Analysis of Audit Exemptions for Small Companies in the EU and UK

This report provides an in-depth analysis of audit exemptions for small companies in the EU and the UK, tracing the history of these exemptions and the changes in audit thresholds over time. It discusses the arguments for and against audit exemptions, considering factors such as shareholder reassurance, fraud reduction, cost savings, and the impact on the accounting profession. The report also examines the potential consequences of continuing to increase audit exemption thresholds, highlighting both the opportunities and risks associated with reduced regulatory oversight. It references key directives and legislative changes, offering a comprehensive overview of the evolving landscape of audit requirements for small businesses in the European Union and the United Kingdom.

Running Head: Audit Exemption to Small Companies
Audit Exemptions in EU

Audit Exemption to Small Companies 1
Part 1
History of audit exemptions in EU and changes in audit thresholds in UK
For many years in history, all the limited companies in UK that were holding the active status
were required to get the audit of their financial statements done by an independent auditor,
irrespective of their size. In year 1994, the state of universality of audit function was changed
when it was permitted under the provisions of EU law to provide exemption to the small
companies in respect of statutory audit (Collis, 2007).
In the initial periods, the limits of thresholds under UK law were fixed below the maxima
level provided in the EU Company Law Directive. However, there were revisions made in the
threshold limits on the upward side till such thresholds matched with the maxima level in EU.
During this entire period there were huge controversies about the adequacy and
appropriateness of thresholds and their impact on the profession of accounting and its users.
An analysis has revealed that out of 25 member states of EU, 92% countries provide audit
exemption to the small companies (Collis, 2007). Moreover, UK is one among the three
countries that is using maximum level of thresholds prevailing as of now in EU.
Since the period of recession that occurred in 1980, a considerable expansion in the number
of micro sized businesses, small businesses and the medium sized businesses. However, the
threshold limits applicable to small companies are always subject to the periodic amendments
for the purpose of indexation, by the European Commission. The size criteria to determine as
to whether an audit exemption is available to a particular company, has been based on mainly
three factors since 1999 to 2008. These factors were the turnover, balance sheet total and
average total number of employees in the organisation. In 1999, the maxima for turnover
were set at € 5 million and that for balance sheet total was set at € 2.5 million. In 2003, the
maxima in both the respects were reset. In terms of turnover, the threshold limit was set at €

Audit Exemption to Small Companies 2
7.30 million and at €3.65 million in terms of balance sheet total. In 2008, the limits were
again revised and set at €8.8 million for turnover and €4.4 million for balance sheet total.
However, the limits for average number of employees had remained same throughout the
period at 50 (Collis, 2007).
The extent of threshold has varied in the different member jurisdiction of 25 member states of
EU. However, the variations in those threshold limits have been on account of differences in
the culture, social and economic positions of those countries. The concept of audit exemption
was brought into the scope in 1994 by way of making amendment of the provisions under
section 246 A of companies act 1985 (Collis, 2010). The said section allowed the companies
to skip the requirement of statutory audit unless its turnover is up-to £90,000 and the balance
sheet has the total of £1.4m and has the average number of employees at or below 50,
provided there was no requirement of full audit by those shareholders of the company who
held minimum of 10% of the total share capital of the company. However, those companies
which have turnover in the range of £90,000 and £350,000 were given a privilege to file an
audit exemption report but this form was withdrawn in 1997 to release companies with
turnover at or below £350,000 to follow the statutory audit provisions. In 2000, the threshold
limit was increased to £1,000,000 in terms of turnover and thereafter in 2003 the said limits
were revised for the indexation purposes and were set at £5,600,000 (turnover) and
£2,800,000 (balance sheet total).

Audit Exemption to Small Companies 3
Part 2
Arguments for and against the audit exemption to small companies
Small companies are those companies where the number of employees ranges from 0-49
(Ojala, et. al., 2014). According to the 4th directive of company law a small corporation is the
entity which does not exceed the any 2 out of 3 prescribed conditions for the consecutive
years. Those conditions are:
 Total assets under £5.1m
 Turnover under £10.2m
 Fewer than 50 employees (Department for Business, Energy & Industry Strategy,
2017).
An audit is carried to examine the true and fair view of the financial statements by the entity.
Since the notification issued in 2003 which is in effect in 2004, the companies are not
anymore required to get the audit done of its accounting books if its turnover has not
exceeded the limit of £ 5.6 million and £ 2.8 million for the balance sheet totals. Over 60% of
the companies have discontinued following the provisions of statutory audit. However, as per
certain reports from DTI, around 85% of the private entities are still getting their accounts
prepared by the professional accountants.
 Arguments against audit exemption
During the process of audit the external auditor has to carry out the thorough examination of
the entity’s financial statements to express his opinion on the completeness, accuracy as well
the validity of the financial statements prepared and presented by the company. There are
various reasons of complying with the provisions of statutory audit even when they are not
mandatory to be followed. These reasons are discussed in the further section of the report.

Audit Exemption to Small Companies 4
The shareholder reassurance is one of the major reason because of which the audit exemption
must not be given to the small companies. As shareholders are the parties which are generally
not involved in the internal business activities of the company but still they require the
information about company’s performance to take informed financial decisions. Further, the
fraud reduction is another major aspect which supports the view that the financial statements
of the small companies must also be audited. Though audit does not guarantee the detection
of each type of fraud or error on part of management or any other party but still the function
of audit has the potential to control the frauds at the organisation as the work of the
organisation staff is externally scrutinised by a professional party. The audit of financial
statements improved the quality of such financial statements as there is little room of any
fraud or error. The audit function also raises the credibility about the financial statements and
the information contained therein, in the eyes of the shareholders and other stakeholders such
as investors and lenders of the company. The compliance with the audit provisions enables
the company to raise funds from the investors more smoothly as the audit function creates a
level of trust and confidence among the potential investors of the company and when the
company has the potential to generate funds from different sources it has more opportunities
to grow and expand its business from the small level to the next level. Moreover, the audit
function builds a sound image of the company in the eyes of the general public and thereby
provides them the opportunity to compete with the large sized firms. If the small company is
planning to sell itself to a large corporation, then the audit serves as an effective tool to
identify the worthiness of such sale transaction (ICAEW, 2018).
 Arguments in favour of audit exemption
Though there are multiple reasons which support the argument of keeping the audit function
for the small companies, there are still some reasons due which suggests the audit must be
dispensed off. These reasons are discussed in the further section of the report (Collis, 2008).

Audit Exemption to Small Companies 5
The exemption to the small companies from the compliance of provisions of statutory
auditor will certainly help in reducing some costs of the small companies. As the function of
audit has to be performed by the professional who charges significant fees to carry out the
audit process on the financial statements of the client organisation, such fees is not generally
affordable to the small companies. Generally, small companies do not prepare their proper
books of accounts and if audit is made mandated then they will have to prepare proper set of
books of accounts which is not feasible in their case looking at the size of their operations.
For many firms, the function of audit proves to be an expensive as well as unnecessary
imposition which provides little or no value to such companies. Therefore, for small
companies, the provision of exemption of statutory audit will be an appropriate decision as
the cost saved in complying with the provisions of the law could be more effectively utilised
in seeking advice to improve the profitability and to enhance the capital value of such
companies (ICAEW, 2018).

Audit Exemption to Small Companies 6
Part 3
If the audit exemption thresholds are continued to be increased:
With the introduction of new conditions (threshold limits) from the financial year 2016 more
than 10000 companies will be made exempted from the audit provisions. The increase in the
threshold limits would support the view that audits are primarily meant for the large
corporations due to the complexity of their businesses (Collis, 2007).
The continuation increase in the audit exemption could have both positive as well as negative
impacts. It can be seen as opportunity particularly for the proactive and innovative accounting
professionals who are serving the growing business of the nation. Whenever, the regulations
are withdrawn from the scope, the need of better advice in relation to entity’s business
increases which provides opportunities to the professional accountants (ACCA, 2016 a).
However, it is necessary to understand that increased exemption from the provisions of
statutory audit enhances the fraud risk as the business which are given exemption from
getting their books of accounts audited gets the privilege to undertake the illegal or fraudulent
business practices by way of manipulation of books of accounts for their personal interests at
the cost of hurting the interests of their stakeholders in their business performance. But, the
said view is not universally correct. It is a growing belief nowadays that the rise in the
threshold limits will ultimately lead to streamline further the audit services provided by the
auditing firm as they will have the chance to explore to the opportunities to provide tailored
and customised services to their clients.
The rise in the threshold limits requires the audit specialists to shift their audit practices and
skills into smaller teams with highly skilled members to serve the requirements of their
clients who require audit services for the non-regulatory objectives such as seeking loan from
the banks and financial institutions (ACCA, 2016 b).

Audit Exemption to Small Companies 7
The increase in the threshold limit is not quite problematic rather it will provide the
businesses to grow exponentially by preventing them to spend their considerable time and
funds in complying with the regulatory provisions of the law. Therefore, it would be correct
to say the continuous raising of threshold limits for the compliances with the provisions of
audit to exempt more and more entities from the audit compliances, seems to be quite
challenging but it has opened up the avenues for the practitioners of auditing profession as
they have the opportunities to offer broader assurance services and to maintain deeper
relationships with their clients.

Audit Exemption to Small Companies 8
References:
ACCA, 2016 a. Higher audit exemption threshold is opportunity as much as threat. Available
at: https://www.accaglobal.com/hk/en/member/member/accounting-business/2016/04/
practice/audit-threshold.html Accessed on: 29.10.2018.
ACCA, 2016 b. Audit exemption threshold: what's the damage? Available at:
https://www.accaglobal.com/in/en/member/member/accounting-business/practice/audit-
threshold.html Accessed on: 29.10.2018.
Collis, J., 2007. Progress towards harmonisation of audit exemption in the EU and the case of
the UK. Available at: https://core.ac.uk/download/pdf/90321.pdf Accessed on: 28.10.2018.
Collis, J., 2008. Directors’ views on accounting and auditing requirements for
SMEs. Londres: Department of Business, Enterprise and Regulatory Reform.
Collis, J., 2010. Audit exemption and the demand for voluntary audit: A comparative study of
the UK and Denmark. International journal of auditing, 14(2), pp.211-231.
Department for Business, Energy & Industry Strategy, 2017.The impact of exempting small
companies from statutory audit. Available at:
https://assets.publishing.service.gov.uk/government/uploads/system/uploads/
attachment_data/file/583972/audit-exemption-small-companies-impact.pdf Accessed on:
29.10.2018.
ICAEW, 2018.The arguments for and against having an audit. Available at:
https://www.michaelwarner.co.uk/the-business-journey/the-arguments-for-and-against-
having-an-audit Accessed on: 29.10.2018

Audit Exemption to Small Companies 9
Ojala, H., Niskanen, M., Collis, J. and Pajunen, K., 2014.Audit quality and decision-making
in small companies. Managerial Auditing Journal, 29(9), pp.800-817.