Professional Scheme
Relevant to Paper 2.5, Paper 2.6, Paper 3.1

The purpose of this article is to inform you of the recent changes which have occurred in relation to the audit regime applying to small companies and to examine the reasons for, and the consequences of, those changes.

The changes in the audit regime for small companies

The proposal is that the present audit threshold below which companies can elect to dispense with the annual statutory audit will be raised from ?350,000 to ?1million. At the time of writing, this proposal is before Parliament and is likely to be enacted in a statutory instrument. Once enacted, the new limit will apply to financial statements for periods ending two months or more after the date the changes are voted through by Parliament.

The other aspects of the rules remain as before, i.e., a company must have relevant assets not exceeding ?1.4million and must not be a public company, a financial service type of organisation nor must it be part of a group whose aggregate consolidated turnover exceeds ?350,000.

Current rules which allow minority shareholders to require an audit are unlikely to change.

It would appear that at the time of writing there are also proposals for further exemptions for companies with a turnover between ?1million and ?4.8million and it is likely that the audit may be replaced by an “Independent Professional Review”.

The number of companies affected by the changes

The Department of Trade and Industry (DTI) published a consultative document in October 1999 entitled “The statutory audit requirement for smaller companies” which indicated that approximately 50% of the total number of companies below the ?350,000 threshold no longer had an audit. A survey undertaken on behalf of ACCA by MORI was also quoted in this document indicating that a similar percentage of the companies with a turnover of between ?350,000 and ?1million would take advantage of audit exemption if the threshold was raised.

The DTI analysed data from 750,000 company accounts filed at Companies House which showed that 520,000 of these companies had a turnover of below ?350,000 and a further 110,000 had a turnover of between ?350,000 and ?1million.

There is a wide range of estimates for the cost of the annual statutory audit, one figure quoted in the DTI paper suggests the typical cost of an audit for a ?1million turnover company as ?5,000, or 0.5% of turnover, so total cost savings are clearly considerable.

However, it should be remembered that the cost savings quoted as likely to arise from the abolition of the audit for small companies may not be fully achievable in practice, because the auditors of such companies frequently perform other non-audit services such as accounts preparation or the provision of taxation services, making it very difficult to calculate “net savings” arising from the removal of the statutory audit.

The costs and benefits arising from the statutory audit

The costs of the audit are as follows:

• The direct costs referred to in the previous section.
• The cost of the time utilised by the managers of small companies in answering the queries of auditors and providing the explanations and evidence demanded by the auditors. (Remember that auditors have statutory rights to receive evidence and explanations from management). These costs are likely to be proportionately much greater for the smaller companies.

The benefits of an audit are likely to include the following:

• Added assurance and protection for shareholders. This is, of course, of no relevance to directors in smaller owner- managed companies. It is very relevant to minority shareholders, however.
• The provision of systems improvement advice.
• A bank or similar lender is likely to take some assurance from the provision of a set of audited accounts, the involvement of an independent professional party in their preparation should improve the credibility of the accounts. If a client takes advantage of the statutory audit exemption and it also lacks ‘in house’ financial expertise to prepare its own accounts, then a decision to use an unqualified accountant to prepare the accounts to achieve greater savings could lead to severe problems with regard to the credibility of the resulting accounts.
• The statutory audit is seen as a cost effective way of providing reliable information in a consistent way since audits should be performed against benchmark auditing standards.
• Users of accounts do need to know that an independent party has considered whether or not a firm is keeping proper accounting records. (Remember that this is one of the statutory duties of an auditor.)
• Credit reference agencies do use audited accounts as a reliable source of data, although it has to be acknowledged that the delay in filing audited accounts is unhelpful in this respect and also that small companies can take advantage of the rules regarding filing abbreviated accounts.
• There is also an argument which says that the annual statutory audit acts as a deterrent to both employee and management fraud, although there is little real evidence to confirm this. However, it is probably true that the removal of the necessity to have an audit from the smaller companies (which are most likely to lack necessary financial expertise), coupled with an increasingly complex set of financial reporting standards, is likely to lead to an increased incidence of sets of accounts being filed which contain material errors whether perpetrated deliberately or accidentally.

The consequences of abolition

• The administrative burdens upon smaller companies will reduce and savings in managers’ time will accrue.
• The cost of an audit is thought to be of relatively little concern to many small companies because the benefits arising from the increased credibility which the audit gives to the financial statements outweigh those costs.
• The scope of the proposed “Independent professional review” likely to apply to companies with a turnover between ?350,000 and ?1million is, at the time of writing, unclear. However, it is thought that such a review will encompass a modest assurance that nothing has come to the reviewer’s attention to suggest that the accounts do not give a true and fair view.
• The abolition of the audit will not be in the best interests of shareholders for the reasons described earlier in this article.
• An audit is essential to consistent and reliable financial reporting, there is a danger that this will be lost if the audit threshold is raised.

Conclusion

This is clearly an important topic for paper 10 and 13 students, make sure you keep in touch with developments.