess of £45,000, raised assessments on those accounts and successfully collected tax on those accounts!
A further question is this - if a company does indeed qualify for audit exemption, but the Treasury insists on seeing audited accounts, and after the audit review the audited set of statements turn out to be not materially different from the unaudited set of accounts, who is to cover the costs of the audit?
In view of the proposed audit exemptions and changes in tax legislation on dividend policy and overdrawn loan accounts, this is an area which must be properly policed to avoid potential losses to Government Revenue by possible omission of turnover and other income and the inclusion of non business expenses etc in accounts submitted for agreement. We consider there may be a danger of accounts being prepared by unregulated and unqualified accountants which may not be correct, with profits being understated. In this connection, we consider that the Government should seriously consider the regulation of the term ‘accountant’ and, in particular, rules on who may and who may not call themselves ‘accountant’. A more limited alternative would be to require that any unaudited accounts should have to be accompanied by a report from a qualified accountant setting out the basis on which they were prepared.
To conclude, we believe that the proposal to raise the audit exemption threshold from £45,000 to £5.6 million in a single step is misguided and an overly simplistic response on the part of the tax authorities to an issue which is largely unrelated to the significance of the audit. We believe that the wider implications of the audit have yet to be properly recognised by the authorities. As we have tried to point out in this submission, we have serious concerns as to the consequences for the financial integrity of IOM businesses, and for competition, if the current proposals were to be adopted. We therefore call on the Department to re-think its plans so as to come up with an alternative approach which is more practical and reasonable.