Importance of audited accounts in maintaining agency relationships

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Disclosure to public has been found to be benefit for companies in several ways, for instance, improving future liquidity, reducing cost of capital and lower unrealistic risk (Diamond and Verrecchia 1991). However, corporate disclosure is costly as some helpful proprietary information could be obtained by competitors (Jansen 2005). To protect the small and medium-sized companies surviving in competition in the market, the UK government has permitted partially release of financial reporting or exemption of audit for private companies.

As a regular commercial process, audit has been to afford neutral verification from the third-party institution about the financial accounts and reports of one firm or organisation. Watts and Zimmerman (1983) stated that audit provides estimable assurance to financial reporting external users like investors and lenders. Healy and Palepu (2001) argued that external disclosure can help to intermediate the stock of firms in capital market. Verrecchia (1983, 1990) found that managers prefer external disclosure to exemption of audit as the former choice can bring benefit in mitigating information asymmetry even though such choice is costly for competition. In addition, public disclosure also establishes an effective setting for reliable information to weaken the higher cost of capital from information asymmetry (Ball et al. 2000). Therefore, audit and public disclosure play a key role as mitigation of information asymmetry in capital market.

Historically, the adoption of UK audit policy was universal mandatory audit; however, this policy has been changed to the Companies Act 1989 as the increased cost of audit leaded to disproportionate cost concession on small companies (Dedman and Kausar 2010). According to Collis (2010), Europe Union (EU) member states are allowed to opt to exempt from statutory audit for small entities and those qualifying as small and medium-sized companies can prepare 'modified' or 'abbreviated' accounts to replace the regular full accounts. Because there are nearly 20 million small and medium-sized enterprises in the EU and 99.8% of those in the non-financial economy which can provide 67% of the employment in private sector, small and medium-sized enterprises (SMEs) have been the main support of economy in the EU (Schmiemann 2008). In the same situation, SMEs also have played important role in the UK economy. The data showed that private entities doubled since the 1980s, increased from 2.4 million to 4.8 million, mainly as growing in micro firms and one-person firms (DTI 1997). The record of BIS (2010) notes that 98.15% of UK companies were small ones and whose contributed 30% of turnover and 31% of employment. Therefore, the EU member states as well as the UK gave the options to small and medium-sized firms to forgo the statutory audit in order to leave enough development space for them and then boost the economy of EU and UK.

Statutory audit and financial reporting derives from the publicity doctrine argument which agrees that companies must pay the cost of publication of their annual report and financial accounts and other related information as their limited liability (Holgate 1995). However, the considerable increase of the audit price forces smaller firms to exempt from disclosure if the cost exceeds the limited benefit (Keasey et al. 1988). Further, based on the fact that the financial reporting function traditionally is outsourced to the independent accountants and the small companies mainly rely on one external accountant to disclose their statutory financial reports (Holmes and Nicholls 1989), Seow (2001) argued that the close relationship between the independent auditor and small companies could make the auditor always works at the accounts that has been prepared, which brings down assurance benefit. Thus, the exemption of statutory audit could be an alternative or better choice of small companies under the comparison between cost and benefit. In addition, since private companies should legally be required to offer the full accounts to their shareholders, the shareholders are usually unaffected by the decision which is whether publicly disclosure or not (Dedman and Lennox 2009). This evidence to some extent support the feasibility of audit exemption for small private companies.

In the UK, the development of company law is organised by the Department for Business, Innovation and Skills (BIS) and the registration is by Company House (Collis 2010). As the associated agency of BIS, Company House has the responsibility for setting up and dissolving limited companies, detecting and recording firm information based on the Company Act and matched legislation, and publishing such information available (Companies House n.d.). Under UK company law (Company Act 2006), a company is qualified as a small or medium-sized one if it meet the least two thresholds of turnover, balance sheet total (meaning the total of the fixed and current assets) and the average number of employees. According to special provisions in the Company Act 2006 and relevant regulations, a small or medium-sized company can prepare and submit the accounts which disclose less information than large and public companies (Companies House 2010). Collis (2010) states that the abbreviated account option for small and medium-sized firms was included into the Compact Act 1981, which indicates the principle of special disclosure based on size was presented into UK company law. Abbreviated accounts for medium-sized companies require higher disclosure level than small ones. Since the UK followed the EU Fourth Directive which allows small firms in EU member states can execute audit exemption, the very small private UK entities can choose exemption from regular audit for the first time in 1994 (Collis et al. 2004, Collis 2010). From then on, the size criteria of small and medium-sized company have increased significantly; the fresh thresholds of small company are £6.5 million of turnover and £3.26 million total assets (Companies House 2010), which equal to the revised EU maximum level ( €8.8m and €4.4m).

These reforms lead large number of firms to enjoy exemption from certain public disclosure of financial accounting, which is argued to be protection for their proprietary information. A major conflict generated by such exemption arises from users who rely on the audit assurance (Dedman and Kausar 2010). It is argued that there may be downsides to exercising these options in term of credit ratings and cost of debt. Banks are the main financial source for small companies (Cosh and Hughes 2003), and the audited reporting is the key factor in the credit decision (Berry et al. 1993).

Apart from the size of the firm, bankers believe that statutory full accounts are the most important data resource of documentary information since they are more reliable (Berry et al. 1987). On the other hand, according to Sengupta (1998), the level of voluntary disclosure in one firm and its cost of debt exists negative relationship, which proves a company would afford higher cost of debt if it opts withhold information. In the contrary, the earlier research found that banks do not care filing options of private sectors as they do not rely on public disclosure but the detailed financial information directly supplied by private firms at the same intervals (Fama 1985). Particularly, although the audit exemption brought a negative impact on credit ratings and cost of debt to the company, the Companies Acts still retains the provision relating to abbreviated accounts option after several amendments (Collis 2010).

This study will continue the ongoing discussion to examine whether smaller, private firms in the UK which exercise disclosure exemption options, suffer from lower credit ratings and higher debt costs, all else equal, relative to firms which do not exercise exemption options. We set Qui score as the dependent variable and establish a regression model to test the impacts of the explanatory variables as Qui score predictors which include qualified financial data and financial ratios in basic accounts. As a major credit rating measure, Qui score is issued by a UK credit rating agency named Qui Credit Assessment Limited. Qui score is expressed in the numerical scale between 0 and 100 measuring the likelihood of company failure in the year following the date of calculation and the companies are classified into five risk groups based on this rating (Doumpos and Pasiouras 2005). All data for this study are available in Financial Analysis Made Easy (FAME) database of Bureau van Dijk's company, in which private companies qualified for filing abbreviated accounts option are present.

We find the negative relationship exists between the levels of statutory disclosure and the credit ratings. If full accounts were filed by small private companies, their credit rating can be improved. This suggests that statutory audited accounts reduce the cost of debt.

The remainder of the paper is structured as follows. Section 2 reviews relevant literature and develop the hypotheses. Section 3 introduces the methodology. Section 4 presents and analyses the results. Section 5 draws conclusions and limitation of the study.

2. Literature review and development of hypotheses

2.1 The history of disclosure in the UK

2.2 The role of disclosure in capital markets

In capital markets, the information problems and agency problems based on information asymmetry hinder the resources to efficiently distribute in the capital market economy. To solve or mitigate the above problems, disclosure itself and institutions which establish reliable disclosure between investors and managers play a key role. As Healy and Palepu (2005) mentioned, the optimal allocation of deposit money to the investment opportunity is a decisive challenge in capital economy. There are many existing entities and fresh companies like to attract and absorb the public savings, which is traditionally in the bank or in the investment institution, to fund their business methods. Similarly, savers also want to invest their free monetary to companies for the interests and dividends. While entrepreneurs and savers would like to do business with each other, the suitable savings to the matching investment opportunities are complex mainly for two problems. One is the "information problem" faced by savers who make investment venture because firm managers usually hold more and better information than savers relate to the value of investment opportunities and managers have motion to overstate the true value of their companies. The other one is the "agency problem" between investors and managers as their savings could be confiscated by entrepreneurs for information asymmetry (Healy and Palepu 2005).

2.2.1 Information problem

The information problem or called "lemons problem" is generated from the differences of information holding by investors and entrepreneurs and inconsistent intentions between them. According to Akerlof (1970), this problem could lead to a failure of effective capital markets. Based on the premise which is both investors and entrepreneurs are rational and they evaluate investment opportunities by their own information, the concise description of this problem is stated that under information asymmetry circumstance, entrepreneurs with bad ideas can claim that their ideas as valuable as good ideas to investors; therefore, when investors value a investment opportunity, they will possibly both good one and bad one as an average level. The consequence is that the capital market will then undervalue some good investment opportunities but overvalue some bad ones relied on the available information of entrepreneurs. The investors who invest the bad ideas but miss good ones are call "lemons" (Akerlof 1970).

There are several solutions to information problem. Kreps (1990) argued that the optimal contracts between investors and entrepreneurs will serve motivation of full disclosure of private information, which can reduce the problem from overvaluation and undervaluation. Healy and Palepu (2005) mentioned that the regulation requiring statutory full disclosure and intermediaries like financial analysts and credit rating agencies who can engage in superior information production are also useful potential solutions to mitigate the information problems.

2.2.2 Agency problem

2.3 Agency factors

Agency problem between principals and management arises from information asymmetry. The rationale of agency relationship is traditionally present in large firms where the external shareholders exist and the audited financial accounts play an agency role in this relationship between shareholders and managers (Jensen and Meckling 1976). The main users of audited financial accounts are the tax authorities, lender, employees and major suppliers and customers apart from the owners (Collis 2003). In small companies, a principal is the one who is away from the management actions, including an internal or external shareholder who cannot verify the information, a lender or other provider of credit (Power 1997).

Power (1997) also contended that information asymmetry may be found among internal shareholders once they are short of essential knowledge to understand financial information. Therefore, requirement for the audit are not related to the company size since agency relationships are present in either large companies or small companies. With economic rationality (Weber 1968), Freedman and Goodwin (1993) argued that the conflict between shareholders and managers even exists the extremely small firms and the full, audited accounts are considered as a necessary protection. However, there are some evidences which indicate that small companies are likely own-managed rather than external-owned (Carsberg et al. 1985). Thus, the audit could be little valued in small firms because in which there are less agency problems than large companies where ownership is separate from control.

Prior research shows that the audited financial accounts play a crucial role in lending decisions made by banks (Berry et al. 1987, Deakins and Hussain 1994). Page (1984) studied how the managers pay attention to the benefit of statutory audit for bank lending and the result shows that 17% of respondents would like to audit fully their accounts in order to be good for the external users especially banks. Lin-Seouw (2001) studied the same topic after legislation of audit exemption first using in the UK in 1994 also obtained the similar conclusion. In ACCA (1998) document, an interview to 17 bankers shows that 94% of them would more like to lend money to the fully audited small companies; and 82% of companies whose turnover size is between £350,000 and £1.5m think public disclosure information of audit can help for the bank.

Morris and Omrod (1990) based on a investigation of credit analysts and credit managers, discovered that if small companies chose to file statutory full financial accounts, the audit could become the very important evidence to access credit risk. By contrast, this study also found that if abbreviated accounts were filed by small companies, the cost was high since about half of the information omitted from the accounts could be collected from other sources. Furthermore, companies who filed full accounts can improve their credit ratings (Collis 2003), which means voluntary full accounts can bring down the cost of capital. Meanwhile, the independent audit could reduce inherent risk and control risk whose are usually on the high level in small firms (Collis et al. 2004).

Previous study indicates that the cost of agency problem could proportionally increase with the size and complex level of the firm (Ettredge et al. 1994). In the contrary, the cost of the simple public disclosure and audit can decrease disproportionately on small firms, particularly when the reporting hardly is provided to the outside users (Keasey et al. 1988). Therefore, the agency costs are less regarded in the small companies as the agency relationships are less significant as well as there are less complexity than large firms. This statement looks logical as the description of DTI (1999) is that the smaller company holds proportionately greater costs of audit.

An agency justification in connection with lending is supported by a study of the

voluntary audit decision made by large quoted US companies in 1926 prior to the audit

becoming a statutory requirement (Chow, 1982). The results show that leverage, and to a

lesser extent size, were significant factors. In this study, leverage was used as a proxy for

the use of accounting numbers in debt covenants, rather than for an agency demand for

the accounts to be audited. In contrast, more recent evidence (Ettredge et al., 1994)

indicates that leverage is not significant in explaining the demand for quarterly reviews

prior to filing with the SEC. This suggests that leverage is a noisy proxy for the agency

demand for the accounts to be audited. This notion is supported by Dichev and Skinner

(2002), who report that leverage is used in other studies for a different purpose: namely,

the closeness of a company to the constraints specified by the debt covenants.


From this review, it would appear that considerable reliance is placed on the audited

accounts of small companies in maintaining agency relationships. Yet the government's

case for limiting or eliminating the requirement for the small company audit appears to

have been motivated solely by the desire to reduce cost burdens.