Running Head: AUDITING 1

Auditing

Student Name

Institution Name

Date
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Auditing

History of Audit exemption in European Union

In UK, for past many years, all the active limited companies were having a regulatory
requirement for independent audit regardless of the company size. The major philosophy behind
having audit for all the companies irrespective of size was that the external examination of the
accounts and independent opinion on the financial statements provides the completeness,
validity, and accuracy of transactions which enhance the quality of the financial statements.
However, the audit regulations started emphasizing the difficulties faced in enforcing a single set
of rules over a widely diverse market where the size of the companies differs significantly.
Hence, in 1994, the universal law of audit was changed and under the EU law, the small
companies were granted an exemption from the statutory audit. This law was first and foremost
adopted by the UK (Collis J., 2007).

In accordance with the article 51 of the 4th Company law directive, all the limited companies
were required to have an independent audit. However, article 11 provides the member states an
option to exempt small sized entities from this rule. As mentioned, the audit exemption was first
introduced in 1994 in UK through the amendment to section 249A of the Companies Act 1985.
This amendment allowed the company having a turnover up to $90,000 and a balance sheet up to
$1.4 million and under 50 employees to forgo the statutory audit. However, this exemption was
not valid if the shareholders having a 10% or more share capital required the full audit. This
threshold set by UK was lower than the maximum threshold set by the EU at that time.
Companies with a turnover of between £90,000 and £350,000 were given the option of filing a
simpler audit exemption report (AER), but this lesser form of assurance was dropped in 1997,
leaving companies with a turnover of £350,000 or less exempt from the statutory audit.
However, another condition imposed at that time necessitated that the entity should also be
qualified as a small company for the purpose of filing the abbreviated accounts. According to
section 247 of the Companies Act 1985, a company is considered to be small if it meets any two
out of the three criteria for entity size test. This criterion is based on turnover, average number of
employees, and balance sheet total. Apart from the entity which was newly incorporated, this
criterion was must to be satisfied in two of the last three years. In year 2000, the criterion was
revised by revising the turnover threshold which was then increased to $1 million and the
purpose was to raise the levels of all the financial reporting purposes to the substantially higher
EU maxima. In 2003, the EU threshold was again adjusted for indexation reasons and the
turnover threshold was reset to $5.6 million and balance sheet threshold to $2.8 million. These
thresholds were then adopted by UK from January 2004 (Collis, Jarvis, & Skerratt, 2004).
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Audit exemption Threshold

On 1 January 2016, the statutory instrument that implemented the 2013 EU directive came in to
force in UK. One of the major changes that were brought forward by this law was a change in the
threshold of audit for limited liability companies.

Companies

According to Companies Act 2006, the companies that qualify for small companies are usually
exempt from audit, except if they are the members of the group or the charities. In that case, the
company is required to follow the threshold set for charity companies (Collis, Holt, & Hussey,
Business Accounting, 2017).

A company is small if it meets two out of three of the following criteria for two consecutive
years:

Old limits, before 1 January New limits after 1 January

2016 2016
Turnover <£6.5m <£10.2m
Total assets <£3.26m <£5.1m
Number of employees <50 <50

Once the company size is decided and established, it is only lost if the limits are exceeded for
two consecutive years. Further, there are also corresponding changes brought forward in the
gross criteria of the group companies. Just as before, these are plus 20% on the threshold for
turnover and total assets.

In the case of ineligible company, the audit exemption does not apply. A company is required to
have an independent audit, if it any time in the financial year, it has been:

 a public listed company

 a subsidiary company as part of the group which is not small
 carrying out insurance market activity or has been an authorized insurance entity
 a corporate body and the shares of the company have been traded
 A Markets in Financial Instruments Directive (MiFID) investment firm or an Undertakings for
Collective Investment in Transferable Securities (UCITS) management company, or
 A corporate body whose shares have been traded on a regulated market in European state.
AUDITING 4

The rules for ineligibility only refer to the financial year for which the accounts are related. The
major objective is to qualify as a small company and then not to be excluded for the relevant
financial year. However, there are several reasons for which the company would still undertake
the audit despite of the fact that it is exempted under the small company criteria (Collis, Jarvis, &
Skerratt, 2004). Those reasons include:

1. a grant provider requires an audit

2. it is required under constitution of the company
3. the audit is required by the company lender
4. To provide a history of audited financial statements in the event of a future sale or public
offering of the business.
5. It is required by the directors or shareholders to have an assurance over the financial
statements.

Groups

The companies within the group are expecting from an audit if the limits mentioned above are
met across the group as a whole. For companies, there are two set of limits, net and gross. This
eases the assessment for the group. If the group is not qualified as a small company, then the
audit is required for each of the company in the group. However, there are exemptions for
subsidiaries if they meet a certain set of criteria and if the parent entity provides the guarantee
with regard to all the actual and contingent outstanding liabilities at the end of the financial year.
However, due to the requirement for guarantee by the parent company, very few companies
usually opt for this exemption.

There are also the other complications with regard to group eligibility. As per the old rules, a plc
within the group would make the entire group ineligible. However, under the new rules under the
new rules a plc will only make that company ineligible, unless the plc is also a traded company
(e.g. listed on LSE) in which case the entire group is ineligible. One advantage of this rule so that
a group with an AIM listed Plc Company will not qualify the group for ineligibility, whereas
under the old rules it would. The actual number of companies that can get benefitted from this
rule is very limited (Collis, Holt, & Hussey, 2017).

Charity thresholds

The audit threshold for charitable companies is very different from all the on charitable
companies and these rules are not impacted by the statutory requirements as mentioned above.
Further, there is a significant difference between a threshold for charitable companies in UK and
in Scotland.
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Medium-sized companies

Medium sized entities are usually subject to audit. However, due to the change in the limits for
small sized entities, there has also been a change in financial reporting threshold for companies
to be qualified as a medium sized. The new threshold mentions that to be qualified as a medium
sized entity, following criteria should be observed:

 turnover: from £10.2m to £36m;

 total assets: from £5.1m to £18m;
 Number of employees: 50 to 250.

A company or a group must meet any two out of the above three criteria to be qualified as the
medium sized entity. With regard to small companies, there are corresponding changes to the
gross criteria that apply in a group situation. As before, these are plus 20% on the thresholds for
turnover and total assets.

Arguments in favor for audit exemptions

1. Agency theory states that in the case of information asymmetry, the agent bears the cost
of supplying information to support the relationship with the principle. With regard to
small company, a principle could be any person who is distant from the company’s
management and is unable to verify the actions of the company’s management. These
include external stakeholders, lenders and creditors. On the other hand, information
asymmetry is sometimes also present among the internal stakeholders if they do not have
enough skills to interpret the financial information. An independent audit process not
only reduces the inherent risk, but also reduces the control risk significantly. These risks
are usually high and hence this makes the audit procedure more necessary for them.
Whilst an audit does not set out to detect fraud, it can play a key role in detecting material
fraud and also acts as a deterrent to fraudsters (Seow, 2001)

2. For majority of the companies, an audit report which is signed by the authentic third party
such as firm, adds a significance and credibility, along with the element of quality in the
company’s financial statements.
3. The valid argument against audit exemption is that audit includes the assurance for the
directors and management in independent companies. the audit process provide the
assurance by enhancing the figures of the financial statements, the general financial
position of the business, \the reliability of the accounting system, the financial base used
for decision making, and the pre-hand identification of trends that may lead to potential
failure. Furthermore, the audit also increases the credibility of the accounts (Collis J.,
2010)

Arguments against audit exemptions

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1. First and foremost valid reason for audit exemption is to reduce costs. The benefit of
audit exemptions in the UK is that it provides the relief to the companies from
unnecessary costs that sometimes fall disproportionately on smaller companies. This
argument is based on the notion that below a certain size of company, the costs outweigh
the benefit and vice versa. It is important to note that a significant portion of an audit fee
is related to the need of an auditor to cover is own compliance costs. The reason is that
audit profession is heavily regulated and audit firms are subject to periodic reviews from
their members of the professional body monitoring teams which visit the firms to inspect
their working files to ensure quality (Collis J., 2010).

2. Another argument against audit is that it frees up a major portion of management’s time
which is spent in preparing the audit schedules and in dealing with the audit teams. This
time and cost saving from the audit can be applied to various other value added activities
and suggestions forwarded by the, say, accountants. These value added activities may
include corporate strategy development, business planning, and industrial benchmarking.

Should the Audit exemption threshold increase or remains same.

The analysis shows that most of the policy makers in the Europe are recognizing the public
interest function of the statutory and independent audit and are also regarding it as a value added
activity for the business and for the economy as a whole (Mitchell, 1999). It means that audit
profession should take it as a strong sign of confidence and should recognize their vital societal
role of the audit and assurance services. In those countries where the audit threshold is
increasing, more and more companies are adopting for the audit service on voluntary basis. It is
therefore vital that the audit threshold should be maintained at minimal level and should at least
be kept at a current level, instead of revising or reviewing it periodically (Beckerlegge, 1999).

Small and medium sized companies have a diverse range of needs such as:

1. Confidence on going concern

2. Ensuring the appropriate disclosures
3. Obtaining assurance on the reliability of the reported financial information
4. Assurance on the coverage of risk.
AUDITING 7

References
Beckerlegge, J. (1999). The profession’s view: Why the current threshold should be maintained.
Accounting Age.

Collis, J. (2010). Audit exemption and the demand for voluntary audit: A comparative study of
the UK. International Journal of Auditing , 14 (2), 211-231.

Collis, J. (2007). Progress towards harmonisation of audit exemption in the EU and the case of
the UK. 30th Annual Congress of the European Accounting Association , 25-27.

Collis, J., & Jarvis, R. (2002). Financial information and the management of small private
companies. Journal of Small Business and Enterprise Development , 110-110.

Collis, J., Holt, A., & Hussey, R. (2017). Business Accounting. London: Macmillan Education
UK.

Collis, J., Jarvis, R., & Skerratt, L. (2004). The Demand for the Audit in Small Companies in the
UK. Accounting & Business Research , 34 (2), 87-100.

Fearnley, S., & Hines, T. (2003). The regulatory framework for financial reporting and auditing
in the United Kingdom: the present position and impending changes. The International Journal
of Accounting , 38, 215-233.

Mitchell, P. (1999). The profession’s view: Why the threshold should be raised. Accountancy
Age , 23, 21.

Seow, J. (2001). The Demand for the UK Small Company Audit – An Agency Perspective.
International Small Business Journal , 19 (2), 61-78.