Two Simple Policy Reversals Could Help Close the Tax Gap says former ICAEW President

How A Simple Decision Could Increase UK Tax Revenue: The Importance of Auditing Standards for Small Businesses

K2 Accountancy Group followers, here’s an important update on a topic that could significantly impact the UK’s economic growth and tax gap. Martyn E. Jones, a past-president of ICAEW and Chair of the Advisory Board at the Department of Economics and Finance at Brunel University London, recently shared his insights on how a simple policy reversal could help the UK government close the tax gap and foster a more robust economy.

The Tax Gap Challenge

The tax gap—the difference between the tax that should be paid and what is actually collected—remains a significant issue for the UK. According to HMRC’s latest annual summary, the tax gap for 2022/23 was estimated at £39.8 billion. This gap has been widening in certain areas, particularly in corporate tax. While the tax gap attributed to small businesses has risen to account for 60% of the total, the gap attributed to large businesses has been falling. This suggests that small businesses are increasingly contributing to the shortfall in tax revenues.

Government Policy and the Tax Gap

In March 2024, the government announced plans to raise the monetary thresholds for statutory audits for smaller companies by 50% for periods beginning on or after 1 October 2024. This change could potentially exempt around 132,000 companies from statutory audits, aiming to reduce business costs and encourage deregulation. While the intent might seem beneficial at first glance, Jones argues that this policy could have unintended negative consequences for the UK economy and tax revenues.

The Importance of Statutory Audits

Jones explains that statutory audits act as an “annual financial MOT” for companies, ensuring accuracy in financial reporting and accountability without additional government expenditure. Audits involve a thorough review of accounting records, systems of control, and financial forecasts. This process helps to prevent errors—both intentional and unintentional—in company accounts and is vital for identifying corporate failings early. The benefits of audits extend beyond compliance, contributing to the overall reputation of the UK as a favourable environment for business startups, growth, and investment.

Audited financial statements are critical for gaining the confidence of investors and other stakeholders, reducing the risk of unexpected company failures, and supporting sustainable business growth. They provide a reliable track record required for stock exchange listings and are essential for maintaining trust in the financial information presented by companies.

The Risks of Raising Audit Exemption Thresholds

Jones warns that increasing the thresholds for audit exemptions is a short-sighted policy that could lead to a decline in the quality of financial reporting and corporate governance. He draws a parallel to the potential consequences of abolishing vehicle MOTs, suggesting that just as vehicle conditions would deteriorate without regular checks, so too would the quality of financial management and reporting in companies without statutory audits. This deterioration could lead to increased risks of company failures, reduced tax receipts, and a negative impact on the UK economy.

A Better Alternative: Adopting ISA for Less Complex Entities (LCE)

Jones suggests that rather than raising audit exemption thresholds, the UK should consider adopting a more appropriate auditing standard for smaller businesses. The International Standard on Auditing for Less Complex Entities (ISA for LCE) offers a simplified, 158-page standard designed specifically for smaller, less complex businesses, compared to the over 1,000 pages of the full suite of auditing standards meant for larger, listed companies.

This standard has been approved by the International Auditing and Assurance Standards Board (IAASB) and is supported by the International Federation of Accountants, providing a balanced approach that meets public interest without overburdening smaller businesses with excessive regulatory requirements.

By adopting the ISA for LCE, the UK could reduce the administrative burden on smaller businesses, enhance the quality of audits, and potentially close the tax gap by ensuring more accurate financial reporting. This would align with global best practices and reinforce the UK’s position as a leader in auditing standards.

Moving Forward

Jones calls on the Financial Reporting Council (FRC) to adopt the ISA for LCE, highlighting the need for a timely resolution to this issue to support smaller UK entities and promote better quality audits. Such a move could help reduce the tax gap, foster economic growth, and maintain trust in the UK’s financial system.

At K2 Accountancy Group, we recognise the importance of robust auditing standards in ensuring financial transparency and accountability. We are committed to keeping our clients informed about key developments that could impact their businesses. Stay tuned to our social media pages for more updates on important financial and tax-related issues, and don’t hesitate to reach out to our team if you have any questions or need professional advice.