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Chapter 3 - Issues arising from the large/small test
General criticisms
3.1
The PJSC received 14 written submissions from
accounting firms and individual practitioners, large proprietary companies,
professional organisations and the ASIC. Although a number of submissions
expressed support for the large/small test, the majority gave either qualified
support or was critical of the new reporting system. The most common criticisms
related to the arbitrary nature and amounts of the threshold limits and the
differential reporting for large ‘grandfathered’ proprietary companies. These
submissions highlighted the practical difficulties in distinguishing between
companies on the basis of size and financial circumstances and the costs
associated with preparing and lodging financial statements.
3.2
A consistent theme of submissions was that the
audit requirement applicable to proprietary companies should be based on a
cost/benefit of the requirement. If the audit requirement is considered
necessary or desirable in terms of public policy, the benefits to the community
must be realised and costs to business minimised. For those large proprietary
companies that are not exempted the cost burden can be onerous and unwarranted.
Several submissions questioned the cost/benefit of the audit requirement for
large proprietary companies. These included the Office of Small Business, which
commented:
It is important that the reasons
for requiring an audit at all are fully considered and justified. Unless the
benefits of retaining the existing audit requirements can be clearly
demonstrated as outweighing the costs, the audit requirement should be removed
for all proprietary companies. If an audit is considered necessary or desirable
on public policy grounds, any benefits must be realised and costs to small
business minimised.[1]
Audit costs
3.3
Several submissions focussed on the compliance
costs for companies that are required to lodge audited accounts with the ASIC.
The Office of Small Business estimated the average audit costs for medium-sized
companies at $25,000.[2]
The Motor Trades Association of Australia (MTAA), which represents franchised
new motor vehicle dealers, estimated the additional audit cost in excess of
$20,000.[3]
Submissions also referred to the indirect costs to business, including the time
spent and resources allocated to non-profitable outcomes. The MTAA commented:
What has resulted is that many hundreds of family owned
Australian companies which are trading profitably and meeting their debts as
they fall due are now required to fulfil onerous and costly audit conditions
for no real purpose.[4]
3.4
The accounting bodies also presented the results
of a 1995 survey by the Institute of Chartered Accountants. The Institute
undertook a survey of its members, to which 1,252 responded out of a total of
3,500. The survey identified 3,735 large proprietary companies of which 2,797
(or 75 per cent) were non-reporting entities. The number of large proprietary
companies which had not appointed an auditor and were non-reporting entities
was 2,132. The majority of these companies (2,068 or 97 per cent) had five or
fewer members. The average cost of having the accounts audited was $12,600.
Based on these estimates, if a company has only two members but is classified
as large, the annual audit costs are $6,300 per shareholder.[5]
3.5
To reduce compliance costs it was proposed that
all proprietary companies should be exempted from the requirement.[6] Alternatively, large
proprietary companies should be required to provide a simplified profit/loss
statement and end of year balance sheet to each shareholder which has been
reviewed by a qualified accountant.[7]
Benefits of audit requirement
3.6
Although submissions did not address the
benefits of the audit requirement in as much detail, they presented a broad
overview of the perceived benefits. The main benefits are summarised as
follows:
- improved business operations;
- maintenance of checks and balances;
- evidence of a company’s solvency;
-
accurate record keeping.
3.7
To some degree however the benefits were less
apparent where there was no separation between ownership and management of a
company as occurs in many large proprietary companies. Unlike public companies,
proprietary companies have a restricted ownership. This limited shareholding
means that owners of the business are involved, at least in some way, with the
management of the business or are closely related to someone who is. As the
National Institute of Accountants (NIA) observed, shareholders are more like
directors of the company than normal shareholders and as such “they have a
greater responsibility to make themselves aware of the position of the business
and have greater access to such information. This suggests that there is less
of a need to make public reports that would be expensive and provide no more
than what should already be known”.[8]
Commercial privacy
3.8
Many private companies are operated by
owner/managers who closely guard their financial information from competitors.
Several submissions raised the issues of privacy and the use of a company’s
financial statements by rival companies. Although these companies previously
lodged key financial data they are now concerned about commercial privacy and
the effects of providing price sensitive information to their competitors.[9] Prior to the introduction of
the large/small test, the criteria for reporting was based on the status of the
company in question. The classification of companies as exempt proprietary
companies enabled those companies that were privately owned to maintain their
commercial privacy. Mr Ron Mann, the sole shareholder/director of Gram
Engineering Pty Ltd, stated that as a consequence of the disclosure of his
company’s financial details his business was vulnerable to industry competitors
who were larger and more diversified:
In my case, I can see the negative effects of placing all my
company’s financial information on public record. I have no objections to my
financial reports being held by ASIC, but not placed on public record. As I
have mentioned earlier, my company specialises in the manufacturing of pre-painted
steel fencing. My two major competitors, BHP Building Products – a part of the
total BHP Steel Group and Metroll Pty Ltd – a major roofing/other steel
products supplier, will have access to all my detailed financial information
and able to use them to their advantage. The financial information (re fencing)
of the company’s competitors are hidden amongst all their other business
activities, therefore putting my company at a strategic disadvantage.[10]
ASIC Class Orders
3.9
Under section 341 of the Corporations Law, the
ASIC has the power to make Class Orders relieving companies from some or all of
the requirements to prepare, lodge and have audited a financial report. The
following is a list of current ASIC Class Orders in relation to the reporting
requirements of proprietary companies:
- Class Order 98/0098, Small proprietary companies which are
controlled by a foreign company but which are not part of a large group;
- Class Order 98/0099, Anomalies preventing certain large
proprietary companies from being grandfathered;
- Class Order 98/1417, Audit relief for proprietary companies;
and
- Class Order 98/1418, Wholly-owned entities.
3.10
While these Class Orders have reduced financial
reporting requirements for some proprietary companies, they have also added to
the complexity of the reporting rules. In some cases the conditions of the
Class Orders have been unnecessarily onerous. Several submissions pointed to
the requirements in CO 98/0098 and 98/1417 as particularly onerous and lacking
flexibility.[11]
In particular, the Office of Small Business noted that the gearing ratio of 70
per cent in CO 98/1417 was arbitrary and precluded some large proprietary
companies from applying for audit relief which would otherwise meet the
conditions of the Class Order.[12]
Relief from lodging financial statements -
Incat Australia Pty Ltd and D G Brims and Son Pty Ltd
3.11
One of the companies that sought relief from the
reporting requirements was the Incat group of companies (Incat Australia Pty
Ltd, Incat Chartering Pty Ltd and Incat Tasmania Pty Ltd). The companies, which
are categorised as large proprietary companies, are builders of aluminium
passenger ferries for the export market and employ 1,000 people. The Incat
companies sought relief from lodging financial statements for the years ending 30
June 1996, 1997 and 1998 on the grounds that the requirement to lodge financial
reports:
- imposed an unreasonable burden on the companies and created a
“competitive disadvantage”;
- imposed an unreasonable burden on an officer of the companies;
and
- was inappropriate in the circumstances of the companies.
3.12
Incat’s rationale was that such lodgement would
lead to a ‘competitive disadvantage’ in that its customers and competitors in
the market would be able to establish Incat’s profit margin.[13] While the ASIC accepted that
customers would be able to make precise estimates of Incat’s average profit
margin on ferries built, the more precise information would not disadvantage
Incat because its customers could already make an approximate estimate of its
profit margin. The ASIC also accepted that it would be possible for Incat’s
competitors to estimate Incat’s profit margins from its accounts, albeit with
less precision than its customers. The ASIC concluded that even without access
to Incat’s financial statements, customers and competitors could make a rough
but valid estimate of Incat’s costs and profit margins. The ASIC’s decision not
to grant relief was affirmed by the Administrative Appeals Tribunal (AAT).[14] An appeal by Incat to the
Federal Court was dismissed on 4 February 2000.[15]
3.13
In another similar case D G Brims and Sons Pty
Ltd sought relief from lodging its 30 June 1997 financial statements. The basis
for seeking relief was that it would impose unreasonable burdens, in that by
lodging the financial report the company would be left at a competitive
disadvantage with suppliers and customers. Following the ASIC’s decision not to
grant relief, the company sought a review of the decision by the AAT. In this
situation the applicant was successful, with the AAT finding that the company
had met the criteria for relief. The AAT decided that the compliance with the
requirement “would be inappropriate because the public interest in the
lodgement of accounts is outweighed in this case by the potential for the
company to be subjected to price competition from major competitors with the
inherent potential to make the company no longer financially viable.”[16]
Overall compliance
3.14
As acknowledged in the ASIC report to the
Senate, there is currently no means of identifying which large proprietary
companies have failed to comply with the reporting requirements. In particular,
non-grandfathered proprietary companies, which do not lodge accounts and are
not granted relief, are not required to confirm they are small and not
controlled by a foreign company. Although there is no estimate of the number of
large proprietary companies affected, the ASIC believed that some companies may
not have fully understood their obligations and consequently failed to lodge
accounts or other information.
3.15
A further concern is the use of trusts and the
restructuring of companies to avoid financial reporting obligations, a practice
confirmed by the accounting firm Atkinson Gibson.[17] Some proprietary companies may
restructure their businesses to bring them below the threshold limits in the
large/small test and hence avoid the reporting requirements of the Law:
Anecdotal evidence suggests that many economically significant
businesses are conducted through trusts and other structures which are neither
companies nor disclosing entities. These trust and other structures are not
required to prepare or lodge accounts under the Corporations Law...It is possible
that some proprietary companies may reorganise their affairs such that they
cease to be large and are no longer subject to the reporting requirements of
the Law. For example, the business could be transferred into a trust or a large
business could be spread across a number of companies owned directly by
individuals, each of which is a small proprietary company.[18]
Unlevel playing field and compliance with the
Accounting Standards
3.16
The ASIC report to the Senate also advised that
the existing Law has created an unlevel playing field between different types
of entities in terms of their financial reporting obligations. In particular,
non-corporate entities such as family trusts and grandfathered large
proprietary companies are not required to lodge financial statements.[19] Several submissions expressed
concern that some non-grandfathered large proprietary companies could be placed
at a disadvantage to their competitors who are grandfathered and are not
required to lodge financial statements.[20]
According to the ASIC, there are 1,592 non-grandfathered proprietary companies
which were previously exempt that are now required to lodge financial
statements. Mr Gerard Meade, Chairman of the Legislative Review Board,
Australian Accounting Research Foundation, stated that differential reporting
was not in the public interest:
Mr Meade—In terms of grandfathering, a
number of people who have put in submissions have contended that grandfathering
creates an unlevel playing field. We would certainly support that contention in
that we have two levels of disclosure by large proprietary companies. Those
that were not grandfathered—that is, they were not previously exempt
proprietary, they did not have audits conducted—are required to prepare
financial reports under the Corporations Law, whereas grandfathered large
proprietary companies are not. Having that differential level is seen as
something which is really not in the public interest. In terms of companies
restructuring, there certainly have been examples where companies and groups
have restructured with the objective of avoiding classification as a large
proprietary company. Once again, that is something that is not desirable, but
it is one implication of the small and large test.[21]
3.17
The ASIC also commented on the quality of
financial statements lodged and the need for all entities lodging financial
statements to comply with at least certain minimum requirements of Accounting
Standards to ensure financial statements are prepared on a comparable basis.[22] The ASIC advised that as the
full requirements of the Accounting Standards applied only to reporting
entities it was possible for large proprietary companies, which claim not to be
reporting entities, to disregard those requirements in preparing financial
statements.[23]
Some of the practices included not recording liabilities for employee
entitlements and not depreciating non-current assets. Mr Tom Ravlic, a financial
commentator, noted by way of example that two comparable large proprietary
companies could produce different financial results depending on their
compliance with the Standards:
Problems have emerged in the past few years with companies
required to lodge documents with the Commission putting forward documents that
do not comply fully with accounting standards. The Australian Securities and
Investments Commission highlighted a handful of companies almost two years ago
in a private meeting with the Big Five accounting firms to indicate the sort of
non-compliance they found objectionable. The companies looked at were clearly
large proprietary companies, but because they considered themselves
non-reporting entities they chose not to comply with accounting rules that
produce a lower reported result. Two companies with the same assets, same
revenues and same expenses could end up with different reported results because
one chose to comply – quite properly – with the complete suite of accounting
standards and the other sought to apply cosmetic surgery to its numbers for a
better look.[24]
3.18
However, as the ASIC advised the PJSC, the
reports of companies must still give a true and fair view. The ASIC is of the
opinion that this would require all large proprietary companies to observe the
recognition and measurement provisions of the Accounting Standards.
Availability of Accounting Standards
3.19
The NIA advised that the Accounting Standards
are important for the production of financial reports and are designed to improve
the running of businesses. Although the Standards are statutory instruments and
referred to in the Corporations Law, they are not freely available on the
Internet as are other forms of legislation:
This can lead to companies either ignoring them or being
oblivious to the existence of the Standards. Neither is a welcome outcome. Free
access through the Internet is essential to improve the performance of business
and encourage compliance. Maintaining barriers to accessing Standards allows
private legislation to govern a public duty. If tax and other legislation that
affects business is relatively accessible, then why are the Standards
instruments not in a similar position? It seems wholly unfair to expect
compliance with the Standards when so few have access to them. In order to
reverse this anomaly, the NIA believes the Accounting and Audit Standards
should be made freely available on the Internet, this will help reduce
compliance costs and improve compliance with the Standards.[25]
3.20
Although it did not seek a response to the NIA’s
proposal from the Australian Accounting Standards Board, the PJSC believes that
the proposal has considerable merit. The improved accessibility of the
Standards will enhance the quality of information in financial reports and
encourage compliance by proprietary companies as well as public companies.
Alternative reform options
3.21
In addressing the effectiveness of the new
reporting system, submissions recommended various changes to the large/small
test that would exempt a larger number of proprietary companies or extend the
scope of the test to include companies which are presently exempt. Other
options for reform included the reinstatement of the previous test of ‘exempt
proprietary company’ and replacing the large/small test with the reporting
entity concept.
Reporting entity concept
3.22
The accounting bodies proposed replacing the
current test with the reporting entity concept as the basis for financial
reporting. The main advantage of the reporting entity concept was that it was
generally recognised as the most appropriate test for determining reporting
obligations, and, in addition, was not based on arbitrary criteria.[26] The AASB Accounting Standards
define a reporting entity as:
An entity (including an
economic entity) in respect of which it is reasonable to expect the existence
of users dependent on general purpose financial reports for information which
will be useful to them for making and evaluating decisions about the allocation
of scarce resources, and includes but is not limited to the following:
- a listed
corporation
- a borrowing
corporation
- a company
which is not a subsidiary of a holding company incorporated in Australia and
which is a subsidiary of a foreign company where that foreign company has its
securities listed for quotation on a stock market or those securities are
traded on a stock market.
3.23
Underlying the rationale for adopting the
reporting entity concept is the view that the Law should only impose reporting
obligations on companies that are reporting entities, as it is only these
entities that have dependent users of financial reports. Some entities will
almost always be characterised as reporting entities, for example, disclosing
entities, publicly listed companies, listed trusts and other companies which
raise funds from the public. However, there are other types of entities that do
not exhibit the characteristics of a reporting entity. They include some small
proprietary companies, sole traders, family trusts, partnerships and
wholly-owned subsidiaries of Australian reporting entities. These entities are
outside the scope of the Corporations Law and are normally exempt from
preparing general purpose financial reports in accordance with the Accounting
Standards:
If a proprietary company either does not have readily
identifiable users who are dependent on the company providing them with
financial information, or it has users, but they are able to demand financial
information from the company (e.g. a major lender), then there should be no
requirement for these companies to prepare and lodge financial reports.
Alternatively, where there are users who do not have access to financial
information from a proprietary company tailored to their specific needs, the
company should prepare general purpose financial reports.[27]
Modifying the threshold limits
3.24
There was a general view that the criteria
comprising the large/small test are somewhat arbitrary. The MTAA, which was
concerned about the additional costs associated with the audit requirement,
recommended that the current assets, revenue and employee threshold limits
should be doubled.[28]
This change was strongly supported by the Office of Small Business, which noted
that the current assets and revenue limits are too low and did not take account
of high volume/low margin businesses. As a result manufacturing companies that
are capital and labour intensive have a higher representation in the large
category compared to other industry sectors.[29]
The accounting firm Price Waterhouse Coopers also raised the practical
difficulties in classifying a proprietary company as large or small on the
basis of threshold limits that are applied only at the end of the financial
year:
There are some proprietary companies whose activities are
seasonal or who, for example, may negotiate significant new business immediately
prior to the end of their financial year which cannot be deferred until after
the end of the financial year for commercial reasons. Such proprietary
companies may then be caught under either of these tests. Whereas we
acknowledge that, within certain limits, the tests also provide an opportunity
for proprietary companies to structure their affairs in such a way as to avoid
being classified as large, the classification can be somewhat artificial for
proprietary companies that are temporarily affected by seasonal or other
changes and which at other times throughout the financial year would be no
different from many other proprietary companies which, on the basis of the
criteria, are classed as small.[30]
3.25
Mr Ian Langfield-Smith, Lecturer at the
Department of Accounting and Finance, Monash University, recommended that
companies classed as large should also include any proprietary company that has
more than 20 members.[31]
Other suggestions for improvement involved incorporating the following
additional criteria to the large/small test:
- a return on capital, to take account of businesses which have
large capital outlays but fluctuating margins[32];
and
- a debt to equity ratio, to bring small proprietary companies that
are highly geared within the reporting system.[33]
Exempt proprietary company
3.26
The Australian Institute of Company Directors
(AICD) strongly supported the reinstatement of the previous test. It advised
that proprietary companies should be classified according to the shareholding
of the entity. In particular, there appeared to be two broad groups of
proprietary companies based on ownership:
- family-owned types of companies; and
- subsidiaries of disclosing entities.
3.27
The AICD recommended that the requirement to
prepare and lodge audited financial statements with the ASIC should only apply
to subsidiaries of disclosing entities, while companies in the first group
should be required to apply all the measurement requirements of the Accounting
Standards. The existing exemption to wholly owned subsidiaries should continue.[34] In addition, the AICD
recommended that as part of a reversion to the previous test, all directors of
companies be required to sign and lodge a declaration of the company’s solvency
with the annual return. The AICD acknowledged that a declaration of solvency
would provide some assurance to the community at large that the company is a
solvent entity and is able to meet its future obligations. This may also
reassure creditors and employees about the company’s financial position, as
well as making directors more responsible for the affairs of the company by
focussing attention on their current obligations for solvency:
Mr Service—We have been discussing this
issue, because the institute is very committed to transparency in those
organisations which have a general responsibility to the public; that is, those
who raise capital, borrowings or deal with the public on a large scale where
there is a wide interest in their solvency. One of the things we believe ought
to happen, particularly if the committee is of a mind to get rid of the present
large/small definition, is that every company should have to have all its
directors sign and lodge with its annual return a declaration of solvency. We
think that that, amongst other things that are of public importance, will
actually make directors really think about this solvency issue. We are all
seeing situations in the courts where directors simply have not addressed their
minds to whether or not their companies are solvent. Whilst as shareholders
they may suffer, very often a lot of other people suffer as well.
I think it is fair to say the institute would not even be
uncomfortable if you were to recommend that proposal and that part of it ought
to be that, when a company has signed its declaration of solvency, it should
have an obligation to give a copy of that declaration to every one of its
employees. They are one of the groups of people that need protection and, I
have to say, are not adequately protected in fact by the law at the moment. The
average employee does not go to ASIC and say, ‘Can I look at this company’s
accounts?’ Employees ought to know that their employer is solvent. We think, in
terms of public policy, that would be quite effective in really making
directors think about what their responsibilities are. They already have those
responsibilities but, clearly, some of them do not address them.[35]
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