Preparing for New Audit Regulations

Small businesses with a turnover of less than £6.5 million and gross assets of less than £3.26 million are urged to consider new audit regulations as the government continues to push ahead with its plans to further simplify the audit exemption eligibility for small companies. 
 
The Companies and Limited Liability Partnerships (Accounts and Audit Exemptions and Change of Accounting Framework) Regulations 2012 came into force on 1 October 2012 and introduced important changes to the audit requirements for UK companies. 
 
The regulations are intended to ease the burden of financial reporting on UK companies by increasing the number of companies that fall outside the scope of the statutory auditing and reporting requirements. 
 
As well as aligning mandatory audit thresholds with the accounting thresholds in the Companies Act 2006 (‘the 2006 Act’), thereby reducing the number of small companies that will be obliged to have an audit, the regulations also create a new exemption for private subsidiary companies. 
 
The exemption is available where the parent company is EU registered and files audited consolidated accounts.  To qualify for the exemption, the parent company must have given an unlimited guarantee in respect of all of the subsidiary’s outstanding liabilities to which the subsidiary is subject at the end of the financial year.
 
For the parent company to give the guarantee, the subsidiary company must file Form AA06 at Companies House, which states that the parent gives the guarantee as set out in a new section 479C of the 2006 Act.  There is no requirement to enter into a separate guarantee agreement; the guarantee is given by virtue of Form AA06 being signed by the subsidiary company and the parent company and filed at Companies House.
 
The procedure therefore appears to be straight forward and could easily be led by the subsidiary company.  However, the Act provides that the guarantee will be enforceable against the parent company by any person to whom the subsidiary company is liable in respect of those liabilities.  The parent company will therefore have to weigh up the cost benefits of using this exemption with the potential exposure that the guarantee brings.  It will ultimately be up to the courts to clarify in due course how far the guarantee extends, but early government discussion on the topic indicates that the wording of the legislation is intended to cover not only the liabilities included on the subsidiary’s balance sheet but also any contingent liabilities.
 
Another important point to note is that even if the subsidiary is not wholly-owned by the parent company, the parent will be liable for 100% of the subsidiary’s liabilities under the guarantee, as there is no requirement in the 2006 Act for the subsidiary to obtain any form of guarantee from minority shareholders in order to take advantage of the audit exemption.  The parent company may seek to persuade any minority shareholders of the subsidiary company to enter into reciprocal proportionate guarantees, however the minority shareholders’ agreement to such arrangements is of course likely to depend on their level of involvement with the company. 
 
Some minority shareholders may consider the independent scrutiny of the auditors to be an important means of monitoring the activities of the company.  If a subsidiary company has minority shareholders who take that view, it may struggle to rely on the exemption as the 2006 Act requires the unanimous consent of all of the members of the company to the use of the exemption for the financial year in question.  Written notice of such agreement must be filed at Companies House.    
 
Before giving the guarantee, the parent company will need to consider whether any agreements with third parties contain restrictions on giving guarantees, or any requirements for the subsidiary to file statutory accounts.  Furthermore, in order to comply with their duties under the 2006 Act, the directors of the parent company will have to consider whether giving the guarantee promotes the success of the parent company and its members as a whole.  This will mean giving due consideration to the liabilities of the subsidiary company in the context of a reduced level of independent scrutiny. 
 
Despite the changes, subsidiary companies may still be required to have a statutory audit in certain circumstances, for example if the company is requested to do so by a lending institution. 
 
Michael Stace is a corporate lawyer and partner with Morgan Cole.  Further information is available at www.morgan-cole.com
 
Michael can be contacted at michael.stace@morgan-cole.com or alternatively on +44 0118 955 3000.