Small companies set for change

On 12 June 2013, the European Parliament adopted the revised Accounting Directive which was borne out of the European Commission (EC) Responsible Business package.  The main objective of this Directive is to reduce the administration burden for small companies and, to a certain extent, improve the quality and comparability of the information disclosed in the financial statements.

The current EC Directive has been in place since 1978 for individual financial statements and the Directive governing consolidated financial statements has been in existence since 1983 and together these two Directives govern the way in which financial statements are prepared, including the form and content.  Collectively they are known as the Fourth and Seventh Directive respectively and the new Directive essentially combines and improves these two Directives with the idea being that the EC’s ‘think small first’ (which is reflected in the Directive) will benefit both preparers and users of financial statements prepared under the new Directive as the EC allege the revised Directive reflects present and future needs of both parties.  There are many cross-references between the Fourth and Seventh Directives and this is the reason why the EC saw it appropriate to merge them into the new Directive as well as the fact that supporters claimed that merging the two Directives would provide clarity, consistency and coherence to the accounting framework for unquoted companies.

The EC acknowledge that during the past 30 years, various amendments to the Fourth and Seventh Directives have added many requirements including new disclosure requirements and valuation rules (particularly detailed provisions on fair value accounting provisions).  The EC admit that these amendments have served to increase complexity and regulatory burdens for companies.  Where financial statements are concerned, the EC have said that, in the current form, the Fourth and Seventh Directives make financial statements less comparable across the EU with small and medium-sized entities suffering the most.  Many in our profession will say ‘my small clients don’t have anything to do with the EU’ or ‘who is going to compare my client’s financial statements with another entity’s in the EU?’.  These statements were considered by the EC and they claim that as small companies grow bigger, they will undoubtedly have more involvement with other countries in the EU.

One of the ‘tasks’ of the UK Government is to reduce the burden on small companies often referred to as the ‘red tape challenge’.  This task is more widespread than just in the UK and the EC have acknowledged that ‘unnecessary and disproportionate’ administration costs that are imposed on small businesses impede growth and unemployment and as a consequence the new Directive simplifies the manner in which financial statements are prepared.  It is currently unclear as to the likely impact on small clients in the UK and future articles will outline the impact once it is made clearer.  At the moment, there are significant concerns for the UK about the impact of the EC’s simplifications and the lengths these simplifications go as some claim that they will result in financial statements being meaningless and certainly departing from giving a true and fair view, which is something the UK must avoid at all costs and is something professional bodies are actively striving for.

The new Directive mandates each Member State to make a distinction between those companies which are small and those which are large.  In the UK we achieve this by way of turnover, balance sheet total and number of employees.  For the purposes of the new Directive, small companies will be those will less than 50 employees, a turnover of not more than €8 million and / or a balance sheet total of not more than €4 million. Member States may also use thresholds for turnover of up to €12 million and a balance sheet total of up to €6 million.  Companies that are classed as ‘micro entities’ have also been incorporated into the new Accounting Directive and a ‘micro entity’ is one with less than 10 employees, a turnover of not more than €0.7 million and / or a balance sheet total of not more than €0.35 million.  Such micro entities are also afforded the same level of protection by the new Directive as small companies with such companies being able to prepare a very simple balance sheet and profit and loss account with virtually no notes to the accounts if the Member State so wishes.

The EC’s ‘think small first’ approach essentially says that more companies will be considered ‘small’ and therefore will prepare profit and loss accounts, balance sheets and related notes that are proportionate to their size as well as the information needs of users and the EC claim that more than 90% of EU companies will fall into the category of ‘small’ for accounting purposes.  The EC go on to say in their impact assessment that financial statements notes will also include between eight and 13 items as opposed to 14 and 24 notes (or more in some cases) as is the case today.  There will also be no requirement to specify ‘extraordinary items’ (although in the UK, FRS 3 defines ordinary activities so widely that all our ‘extraordinary’ items have disappeared and are referred to as ‘exceptional’ items).  Such exceptional items will be reported, instead, as a simple explanation in the notes to the accounts, though I am not sure preparers of financial statements will view this as a significant simplification.

A key feature of the Directive is the fact that it reduces and limits the amount of information that small companies will have to provide in their financial statements – notably in the notes to the financial statements.  If the UK were to take the Directive and adopt it forthwith small companies would only prepare a balance sheet, a profit and loss account and notes which would only be prepared to satisfy regulatory requirements.  There is an option within the Directive which permits Member States to allow small companies to prepare abridged balance sheets and profit and loss accounts and small companies will still be entitled to provide more information, or additional financial statements (such as a cash flow statement) should they so wish.  The fees paid to accountancy firms has been mentioned in the EC’s Explanatory Memorandum and they acknowledge that companies operating in Member States that the savings they are setting out to achieve at company level will stem from a reduction in fees paid to accountancy firms with the ‘negative impact’ on such firms only being marginal.

However things are not as simple as merely rushing to adopt the new Directive tomorrow.  The Directive will be adopted by the European Council and published in the Official Journal.  At this point, the Department for Business, Innovation and Skills (BIS) will more than likely launch a consultation and it will be then that we will have a better idea of when Companies Act 2006 will be amended and how.

Conclusion

The new Directive has largely been welcomed, but not without some reservations.  Certain critics have alleged that if the UK does adopt the new Directive in its entirety, it will result in financial statements that are misleading, watered-down and fail to give a true and fair view – something that has been enshrined in the Companies Act for many years.

There are going to be substantial issues in the UK that will need to be considered, so this is likely to take some time – in particular a review of the FRSSE will have to be undertaken insofar as disclosure requirements are concerned.

Category: Accounting and standards