Changes are afoot in the auditing profession. Firstly, Government regulations have been published which will exempt from audit companies with a turnover of less than £5.6M (previously £1M) and where the total of all assets on the balance sheet (ignoring liabilities) is less than £2.8M (previously £1.4M). The new exemption applies to accounting dates from 30 March 2004.

Groups of companies have slightly different criteria but in general terms it will be the consolidated financial position which will determine whether or not an audit is required.

• It will not be possible to achieve audit exemption by extending your accounting reference date (“ARD”) to a date beyond 31 March 2004, unless this was effected prior to 9 January 2004.
  
• Discuss the matter with your auditors to ensure that you are eligible for exemption. Remember for example the gross assets must be below £2.8M – a test often overlooked where there has been a misconception that this was a net asset test; also, you need to be aware that, unless you are the holder of more than 90% of the ordinary shares in the company, your fellow shareholders have a right to require an audit.
  
• Speak to your bankers – they may have a view and it is likely that your facility letter will require an audit, although it is often a function of the bank’s standard terms and conditions, as I have seen the requirement for audited accounts for sole traders and partnerships!
  
• Consider what benefits may derive from continuing with an audit and contrast this to the costs. There is no clear evidence of the Inland Revenue differentiating between companies which have audits as against those which do not but if your strategy is for a sale of your company some comfort may be drawn from continuing to have audited accounts available.

What has this to do with independence? Very little in isolation, but auditor independence issues are also being reviewed and if certain companies no longer require an audit, the implications of the independence regulations will not affect them to the same extent.

What should be considered if you have a company which potentially qualifies for audit exemption?

New ethical standards for auditors are the subject of a consultation paper issued in December 2003 which requires responses by 1 March 2004 with implementation scheduled for “early 2004” (clearly the Government continues with its policy of forcing matters through whilst paying lip service only to a proper consultation period – the usual product of which is poorly thought through and inadequately drawn regulations). The new rules will introduce sweeping changes for all audit firms “irrespective of size” on “audits of whatever nature and size” supplemented by additional requirements for listed companies and other public interest entities (e.g. large charities, pension funds, public sector bodies, credit unions).

Prior to embarking upon the impacts of the consultation paper and the questions which it raises, I think it useful to visit the background. Let us make no mistake – the reason that we are here is because of notable failures among, predominantly, the major auditing firms. These failures have not only raised serious concerns over the effectiveness of the audit process and the integrity of the accounting profession as a whole but have also adversely affected confidence in the capital markets.

The composition of the membership of the bodies responsible for the paper is drawn predominantly from the public sector, big business and the larger audit firms and these individuals will have little experience of dealing with SME’s and the interaction between the auditors and the company’s executives, and it may be worthwhile exploring this relationship. Many SME’s will have no finance director and indeed they may not even have a financial controller or similar: in terms of evaluating the financial implications of certain courses of action which may be taken by the directors they will often turn to an outside source of advice and very often this will be the audit partner who, over a number of years, is likely to have an understanding of the business (this “understanding” is potentially described as “familiarity” in the consultation paper and is further analysed as representing a threat to independence!) Advice may be sought on, for example, business strategy, acquisitions, shareholder matters, recruitment of financial personnel, taxation advice both corporate and personal, accounting systems, accounting policies etc. Absence of such advice from someone knowledgeable in the company’s affairs would be likely to be prejudicial to the businesses and to remove this advice would be detrimental to the SME - through loss of sensible input from a trusted source. Very often the auditor will know all the Board of Directors, who in many instances will also be the shareholders, and again commonly may be family members: having this full understanding of the people and personalities involved is also an important factor in providing broad financial advice. The risk of rigorously following a set of rules drawn up to cater for a totally different set of circumstances is that one dispenses the “baby with the bathwater”.

So what is proposed? A few highlights will give a flavour of what audit firms will no longer be able to do:

Information technology services

This could preclude audit firms from providing off the shelf software with a degree of customisation for clients. In an SME situation this would be prejudicial to the client’s interest on the basis that the audit firm often has a knowledge of the client’s systems and requirements and is in the best position to provide the support in producing what is required.

This situation is totally different to large bespoke systems which the major firms might provide with high levels of customisation.

Recruitment services

An audit firm is to be precluded from “taking responsibility for the appointment of any director or employee of the audit client”. For audit clients having limited knowledge of financial matters and the difference between a good and bad accountant they will often turn to their audit partner to conduct at least part of the interview process.

The audit firm is also to be precluded from advising on remuneration packages of directors and key management of an audit client. This could prevent any input on what accountants in industry may be earning, advising on such as employee incentive (“EMI”) schemes and other employee bonus schemes. This surely cannot be what is intended as this is part of the general advisory role that an audit firm would provide based on their knowledge of the objectives and aspirations of the shareholders and managers.

Corporate finance and other transaction related work

Work undertaken in connection with corporate finance transactions will be affected by the proposed changes. In undertaking due diligence work at the request of the client this is often best undertaken by members of staff who are familiar with the industry sector in which the acquisition is being made. This has distinct advantages from the client’s point of view as the due diligence is likely to be more focussed and better informed, but the proposals could prevent this.

It is possible that in the structuring as part of the acquisition that the audit firm will also be involved in preparing projections and fundraising on behalf of the client, and if there is the provision of financial assistance for the purchase of own shares it is possible/probable that the acquiring company’s auditors will then be appointed as the target company’s auditors for purposes of giving the necessary letter of comfort. This is a description of a normal series of events in the SME sector. No doubt there are perceived threats on a number of fronts but the reality is that this is the way transactions are completed hopefully in a cost effective manner to maximum advantage.

The ability to conclude deals at the smaller end of the corporate range is already under threat through the scale of deal costs and the efficiencies thus far afforded will be forfeit if this is taken as being a precluded set of circumstances.

Accounting services

Auditors will continue to be able to provide accounting services provided that they “do not involve initiating transactions or taking management decisions”. It seems to me that processing purchase invoices and then preparing a cheque listing suitable for approval by the client is initiating a transaction for payment and would hence be caught. Without further clarification the work undertaken by firms for SME clients such as the writing up of cash books, coding invoices, posting these and preparation of management accounts for discussion with the client will be a problem. This is prejudicing clients’ interests by forcing them down a route which would provide a less coherent accounting arrangement.

A recent newspaper article highlighted the dwindling number of new entrepreneurs as a major threat to the UK economy. In an environment of ever increasing employment legislation and added cost to businesses, to deprive this dwindling number of wealth creators of informed financial advice given with an independent view is to exacerbate a problem and what has been gained? What price independence?