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Chapter 4 - Conclusions and recommendations
General conclusions
4.1
The PJSC concluded that there are fundamental
conceptual and practical problems with the new financial reporting system for
proprietary companies. Because of these problems the new system has not
achieved the objectives set for it. While the new system has eliminated
reporting requirements under the Corporations Law for 99.4 per cent of all
proprietary companies, small proprietary companies are still subject to the
full requirements of the Accounting Standards if they meet the definition of a
‘reporting entity’ as defined in the Standards. At the same time, small
proprietary companies are less accountable in a public manner. On the other
hand, proprietary companies which are classified as large according to the
large/small test but are non-reporting entities can disregard the full
requirements of the Standards. Other objectives of the system, such as reducing
compliance costs and eliminating the complexity of the reporting rules, have
not been met for the same reasons.
4.2
The PJSC was particularly concerned about the
complexity of the rules for determining the reporting requirements of
proprietary companies. Although in many cases applying the requirements of the
Law, that is the large/small test, involves the application of threshold
limits, the rules for determining reporting obligations have proven to be
complex, unnecessarily onerous and costly. This is largely due to:
- an inconsistency between the reporting requirements under the Law
and the reporting entity concept of the existing accounting standards;
- the existence of ASIC Class Orders which are not widely
understood; and
- the ASIC’s discretion to grant relief from the reporting
requirements.
Inconsistent requirements
4.3
As the ASIC and the accounting bodies noted in
their submissions, the introduction of the large/small test has created an
inconsistency in relation to the reporting requirements of proprietary
companies.[1]
The inconsistency arises because the Accounting Standards contain a separate
test for determining a company’s financial reporting obligations. As the Law
stands, large proprietary companies are required to prepare financial reports,
which include financial statements made out in accordance with the Standards.
However, the Standards apply the reporting entity test to determine which
companies must comply with the full requirements of the Standards when
preparing their accounts. As the accounting firm, Ernst & Young noted,
“since the reporting entity concept is recognised in the Accounting Standards,
it is still possible for a large proprietary company to argue that it is not a
reporting entity and therefore prepare financial statements that do not comply
with the Accounting Standards.”[2]
According to the ASIC, many companies appear to take the view that they can
disregard those requirements completely as the full requirements of many
Accounting Standards apply only to reporting entities.[3] Conversely, small proprietary
companies, which no have reporting requirements under the Law, are required to
prepare general purpose financial statements if they are reporting entities,
regardless of whether it is a small or large proprietary company. While in many
cases applying the large/small test and the reporting entity concept result in
the same outcome, and hence the reporting requirements are the same, there are
often situations where this is not the case.
4.4
The ASIC has recently reviewed the application
of the reporting entity test and issued a draft information release which
outlines the accounting requirements applicable to both reporting and
non-reporting entities.[4]
The draft release advises that all entities reporting under Chapter 2M of the
Corporations Law, whether classified as reporting or non-reporting entities,
must apply the recognition and measurement requirements of the Standards “in
order to determine the financial position and profit or loss of the entity.”
Non-reporting entities must also consider disclosures that are necessary to
give a “true and fair view” even though they may not be directly prescribed by
the Standards. This would include disclosure according to Accounting Standards
of significant related party transactions (AASB 1017) and the classification of
financial instruments (AASB 1033). In its written submission and evidence to
the PJSC, the ASIC expressed concern over the incorrect classification of some
entities and the level of disclosure in financial statements:
ASIC reviews of financial reports have revealed that some
companies which claimed to be non-reporting entities should have been
classified as reporting entities. The practices of some companies that claimed
not to be reporting entities included not recording liabilities for employee
entitlements and not depreciating non-current assets. The draft release
outlines ASIC’s view that the current Law requires the measurement and
recognition requirements of accounting standards to be applied to both
reporting entities and non-reporting entities so that financial reports reflect
all assets, liabilities, revenues and expenses. If the measurement and
recognition requirements are not applied, there is no assurance that a
company’s balance sheet reflects all and only all assets and liabilities, and
that a company’s profit and loss statement reflects all and only all revenues
and expenses. The net assets and profit/loss of each entity could be determined
at the whim of their directors and the results of different entities would not
be comparable.[5]
4.5
The submissions from Incat Tasmania Pty Ltd, the
National Institute of Accountants (NIA) and the accounting bodies also
addressed at length the inconsistency in reporting requirements. In the view of
the PJSC, this inconsistency is the main reason for the complexity that exists
in determining the reporting requirements of proprietary companies. It has also
lead to the incorrect classification of entities as non-reporting entities and
the resulting non-compliance with the relevant accounting standards. The
existence of the anomaly also has implications for the accountability of
proprietary companies in a public manner and the quality of financial
information lodged with the ASIC. As the ASIC draft release noted, many
companies that were incorrectly classified as non-reporting entities had a
large number of creditors and employees and it was “reasonable to expect the
existence of users dependent on general purpose financial reports.”[6] The PJSC believes that
reporting and non-reporting entities, which hold out their financial reports to
be general purpose financial statements, must comply with the recognition and
measurement requirements of the Standards. This would be consistent with the
provisions of the Law requiring financial reports to give a “true and fair
view”.
ASIC’s discretionary powers to grant relief
4.6
Section 342(1) states that to make an order
under section 340 (specific exemption orders) or 341 (Class Orders), the ASIC
must be satisfied that complying with the relevant requirements of Parts 2M.2,
2M.3 and 2M.4 relating to financial records, financial reporting, and the
appointment and removal of auditors would:
- make the financial report or other reports misleading; or
- be inappropriate in the circumstances; or
- impose
unreasonable burdens.
4.7
Section 342(2) sets out the criteria which the
ASIC must have regard to in deciding whether the audit requirement would impose
unreasonable burdens. They include the expected cost/benefits of compliance and
any practical difficulties faced by the company in complying with the audit
requirement. Section 342(3) requires the ASIC to take account of several
factors in assessing the benefits under section 342(2).[7]
4.8
The majority of submissions advised that the
criteria for audit relief in sections 342(2) and (3) are appropriate, although
the NIA suggested two additional criteria to which the ASIC should have regard,
namely the company’s past compliance history and the type of relationship
between shareholders. But the real issues in relation to the granting of relief
were the ASIC’s discretionary powers to grant relief from the lodgement of
financial statements and its interpretation of the criteria in section 342.[8] As stated by the accounting
firm, Atkinson Gibson, the ASIC’s discretionary powers and the process of
applying for relief are a disincentive for many companies to seek relief:
Some of my clients have little faith in the exemption process
given their perception that exemptions are rarely granted. This does not
provide any incentive for them to engage in the exemption process.[9]
4.9
Submissions drew attention to two cases where a
company sought relief from the lodgement of its financial statements: Incat
Australian Pty Ltd and D G Brims and Sons Pty Ltd. As noted in Chapter 3 of
this report, both cases were similar in so far as the claim for relief was
based on the issue of unreasonable burden in that by lodging financial
statements the companies would be at a disadvantage with their competitors. The
AAT upheld the ASIC’s decision not grant relief in one case but found that
relief should be granted to the applicant in the other case. Although the
subject of both decisions was based on the Law as it was prior to the Company
Law Review Act 1998 (prior to 1 July 1998), they illustrate the
difficulties that still apply in the Law, in particular to section 342.
4.10
The two cases also highlight the inconsistencies
that can occur when the determination of a company’s reporting requirements are
left to the interpretation of the criteria in section 342 by the ASIC and the
AAT. There was also a general view among the submissions that in many instances
relief should be granted and the requirements for relief, which are set out in
the ASIC policy statements, are unnecessarily onerous and restrictive.[10] The NIA reflected the comments
of submissions in stating that:
Most firms would not seek the relief if they did not honestly
believe it is required. Related to this is the issue of what factors ASIC takes
into account when coming to its conclusion. The NIA believes that paragraph
342(2)(e) of the Corporations Law should be interpreted as widely as possible
to give companies every opportunity to prove that it would be an unreasonable
burden or is inappropriate in the circumstances to require them to comply.
Further, the requirements themselves for seeking relief should not be made so
onerous as to make it difficult to seek relief, they should be simplified and
be inexpensive to comply with. There is no point requesting relief from one set
of requirements if to do so requires the same amount of time and expense.[11]
Unlevel playing field and ‘grandfathered’
large proprietary companies
4.11
In its August 1995 report, the PJSC recommended
that the “grandfathering clause” in the First Corporate Law Simplification Bill
should be subject to a three-year sunset provision. This would have the effect
of eliminating the differential regulation of large proprietary companies. The
PJSC could see no basis for regulating some large proprietary companies
differently from other large proprietary companies. If the rationale for
requiring large proprietary companies to lodge audited accounts was that they
exercised significant economic influence and it was therefore reasonable to
expect potential users of their accounts, then all large proprietary companies
should be subject to the same reporting requirements. Exemptions or the
granting of relief for large proprietary companies, the PJSC argued, should
only be available if, in the particular circumstances of the company, the
requirements imposed an unreasonable burden.[12]
The principal recommendations in the August 1995 report addressed these
circumstances.
4.12
The PJSC concluded that the grandfathering
arrangements are a significant shortcoming of the new reporting system,
particularly as these companies comprise a high proportion of the population of
large proprietary companies. According to the ASIC report to the Senate,
approximately 42 per cent of all large proprietary companies are
‘grandfathered’.[13]
As the ASIC report to the Senate acknowledges, this situation has created an
unlevel playing field through information asymmetry. The grandfathering of
certain large proprietary companies has placed new entrants and smaller, less
diversified companies at a competitive disadvantage and encouraged a market in
grandfathered companies.
4.13
The unlevel playing field has also imposed
barriers to effective competition and increased the likelihood of market
inefficiencies. The accounting firm Atkinson Gibson described the
anti-competitive impact of the reporting requirements on large proprietary
companies which are not grandfathered:
Some of my clients are competing against large Australian
companies and/or multi-national companies. Some are finding the commercial
marketplace a very hostile environment. They are concerned that they could be
the target of a takeover by a larger predatory company/and or “squeezed” in the
market place by a large competitor who has a disproportionately larger
financial resource.
Such activity is not uncommon and involves predatory pricing and
poaching of staff. Thus the issue makes some of my clients feel very vulnerable
and view the requirement by government for them to make financial information
public as an act which at the very least weakens their position and at worst
could lead to the demise of their business. This is a serious issue to them.[14]
Insolvent trading
4.14
Financial accounts and the auditing of them are
important measures of corporate governance. Quite apart from their value to
directors and shareholders, they help to ensure that those who deal with the
company, for example, creditors and employees, can be confident in their
dealings with it. Creditors and other users of financial statements are
interested in knowing a company’s revenues, assets and liabilities, and, if the
company is trading actively, whether the company is solvent regardless of its
size and economic impact. Employees also have an expectation that the company
can meet its current and future obligations and their entitlements will not be
threatened. It is important therefore that creditors, potential creditors and
others are able to make appropriate decisions confident in the information that
is disclosed by the company.
4.15
The PJSC believes that as a result of recent
changes to the Law there is a greater need for directors to address their
current obligations for solvency. One of the changes to the Law introduced by
the Corporations Law Amendment (Employee Entitlements) Act 2000 was to
extend the existing duty on directors not to engage in insolvent trading.
Section 588G of the Law prohibits insolvent trading by directors. The Employee
Entitlements Act extends that prohibition so as to place directors under a duty
not to engage in a non-debt uncommercial transaction.[15] Directors who breach this new
duty are personally liable for the uncommercial transaction. This new duty on
directors provides creditors and employees with an additional safeguard beyond
the existing prohibition on insolvent trading. As the PJSC’s report on the
Employee Entitlements Bill noted, the amending legislation was aimed at
companies that are structured and managed so as to deliberately fail and
therefore avoid their obligations to creditors and employees.[16]
4.16
A shortcoming of the large/small test is the
exclusion of companies in which there may be a significant public interest.
These companies are not required to prepare or lodge accounts, and hence are
less accountable in a public manner. As the ASIC report to the Senate
acknowledges, there are likely to be companies that are excluded because they
do meet the current threshold limits which have creditors, potential creditors,
employees and others who would access those companies’ accounts if they were
publicly available.[17]
Conversely, where a company has prepared and lodged accounts, there is the
question of the value of the financial report to creditors and other users.
Reform options
4.17
A number of reform options were proposed to
address the shortcomings in the new system. The first option was to replace the
large/small test with the reporting entity concept. The option advocated by the
accounting bodies would require only those companies meeting the reporting
entity test in the Accounting Standards to prepare and lodge audited accounts.
If the reporting entity concept is not adopted, the second option would be to
retain the existing large/small test with minor changes. Several submissions
favoured maintaining the large/small test and improving its efficacy. This
would be achieved by removing the grandfathering provisions and increasing the
threshold limits for large proprietary companies. The third option was to
reinstate the previous distinction between exempt and non-exempt proprietary
companies as advocated by the AICD. Under this option, all company financial
statements that are required to be lodged with the ASIC would be audited.
4.18
The PJSC was not persuaded that the large/small
test should be retained either in its current form or with the changes
suggested to improve the efficacy of the test. The use of an arbitrary albeit
quantitative test can result in some companies being incorrectly classified and
some companies, in which there is a significant public interest, not having to
prepare and lodge financial statements. The PJSC believes that the operation of
the large/small test will continue to be ineffective if the reporting
requirements can be circumvented and if the ASIC is unable to identify which
large proprietary companies have failed to comply with their reporting
obligations.
4.19
Reporting requirements under the Law and those
in the Accounting Standards serve different purposes. The former are used to
determine which proprietary companies need to prepare financial statements and
have them audited, and the latter concept is applied to proprietary companies
that are required to prepare financial statements and have them audited. While
replacing the large/small test with the reporting entity concept would align
reporting requirements under the Law with those in the Accounting Standards,
the PJSC believes that the current definition and application of the concept is
impractical and relies on a subjective judgement. It is open for different
people (directors and auditors who are required to make such a determination)
to arrive at different conclusions as to whether a particular company is a
reporting entity.[18]
In applying the reporting entity test, the PJSC believes that directors and
auditors must not only consider the relationship between shareholders and
management, but also whether there are existing and potential users of the
accounts who may be dependent on the financial reports.
4.20
Of the three options put forward, the PJSC
favours the reinstatement of the previous test of ‘exempt proprietary company’
to reflect the two broad groups of proprietary companies: family-owned type
companies and subsidiaries of disclosing entities. The reporting requirements
of the Law should reflect these separate groups and the nature and size of
share ownership in proprietary companies. While this approach may result in
certain non-exempt proprietary companies reporting publicly, even if there may
be no significant public interest, the existing reporting requirements create a
far greater problem by excluding proprietary companies that are reporting
entities from the requirement to prepare and lodge audited general purpose
financial reports. The exempt proprietary test should nevertheless recognise
that there is a demand for financial information by creditors and others, and
recent developments in the Law affecting the duties of directors.
Audit requirement
4.21
While the benefits of the audit requirement are
clear, the PJSC found it difficult to assess their magnitude. The arguments for
exempting all proprietary companies from the audit requirement focussed solely
on the costs a company incurs in preparing accounts and the audit of those
financial statements. The arguments have some merit but they ignore the needs
of creditors, employees and others in the community who may be affected if the
company fails. Audited financial statements assist those outside the company to
monitor its performance and to derive some assurance that the company is a
solvent entity. It also reduces the potential for managers and other insiders
from misusing their inside information. As the NIA observed:
the larger the company, the greater
the damage that can be done by fraud or mismanagement and the greater the
temptation to take advantage of a position of power. And while yes they
[shareholders] should be more involved, often many shareholders of proprietary
companies will leave the day to day running of the company to management, who
would be in a position to hide information that would otherwise be available
through annual financial reports. [19]
4.22
The PJSC believes that it would not be
appropriate to relieve all proprietary companies of the audit requirement for
several reasons. This option would not be consistent with the reporting entity
concept in the Accounting Standards, as some proprietary companies,
particularly those that seek to raise equity or loan capital, will almost
always exhibit the characteristics of a reporting entity. Users of financial
reports, who are unable to access financial information about the entity, depend
on high quality financial reports from the company in making their resource
allocation decisions. For reporting entities that have dependent users of those
reports the need for audited financial statements will always outweigh other
considerations. But, as submissions noted, for some proprietary companies the
issue is more complex. The PJSC nevertheless concluded that the ownership of
the company is a better indicator of the need to impose an audit requirement
under the Law than the arbitrary test of a company’s economic significance.
Recommendations
4.23 The PJSC recommends that:
- The previous distinction between exempt
and non-exempt proprietary companies be reinstated, to replace section 45A of
the Law;
- All
directors of proprietary companies be required to sign and lodge a declaration
of solvency with their annual reports;
- In
preparing financial statements, reporting and non-reporting entities apply all
the recognition and measurement requirements of the Accounting Standards; and
- All
company financial statements, which are required to be lodged with the ASIC,
should be required to be audited.
Senator
Grant Chapman
Chairman
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