REGULATION, RISK, PERFORMANCE AND POLICY: A STUDY OF THE IMPACT OF UK SMALL COMPANY ABBREVIATED ACCOUNTS LEGISLATION John Kitching Small Business Research Centre, Kingston University Email: [email protected] Eva Kašperová Small Business Research Centre, Kingston University Email: [email protected] Jill Collis Brunel Business School, Brunel University Email: [email protected] The paper explores the contradictory risks associated with UK small company financial reporting regulation and examines policy options in the light of the revised European Accounting Directive permitting Member States to relax publication regimes for microentities. Using data from preparers of small company abbreviated accounts and a wide range of accounts users, we elaborate the dilemma for UK policy-makers. The paradox for micro-companies, that financial confidentiality and disclosure both potentially serve their interests, means policy-makers face a trade-off between reducing the regulatory burden on micro-companies and supporting disclosure in order to reduce credit risk and improve credit allocation, both of which are argued to facilitate economic growth. The deregulatory thrust of the revised Directive, intended to ‘free up enterprise’ might produce the opposite consequences - to make the UK one of the best places in Europe to start, finance and grow a business. KEYWORDS: abbreviated accounts, micro companies, financial reporting, disclosure, credit risk Acknowledgements: The authors are grateful to the Scottish Accountancy Trust for Education and Research for funding the research upon which the paper is based, and to the Institute of Chartered Accountants of Scotland (ICAS) for supporting the research.

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INTRODUCTION: RISK, RISK MANAGEMENT AND REGULATION Risk has been identified as an endemic feature of contemporary social life, arising out of the dynamic character and interactions of modern organisations undertaking their normal activities (Giddens 1990; Beck 1992). Governments play a principal role in managing the risks organisations generate - through regulation, intended to limit the exposure of individuals and organisations to physical, economic and environmental harm (Hutter 2005; Better Regulation Commission 2006). But regulations themselves have come to be regarded as sources of harm to economic well-being and, therefore, constitute a risk that needs to be managed through measures to remove, simplify and consolidate particular laws (e.g. DTI 1985; HM Treasury/Better Regulation Executive/Cabinet Office 2006; HM Treasury 2011). Policy-makers accept that regulatory interventions should be proportionate to the risks posed (HM Treasury 2011) and that the administrative burden of enforcement should be based on a comprehensive risk assessment (Hampton 2005). Regulatory reform programmes have been pursued by governments in many developed and developing countries during recent decades in order to stimulate economic growth (e.g. Nijsen et al. 2009) and international organisations advocate such reforms as essential to facilitating economic recovery and long-term growth following the 2008-9 financial crisis (OECD 2010).

The UK Coalition government has implemented a number of initiatives intended to reduce the regulatory burden on businesses (HM Government 2010; HM Treasury 2011), particularly micro and small enterprises (e.g. Better Regulation Executive 2010), as part of a policy agenda to make the UK one of the best places in Europe to start, finance and grow a business (HM Treasury 2011). Such businesses are argued to be at greater risk of harm from regulation because of higher fixed compliance costs and lower resilience to external shocks due to limited resources (Chittenden et al. 2002; Crain and Crain 2010). For instance, a three-year ‘moratorium’ on domestic regulation for micro businesses with fewer than 10 employees was announced in early 2011 (HM Treasury 2011).

This paper focuses on one specific field of risk management by government - regulation of small companies’ financial reporting practices.

In the light of the revised European

Accounting Directive permitting Member States to replace financial reporting regimes for micro-entities (European Union 2012), we investigate the impact of current UK financial reporting regulation on small companies and other stakeholders, and consider the implications of relaxing micro companies’ disclosure obligations for accounts preparers, 2

accounts users and the wider economy. We begin by setting out the UK regulatory context of financial reporting and outline policy prospects in the light of the revised Directive. Then, we review the literature on small company financial reporting and its effects, paying particular attention to notions of credit risk. We then outline our analytical framework and methodological approach before presenting the findings from a study investigating the value of small company abbreviated accounts to preparers and users, considering the policy implications and drawing conclusions.

UK FINANCIAL REPORTING REGULATION: CURRENT CONTEXT AND FUTURE PROSPECTS Under the Companies Act 2006, limited companies in the UK are required to prepare annual financial statements giving a true and fair view of financial performance and financial position for members and to file a copy with the registrar at Companies House, the UK public registry. Publication of financial statements is widely regarded as the price companies must pay for the privilege of limited liability. Currently, EU law permits Member States to operate different reporting regimes for companies of different sizes.

Companies required to prepare full accounts must provide a profit and loss account (statement of comprehensive income) and a balance sheet (statement of financial position). The profit and loss account summarises the revenue and expenditure over the accounting period and the balance sheet summarises the value of the entity’s assets, liabilities and equity on the last day of the accounting period for which the profit and loss account has been prepared.

Small companies are permitted to file abbreviated accounts comprising an

abbreviated balance sheet and related notes. This is not compulsory – small companies may file full accounts if they wish. Companies must still prepare full accounts for members.

The EU Fourth Company Law Directive allows Member States to permit qualifying small and medium-sized reporting entities to register less detailed abbreviated accounts1 in place of the full statutory accounts that large companies are required to file.2 Under the Companies Act 2006, a non-publicly accountable entity qualifies as small if it does not exceed any two of The Fourth Company Law Directive refers to ‘abridged’ accounts. The UK Companies Act 1981 refers to ‘modified’ accounts, later changed to ‘abbreviated’ accounts in the Companies Act 1989 and retained in the Companies Act 2006. 2 Entities qualifying as medium-sized are also permitted to file abbreviated accounts, but greater disclosure is required than for small companies. 1

3

the following three size thresholds: annual turnover £6.5 million; balance sheet total £3.26 million; and average employment of 50. Apart from newly incorporated entities, these conditions must have been satisfied in two of the last three years. In 2010/11, approximately 3 per cent of the annual accounts registered in the UK were categorised as ‘abbreviated small’ (Companies House 2011: Table F2). The ‘audit exempt’ category, comprising 71 per cent of accounts filed, includes many small companies filing abbreviated accounts, as these are also exempt from the statutory audit. Recent estimates suggest that 50-60 per cent of companies in the UK file abbreviated accounts (POBA 2006).

The revised European Accounting Directive permits Member States to exempt micro-entities from a general publication requirement, provided that balance sheet information is duly filed, in accordance with national law, with at least one designated competent authority and that the information is transmitted to the business register (European Union 2012). The purpose of the measure is to reduce the administrative burden of filing accounts on the public register and to align micro-entities’ reporting requirements with the real needs of users and preparers of accounts. Initial estimates indicated that 5.3 million EU companies would save €6.3bn, although this figure has subsequently been revised downward (European Union 2011). The Directive defines micro-entities as companies not exceeding two of three criteria – total assets of €350,000, net turnover of €700,000, and average employment during the financial year of 10. The UK government has welcomed the revision and plans to implement changes following consultation later in 2012 and suggests that up to 1.5 million companies might benefit (BIS 2012a). These proposals should be seen in the context of a wider programme of measures intended to modernise the company law framework, intended to enable companies to compete and grow effectively (BIS 2012b, 2012c). Although we do not yet know what the UK government proposals will be, we can consider the likely consequences of options they might take.

PRIOR RESEARCH ON FINANCIAL REPORTING REGULATION AND ITS EFFECTS Different literatures imply opposing positions on the impact of financial reporting regulations on companies and their stakeholders. The finance literature emphasises the crucial role of disclosure in addressing the information and agency risks faced by investors/creditors contemplating providing finance to particular companies.

Investors/creditors lack the

information possessed by company insiders to judge whether companies report their financial 4

position and performance accurately (the information problem) or, having invested, they lack the information to know whether company insiders are acting in investors’/creditors’ best interests (the agency problem) (e.g. Diamond and Verrechia 1991; Healy and Palepu 2001; Easley and O’Hara 2004). These information asymmetries between financiers and business insiders render accurate credit assessments more difficult with credit-seekers experiencing greater constraints (Stiglitz and Weiss 1981).

Disclosure, conversely, reduces risk and

improves the availability and cost of finance. While most studies focus on large, publicly listed companies, and their access to the capital markets, similar arguments have been proffered in relation to the informational opacity of small companies in relation to banks, suppliers and other credit providers (e.g. Binks et al. 1992; Berger and Udell 1998; Arruñada 2011). Small enterprises use a number of sources of external finance (e.g. Cosh et al. 2009; Fraser 2009). External providers often make funding conditional upon the provision of financial information (Marriott et al. 2006), including published accounts but also other information sources such as more detailed and timely management accounts (e.g. Berry et al. 2004). Small companies often voluntarily choose to file full accounts, and undertake an audit, because they perceive benefits to accounts users (Collis 2012).

Academics, lobby groups and policy-makers focusing on the impact of regulation on small businesses treat regulation principally as a cost or constraint (e.g. Chittenden et al. 2002; Federation of Small Businesses 2012a). Such a view underpins the revised Directive and UK government proposals. Regulation is argued to raise the administrative costs to businesses, and to encourage business owners to divert resources from profit-generating, value-adding activities to ‘unproductive’ ones, and, consequently, to weaken business performance (Chittenden et al. 2002, 2005). Such costs might deter start-up, incorporation, investment, innovation and growth.

Policy-makers must, therefore, balance competing risks when considering financial reporting regulation: one, to ensure that potential investors/creditors and others have access to sufficient information to support their decision-making; and, two, to free micro-businesses from unnecessary restrictions in order to allow them to undertake economic activities that benefit the wider society. The study seeks to elaborate on this policy dilemma.

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BALANCING THE MICRO-COMPANY REGULATORY BURDEN AND CREDIT RISK Regulation is one of the instruments governments can use to manage risks. Regulatory reform, by changing regulatory obligations and entitlements, inevitably involves redistributing exposure to risks and/or the penalties for producing, or being vulnerable to, risks. Regulation, including financial reporting rules, is a dynamic force shaping business activity and performance (Kitching 2006, 2007; SBRC 2008).

By influencing agents’

resources and reasoning (Pawson and Tilley 1997), regulation enables and motivates as well as constrains business owners to act in particular ways.

Financial reporting regulation

impacts companies directly, by encouraging or discouraging particular activities - and indirectly, by encouraging or discouraging stakeholder actions. Conceptualising small firms as embedded within a wider network of stakeholders - including actual and prospective suppliers, competitors, customers, infrastructure providers and regulatory authorities – permits us to envisage a wide range of regulatory influences. The precise impact of particular regulations is contingent not only upon how companies adapt, but also upon how other stakeholders adapt to them, and specifically how they adapt to companies’ adaptations.

Following the recession and financial crisis of 2008-9, many small businesses have found it difficult to secure affordable credit; others report discouragement from credit-seeking (e.g. Fraser 2009). It is at the smaller end of the business size spectrum that particular problems have been identified (Federation of Small Businesses 2012b). Access to credit is important for many small firms in the form of bank overdrafts and loans, and trade credit, and involves providers making credit risk assessments. Credit providers assess credit risk on the basis of information they can glean from public and private sources. Better information, as defined by the provider, facilitates superior credit risk assessment.

Policy-makers seeking to tackle the problems of the micro-company regulatory burden, credit risk and national economic performance must weigh the potential consequences of particular proposals. For policy-makers, two arguments might be presented regarding regulation. The first, ‘market failure’ argument, insists that regulation is necessary because the unregulated market will produce a suboptimal level of particular goods, including information (e.g. Baldwin and Cave 1999; Beyer et al. 2010), which might present a risk to human welfare – to entire societies or to particular stakeholder groups. Too little regulation provides inadequate protection for creditors, posing the risk of restricting firms’ access to finance, as would-be 6

financiers choose not to invest, thereby constraining small company activity and performance. A second, more recent, ‘deregulation’, argument, claims that regulation itself poses a risk to the public good by increasing the administrative, substantive and psychological costs of compliance for micro companies which might unduly constrain activities that increase social welfare, for instance, by discouraging business start-up, investment, innovation and growth. Policy-makers must, therefore, take account of the likely diverse forces imparted by changes in the financial reporting regime.

METHODOLOGICAL APPROACH To examine these issues, we draw on data from a recent study investigating the value of small company abbreviated accounts for preparers and a wide range of accounts users, including small companies, large and medium-sized companies, banks, credit reference agencies and credit insurers (Kitching et al. 2011). Data were collected using face-to-face and telephone interviews, and online and postal survey (Table 1). The study, therefore, incorporated a strong qualitative component in order to contribute fresh insights into the motivational and process issues surrounding filing and using abbreviated accounts: how and why do small company filers and users of abbreviated accounts act in the ways they do?

Survey

approaches to understanding financial reporting practices dominate the literature but arguably provide limited insight into such issues.

Quantitative studies are suggestive of causal

connections but qualitative data on agents’ motivations is required to substantiate such claims. Further details for each respondent group are provided below.

TABLE 1 RESPONDENT GROUPS

Data source

Survey

Interview

sample

sample

Small company preparers/users of abbreviated accounts

149

12

Accountants in practice

255

10

Organisational accountants

159

10

-

18

Other accounts users and intermediary bodies

7

Small company preparers/users of abbreviated accounts – a postal survey of 149 small company preparers of abbreviated accounts was conducted. A stratified random sample of 2,750 companies was drawn equally from three broad areas (London, Scotland, and the rest of England and Wales) from the FAME database. Questionnaires with prepaid envelopes for reply were distributed to named company directors (response rate, 5 per cent). The vast majority of respondent companies had an annual turnover of less than £830,000 (85 per cent of the small company sample) and employed fewer than 10 people (81 per cent).3 Follow-up interviews were conducted with 12 small company respondents who were also users of abbreviated accounts: nine employed fewer than ten people. Accountants in practice – an online survey of 255 accountants, drawn from the ICAS membership database, was conducted. 964 members were invited to participate (response rate, 27 per cent). Practices varied in size from one-person businesses to international firms with 3,000 employees. The majority of practices were micro (74 per cent of the sample) and small (18 per cent). Follow-up interviews with 10 respondents were conducted with those who were users of abbreviated accounts, either for their practice’s own requirements or on behalf of clients. Organisational accountants – we conducted an online survey of 159 accountants working primarily in large and medium-sized organisations in the private, public and voluntary sectors, drawn from the ICAS membership database. 1,208 members were invited to participate (response rate, 13 per cent). Most respondents worked in private limited companies (61 per cent) and public limited companies (23 per cent). Respondents worked for large organisations, employing 250 or more people (41 per cent), medium-sized (50-249 employees) (29 per cent) and small organisations (up to 50 employees) (27 per cent). Follow-up interviews were undertaken with 10 accounts users. Other accounts users and intermediaries – interviews were conducted with senior managers or officials in 18 organisations, including banks, commercial credit reference 3

These thresholds reflect the European Commission’s initial proposed ceilings for the new category of micro-entities used in the revised Accounting Directive. The thresholds were subsequently lowered. 8

agencies, credit insurance companies, public sector organisations and a small business membership organisation. Approaches were made to approximately 50 organisations. Most of those declining to participate indicated they were not users of small company abbreviated accounts.

Drawing primarily on the qualitative interview data, we now turn to presenting the empirical findings to explore the risks associated with financial disclosure and non-disclosure.

RISKY REGULATION; SMALL COMPANIES PREFER CONFIDENTIALITY Prior studies of small company financial reporting behaviour have identified avoidance of public disclosure of sensitive business information and following accountants’ advice as the principal reasons for filing abbreviated accounts (Collis and Jarvis 2000; POBA 2006). Such motivations must be seen in the wider historical context of the requirement to file full accounts; limited disclosure is widely preferred to greater disclosure. The survey findings strongly support the literature. ‘Following accountants’ advice’ was cited as the main reason by 65 per cent of respondents, and ‘avoiding public disclosure’ by 26 per cent. These proportions were broadly similar across micro and small companies; for micro companies, the proportions were 66 per cent and 25 per cent respectively. Survey data from accountants in practice indicated that, for most, filing abbreviated accounts is the ‘default position’ with small company clients, for confidentiality reasons. A large majority (71 per cent) of accountants in practice with small company clients reported that all such clients filed abbreviated accounts. A small number of micro company respondents (10 per cent) reported time and financial costs as the primary motivation for filing abbreviated accounts, with a smaller proportion also reporting these costs as a second and third reason for filing such accounts. Given the widespread availability of accountancy software, some have questioned whether financial costs are serious constraints as the cost of the filing decision may be small (Arruñada 2011; Collis 2012).

In interview, small company respondents emphasised filing the legally prescribed minimum requirement to avoid disclosure, either following accountants’ advice or independently, as the principal motivation for filing abbreviated accounts. Maintaining confidentiality - from competitors, customers, suppliers and employees – is believed to facilitate greater control over the terms of stakeholder relationships. Respondents were keen to avoid disclosing information that might be used to their disadvantage. Prospective competitors, for instance, 9

might be attracted to the company’s markets if they believe there are good profit margins to be made; high-margin items are often easier to identify in smaller companies where there are usually fewer product lines. Suppliers might raise prices, employees might seek higher salaries and customers might seek discounts if they believe the company is successful and want to capture a greater share of the value produced by the company. Prospective clients might seek to place business elsewhere if they perceive the company as too small. “It was really to stop competitors finding out about us … My concern, for instance, with full accounts is that my competitors can find out my gross margins, which I don’t want them to know.” (Small Company 11: wholesaler, 3 employees) “It was unnecessary for us. We didn’t need to file full accounts ... [The owners]4 don’t particularly want to publicise what we’re doing and how well we’re doing. I think that was the key driver in terms of filing abbreviated accounts. It was keeping things private. There’s no sense in letting suppliers work out how well we’re doing.” (Small Company 8: kitchenware wholesaler, 26 employees, italics denote respondent emphasis) “For example, we wouldn’t particularly want our staff to know what the directors’ remuneration was or any of that kind of thing. The less information we can lodge to meet our requirements is the way to go as far as we’re concerned.” (Small Company 10: flooring contractor, 11 employees) “If you’re working with large companies and people start pulling your accounts and saying, ‘Oh they only turned over 100 grand! We’d best not give them this order for 5,000 envelopes’. The public availability of information damages people.” (Small Company 5: mail service, 5 employees)

Summarising, the survey and, particularly, interview data provide strong evidence that small company directors value the option to file abbreviated accounts highly but for different reasons to those proposed by the European Commission and UK government. 4

Small

Square brackets contain text inserted to retain the sense of verbatim quotations. 10

company directors do not seek primarily to reduce the administrative burden when filing abbreviated accounts – indeed, these costs are likely to be small if not negligible in many cases - but, rather, to restrict financial disclosure and the disadvantages presumed to flow from that. Confidentiality is perceived to facilitate greater influence over the terms of relationships with competitors, suppliers, customers and employees, and, as a consequence, to enable small companies to capture a larger share of the value they create.

RISKING MICRO-COMPANY ACCESS TO RESOURCES AND MARKETS Small company preparers reported that filing abbreviated accounts had generated no adverse impacts for their companies. None reported problems winning customers, or securing credit from banks, suppliers or other finance providers. This presents a puzzle for those schooled in the financial literature to believe restricted disclosure leads to credit problems. To explore abbreviated accounts user perspectives we obtained data from small companies, large and medium-sized organisations in the private, public and voluntary sectors, accountants in practice, and finance and credit management professionals (banks, credit reference agencies, credit insurers and brokers).

Users draw on public accounts information to assess the financial position and creditworthiness of existing and potential customers, suppliers, competitors, and acquisition targets. The abbreviated accounts filed at Companies House are often a starting point for enquiry, influencing the decision to continue, or discontinue, search activity, or as one element in a larger ‘information jigsaw’.

Abbreviated accounts data, alongside other

information sources, contributes to decisions to initiate, continue, terminate, or renegotiate the terms of, relations with other companies – for example, choosing whether to do business with a particular supplier or customer, setting credit terms or asking for cash up front from clients, allocating loans and overdrafts to borrowers, awarding credit ratings to businesses, or providing credit insurance cover to those who trade with particular firms.

One high street bank respondent referred to users of public abbreviated accounts information as ‘users under sufferance’, whose motivation to use them is based on their accessibility and low cost, rather than because they are entirely adequate for user needs. Users prefer more information to less because they believe it enables them to make superior assessments of credit risk.

Finance and credit management professionals were particularly critical of

abbreviated accounts because of the limited information content, requiring supplementation 11

from other sources in order to facilitate a well-informed loan, credit rating or insurance decision. Limited transparency encourages finance and credit management professionals to act cautiously, with adverse consequences for small companies – as seekers/beneficiaries of finance, credit ratings and credit insurance decisions. Other things being equal, companies with known turnover and profit data would likely obtain a superior credit rating than other companies - unless the figures reveal poor performance. “When you have the full information, you know what the company’s turnover is. You know what the company’s profitability is. You have some degree of breakdown of the items on the balance sheet. When you have the abbreviated accounts, it’s still far better than not having the abbreviated information, obviously, but it’s much more about having to make assumptions and make the best use of the available data.” (Accounts user/intermediary 9: credit reference agency) “The problem with abbreviated accounts is that a lot of the information that we need to be able to calculate those [financial] ratios is just not available. So we’re having to use a very much more limited model which is not nearly as accurate. Which means that ... we have to be far more cautious in the level of cover that we are able to [provide]. I think where we do have abbreviated accounts, we would probably tend to reject a higher proportion of those buyers because of that.” (Accounts user/intermediary 14: credit insurer)

Problems of limited disclosure were evident in the comments of small company directors themselves - in their capacity as accounts users rather than preparers. Interview respondents acknowledged the dilemma involved in their contradictory roles as both preparers and users of abbreviated accounts: rueing the limited transparency available to users while valuing the confidentiality afforded to preparers. “I think that abbreviated accounts is a useful tool because it allows us to comply with the law without giving our competitors too much of a heads up about what we’re doing. Whilst it has its disadvantages in terms of me finding out information about other companies, I’m quite happy that people can’t find out much about my business.” (Company 11: wholesaler, 3 employees) 12

“When I’m looking at suppliers and potential customers and so forth, it’s always much more useful to see the trends in their profit and loss accounts. And it’s always slightly disappointing when you see... the abridged accounts. It’s technically disappointing not to be able to see the profits. But then I do it myself, so I can’t really complain.” (Company 2: business information service provider, 4 employees)

To sum up, stakeholders typically reported strong views on the disadvantages of the limited disclosure offered by abbreviated accounts for their credit decisions. Users reported that abbreviated accounts are a useful data source to support credit risk assessments and to take credit decisions – but only up to a point: some information is better than none, but most users were also very critical.

For users, abbreviated accounts provide only limited financial

transparency, with important consequences both for users and for small companies themselves.

Limited disclosure, users insisted, might generate unintended adverse

consequences for small companies - business not won, finance not secured, poorer credit ratings and lower credit insurance cover for those with whom they do business. Failure to disclose information encourages finance and credit management professionals to act cautiously. Such behaviour clearly has important implications for access to finance that will constrain their capacity to invest, innovate and grow, and to contribute to national economic performance. It is worth repeating that none of the 12 small company interview respondents reported any problems arising from filing abbreviated accounts although it is possible they remain unaware of them.

ASSESSING CREDIT RISK IN UNCERTAIN TIMES The recession and financial crisis of 2008-9 led credit ratings agencies to downgrade small firms’ credit risk ratings substantially (Fraser 2009). Subsequently, this led to businesses, financiers, credit rating agencies and insurers to place an even greater value on financial transparency in their dealings with companies (CBI/ACCA 2010). Tighter lending criteria imposed by finance providers form part of the explanation for the decline in lending to small and medium-sized companies (Bank of England 2012a, b); ‘discouraged demand’ also contributes to reduced borrowing (Freel et al. 2012). Data from the SME Finance Monitor indicates reduced demand for new and renewed bank loan and overdraft finance for Q4, 2011, particularly among micro-companies and those with poor risk ratings (BDRC 2012). Credit risk ratings awarded by the credit reference agencies are inversely related to business 13

size: the smaller the firm, the poorer the rating (BDRC 2012).

There is considerable

evidence, therefore, that banks and other lenders consider small companies to be a growing credit risk in a difficult economic climate.

The finance and credit management professionals interviewed reported that credit risk assessments had tightened considerably as a consequence of the financial crisis. Accounts users increasingly considered filed accounts – both abbreviated and full – to be of only limited value in a volatile environment because they are several months out of date at the point they become available. The crisis has intensified demand for real-time information, for instance, management accounts or customer payment data (CBI/ACCA 2010). Allied to their limited information content, companies filing abbreviated accounts were considered greater credit risks and likely to suffer as a consequence. “My contention is that small businesses, by following what they’re legally obliged to file at Companies House, it leads to credit starvation, particularly trade credit starvation in the market place. And that’s been exacerbated in the credit crisis.” (Accounts user/intermediary 10: credit reference agency) “Many of the leading insurers made significant losses through 2008-9. The majority of that was small claims on SME companies. That’s an area where they need to improve … Unless insurers have proper information on SME companies there’s going to be a limit to how much they can support those companies. Certainly, in certain difficult sectors, there’s going to be very little leeway given to

providing

credit

unless

full

information

is

disclosed.”

(Accounts

user/intermediary 14: credit insurer)

Such caution even extends to companies already known to credit providers, suggesting that prior knowledge were no guarantee of continuing relationships, at least on previouslyaccepted terms. Once-reliable customers and suppliers were often perceived as higher risk than previously. “We [use abbreviated accounts], given the current state of the market-place at present ... I looked recently at some glass companies who are supplying to us. Glass is a major component of our production process ... whilst we have tended to 14

use [major companies], some of the smaller companies are offering some fantastic deals. That is where our competition is sometimes getting a lead. So, our view was ‘while it’s riskier, we’ve got to go and vet them and consider them’. I did that on a couple of existing suppliers to see whether or not we could increase the level of order.” (Organisational accountant 9: construction, 80 employees)

Summarising, accounts users made it clear that credit risk assessments were particularly sensitive to wider economic circumstances. Finance and credit management professionals, and businesses with whom small companies trade, reported a heightened sensitivity to credit risk. Greater disclosure is required if small companies are to access the financial resources and markets they require to survive and prosper. Without further information financiers and other accounts users are likely to err on the side of the caution in granting credit, awarding credit ratings or making credit insurance decisions.

Next, we consider the potential

implications of the revised European Directive to relax micro-entities’ financial reporting obligations.

REDISTRIBUTING RISKS: RELAXING THE FINANCIAL REPORTING REGIME Regulatory reform and facilitating micro and small business access to credit have both been longstanding policy concerns in the UK, ones taking on added urgency in the aftermath of the financial crisis of 2008-9 (HM Treasury 2011). In the light of the findings presented above, we consider the implications of UK government proposals to relax micro-entities’ reporting obligations for company, and national, economic performance (BIS 2012a).5

Micro

companies are known to suffer from constrained access to finance, even in good times, partly because lenders lack adequate information to make appropriate risk assessments and the cost of accessing such information is perceived to outweigh the benefits of discovery (Binks et al. 1992; Hutton and Peasnell 2011), a problem acknowledged by the Independent Commission on Banking (2011). The Breedon Review suggests a £191bn finance gap for small firms might emerge as the economy recovers while banks continue to reduce their balance sheets (Industry-led Working Group on Alternative Debt Markets 2012). Business lobby groups have been extremely critical of banks for their perceived failure to extend sufficient credit to small businesses (Federation of Small Businesses 2012b).

5

Project Merlin, an initiative

At this time, April 2012, we do not know what precise shape the UK government’s proposals will take. 15

intended to improve small firm access to finance, involving the five main UK banks, has fallen short of its targets for SMEs (Bank of England 2012c).

Small firm access to credit tightened during 2011, particularly for micro firms and those with poorer than average credit ratings (BDRC 2012). Disclosure to finance providers might be particularly important for these businesses if they are to secure appropriate levels of finance in a timely manner. Approximately half of SMEs used external finance during 2011, most commonly overdrafts, credit cards and loans (BDRC 2012), but many have also had loan and overdraft applications refused (FSB 2012). Businesses commonly rely on retained revenue and owners’ personal savings (e.g. Fraser 2009). A third of SMEs have been described as ‘permanent non-borrowers’, those with no borrowing history and with no plans to borrow in future (BDRC 2012). Micro-enterprises report a lower, and declining, use of external finance in the last five years, are more likely to be permanent borrowers (BDRC 2012) and have been less successful in loan applications due to cash flow and collateral considerations (CBI/ACCA 2010) than larger SMEs. Use of overdrafts, in particular, has fallen sharply among micro businesses (BDRC 2012). Marked declines in the use of external finance were evident among micro firms with an average or worse than average credit rating. Smaller operators have reportedly been squeezed by suppliers tightening payment terms and by customers seeking to extend them (Bank of England 2012b)

Micro firms, and those SMEs with a worse than average credit rating, were the most likely to be discouraged ‘would-be seekers’ of finance during 2011 – those not reporting a borrowing event (an application for new facilities or renewal, a bank seeking to cancel or renegotiate an existing facility, or reducing or paying off a facility early) but reporting that ideally they would have liked to apply for loan/overdraft funding in the previous 12 months (BDRC 2012). Hutton and Nightingale (2011) suggest that higher-risk firms and those with growth ambitions but lacking collateral are more likely to be discouraged borrowers following failed attempts to secure bank finance.

The debate over small business financial reporting is complicated because both disclosure and non-disclosure potentially serve company interests; the former facilitates access to credit, the latter preserves confidentiality and, to a lesser degree, reduces perceived time and financial costs.

Policy-makers must take account of these contradictory tendencies;

initiatives taken to address the risks associated with one aim necessarily aggravates the risks 16

associated with the other. Redistributing the risks of regulation in favour of relaxing microcompanies’ regulatory requirements restricts the benefits arising from disclosure. Accounts users identified a number of likely disadvantages of small company exemption from filing statutory accounts, including restricted access to credit and fostering financial indiscipline. Users believed relaxing reporting requirements would aggravate problems of credit risk assessment and increase small company failure to win new business and obtain adequate credit from banks, suppliers and other financiers. “… We’d like to see companies filing much more than they do. The government’s approach in the last ten years has been to minimise the cost, minimise the amount of information that is being filed for very small companies ... But what we would like to see is more information, especially both profit and loss, and balance sheet filed. Because that means there’s more information, more transparency in the market so that when companies decide to trade with each other, they can get more reliable, accurate information from us.” (Accounts user/intermediary 5: credit reference agency)

Some accounts users further believed exemption might encourage financial indiscipline. Stakeholders might perceive the absence of filed accounts as indicative of a wider problem of poor management, rather than simply a means of retaining confidentiality. Lacking any obligation to make information publicly accessible, some small company directors might be encouraged to adopt unsound financial management practices. Such behaviour would lead to problems for small companies and undermine stakeholder confidence by increasing the risks of transacting business with them. Customers and suppliers, for example, might switch attention to larger organisations, for whom financial information is publicly available, as trust in small company finances declines. Poor behaviour on the part of some micro-companies might generate negative externalities, reducing confidence in such businesses more generally.

While we accept this broad view of the risks associated with relaxing micro-companies’ reporting obligations, we would qualify it in two respects: one, by extending the scope of the potential benefits arising from disclosure for micro-companies; and, two, by specifying possible limits to the benefits of disclosure for micro-companies. First, the benefits of disclosure refer not only to improved access to credit from banks, suppliers and other finance providers - but also to winning business in the first place. Customers seeking new suppliers 17

might prefer to place orders with businesses whose financial position, performance and creditworthiness is better known than with others.

Second, and conversely, the benefits of greater disclosure (and its costs) are perhaps unequally distributed across micro-companies; some are better able to benefit (or incur lower costs) than others. Arguably, micro-companies who are permanent non-borrowers are the ones most likely to benefit from regulation relaxing financial disclosure obligations. Many micro-companies are one-person businesses operating with few tangible assets, funded by personal savings and/or retained earnings, with no intention to expand, who express a strong preference to avoid seeking external finance, and trade mainly with businesses whose decisions are not influenced by credit reference agencies or insurers. For micro-companies meeting these conditions, reducing public reporting obligations might offer benefits in terms of greater confidentiality and, to a lesser degree, from time and cost savings arising from not filing accounts at Companies House. Lower levels of public disclosure might not constrain such companies unduly, although risks remain regarding the temptation to financial indiscipline. For policy-makers, the question arises as to whether these are the kinds of micro-businesses policy should really seek to support. These firms are not likely to be, or become, the innovative, high-growth enterprises policy-makers would prefer to spearhead the national recovery.

Such gains, however, seem likely to be marginal in relation to those associated with current levels of mandatory public disclosure. Micro-companies not meeting the above conditions might suffer if they decide to file reduced, or no, accounts information at Companies House. Clearly, where owner-managers perceive no benefits of disclosure, they may choose to file the legal minimum requirement. But, owner-managers might remain unaware of the business orders they do not win because potential customers and suppliers identify them as a risk to do business with, or as a credit risk, even though they would be willing to disclose detailed accounts information privately to prospective customers and suppliers, if requested.

CONCLUSIONS We have examined the possible consequences of the UK government taking up the option to relax micro-companies’ financial reporting obligations following the introduction of the revised European Directive. Conceptualising regulation as a dynamic force shaping small business activity and performance, we have identified the risks likely to be generated by 18

relaxing regulatory requirements. While we do not yet know the UK government’s precise policy plans, they have indicated the preferred direction of travel, and the arguments presented here, although provisional, should be considered highly relevant to policy-makers.

Micro-company stakeholders such as finance providers (including banks, credit card companies and suppliers), credit reference agencies and credit insurers will respond in particular ways to company directors’ decisions to take advantage of regulation permitting them to file the legal minimum; responses that will have consequences for those very same companies.

Regulatory change is likely to generate contradictory consequences for its

primary intended beneficiaries, micro-companies, producing larger-scale risks for the national economic recovery.

The paradox for micro-companies is that both financial confidentiality and disclosure potentially serve their interests. Confidentiality protects companies from accounts users whose actions might cause them economic harm while, at the same time, limiting the support that financiers, suppliers, credit reference agencies and insurers might provide - possibly unbeknown to the companies themselves.

Disclosure potentially overcomes such

disadvantages while at the same time making it easier for competitors and others to exploit financial information to the detriment of micro-companies. In the shadow of the recent financial crisis and recession, and the part played by poor credit risk assessment, transparency has become increasingly valued by financiers and is likely to remain so during the stuttering recovery.

For policy-makers, there is a trade-off between reducing the regulatory burden on microcompanies in order to attempt to stimulate growth, and increasing financial transparency in order to reduce uncertainty, improve credit allocation, and facilitate economic development. The deregulatory thrust of the revised European Directive might produce adverse outcomes for micro-companies and for the UK economy. The very small companies intended to benefit from the measures might find themselves less able to win new business and/or secure favourable terms from lenders and creditors. Deregulation to ‘free up enterprise’ might, therefore, produce the opposite consequences of those intended - to make the UK one of the best places in Europe to start, finance and grow a business.

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