The audit exemption threshold rose again last year. Now more than 90% of UK registered companies can choose whether or not to have an audit on their financial statements. Much commentary has focused on this as cutting away red tape, freeing up time for the important business of business. But little has dealt with the important question: What impact does not having an audit have on companies’ financial reports and their bottom line?
The government, keen to reinforce its pro-business credentials, says that the net effect is a saving. The results of a poll of small businesses conducted by the Department for Business, Energy & Industrial Strategy published this January showed businesses estimated average savings of £4,500 from not having an audit in 2015.
However, the results of an independent academic study commissioned by ICAEW’s Research Trusts looking at the consequences of audit exemption came soon after. Professor Elizabeth Dedman and Dr Ja Kim of Nottingham University Business School used data from Companies House filings to analyse 10,705 audit-exempt private company financial reports from 2006 to 2014.
They found financial reporting quality is lower for companies that do not have an audit when compared with those that do. This is in line with the results of another academic study, published in 2012, which found that audited accounts were about half as likely as unaudited accounts to contain errors.
More of a surprise was the finding that companies that do not have an audit appear to pay more tax per pound of profits than those that do. The researchers estimate that an unaudited firm could save more than £28,000 in tax if it had an audit – more than three times the sample’s average audit fee.
The reasons for this merit further research. Henry Irving, head of ICAEW’s Audit and Assurance Faculty, points out that “the published research shows that it is difficult to generalise. It’s not to say that using the audit exemption is bad or that it’s possible to spot higher failure rates from non-audited companies. But choosing not to have an audit is not all good news for companies.”
Another of the study’s findings was that companies were tending to cluster just below the exemption threshold, suggesting they might be making decisions so they classify as being audit exempt. What’s more, fewer of these companies than expected have an audit. The results, says Irving, “are important for government. But also for third parties who rely on published financial information, for credit ratings, for employees, and for owners. It’s interesting to see what the knock-on effects are of giving companies a choice as to whether they should have an audit.”
The value of audit
Some companies that chose to dispense with an audit ask their external accountants to continue preparing their statutory accounts. “It’s rare for us to have done the statutory accounts and the audit and for the company to dispense with us altogether,” says David Gallagher, technical director at MHA MacIntyre Hudson.
Other companies, despite being exempt, decide to continue to be audited. Some bank covenants insist on an audit, as do other finance providers. The needs of minority shareholders is another reason, especially when these include employees.
Sometimes growing companies decide to start having audits before they think they will need them. Chris Appleton, chairman at Nexia Smith & Williamson, says it generally means they are ambitious and planning for success. “They want to be seen as serious players in their markets. A good number of companies that used to be within the audit threshold but now fall below it are continuing with an audit to maintain internal discipline and provide external assurance.”
First-time audited companies often find that the move to an audit culture is quite demanding. Problems tend to be provision of information and supporting evidence. “But they find unexpected value in the service through the quality of feedback to the directors on their processes and controls,” Appleton says.
Gallagher agrees that the first year of an audit is always the most challenging. “When we start auditing an entity that hasn’t been audited before we almost always expect to find prior year adjustments,” he says. He cautions against companies opting not to have an audit in the new accounting regime.
Nigel Hughes, managing director of Totteridge Associates and chair of ICAEW’s Practice Committee, says audit represents “compulsory access to a second, professional pair of eyes looking at the accounts”. He thinks the value for companies in continuing their relationship with their advisers is not so much with the audit, but with the auditor, and points to the dichotomy between advisory work and audit.
“Audit is seen as compliance, whereas the value the client gets seems to come from the advisory work on the back of the audit – the fact that the client has to speak to someone who looks at the company’s affairs with an independent gaze. I suspect that companies are less concerned about the value of the audit as such. But if they have a good accountant then they value their relationship with them. That should mean that the audit threshold is almost irrelevant.”
The role of external accountant as professional adviser resonates with Peter Barton, partner and head of audit and assurance at Wilkins Kennedy. “Not having the audit can free you up as you’ve forever got your eye on who does what and threats to independence when you’re the auditor.”
One of the fastest growing services for the firm is internal audit. Here, says Barton, the terms of reference are defined with the client, who sees a specific purpose in the service. “You can often be far more helpful with internal audit work than you are in performing a statutory audit and with the management letter.”
Hughes agrees that relinquishing the audit does not so much create new opportunities as open up existing ones. “Relaxation from having to comply with audit standards is a bonus, as this can enable companies and their professional firms to concentrate on the things that they need to. Alongside that, firms can ask: what are the other possibilities? This is where we are starting to see an interest in legal services such as probate, and in human resources work. It all comes back to the idea of the accountant as the trusted adviser.”
The question for small practices is whether, in the face of falling audit assignments, they should keep their registered audit status. Some firms are able to as they specialise in particular types of client or those to which the exemption does not apply. In several cases, they are keeping their registration going as they think it helps demonstrate that they are open for corporate work.
Others have decided that the cost-benefit analysis no longer works. Many of them are entering into agreements with larger firms: the original adviser keeps the statutory accounts work while the larger firm does the audit. This works well for both parties, says Gallagher, whose firm has picked up some of these audits. “The small practices lose the bit they don’t want to do any more; meanwhile we enjoy doing those pure audits where the accounts have been prepared by a professional firm.”
This is leading to another development within second tier firms: audit specialisation. While MHA MacIntyre Hudson is not yet thinking about this on a firm-wide level, Gallagher is aware that some offices are starting to think about it seriously. “In time we will have more specialised auditors – fewer people who perform a smaller number of audits. That’s been the case in the profession for a number of years but I can start to see it in our firm.” Barton agrees: “I always thought of myself as a generalist but over the past few decades audit has definitely become a specialism.”