House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Parliamentary Secretary to the Treasurer, the Hon Chris Pearce MP)

Chapter 9 Regulation impact statement: thresholds for reporting for large proprietary companies

Background

9.1 A proprietary company is a company incorporated under the Corporations Act that is limited by share capital, has no more than 50 non-employee shareholders and has not raised money from the public. Under the Corporations Act 2001 , a proprietary company is large for a financial year if it satisfies at least two of the following tests:

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the consolidated gross operating revenue for the financial year of the company and the entities it controls is $10 million or more;

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the value of the consolidated gross assets at the end of the financial year of the company and the entities it controls is $5 million or more; and

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the company and the entities it controls have 50 or more employees at the end of the financial year.

9.2 A large proprietary company is required to prepare and lodge an annual report with the Australian Securities and Investments Commission (ASIC). However, there are two minor exceptions to the general requirement for large proprietary companies to lodge annual reports. These exemptions are applied to wholly-owned subsidiaries using an ASIC class order and companies incorporated prior to 1995 and had their accounted audited.

9.3 The annual report is made of up an audited financial report and a directors' report. Once they are lodged with ASIC, they are made available to members of the public for a prescribed fee ($17 if the report is less than 10 pages and $33 if it is 10 pages or more). Estimates from ASIC indicate that, on average, annual reports are accessed approximately 3 times per year. However, this figure underestimates the actual number of people that benefit from the information contained in the annual reports. A range of users, including credit-rating agencies and journalists, directly access this material from ASIC and disseminate it further within the community.

9.4 There are currently 5,030 large proprietary companies which lodge annual reports with ASIC. The requirement for large proprietary companies to lodge their financial reports was introduced in the First Corporate Law Simplification Act 1995 to focus regulation on the financial affairs of proprietary companies which have a significant economic influence. Requiring these companies to lodge annual reports is in the public interest for the following reasons:

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The collapse of an economically significant company could have a wider impact on the community in general particularly in regional areas. As such, the community has an interest in the financial position of large proprietary companies.

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Smaller trade creditors are not in a position to demand financial information before doing business with a company. In most cases, trade creditors spread their risk by supplying goods or services to a large number of companies. However, the larger a company gets, the more likely it is that trade creditors will be supplying goods or services only to that company.

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Employees and representative groups are not in a position to demand financial information from a company. The ability to access public information on the financial position of the company ensures they have some comfort that the company is able to guarantee their ongoing operations. It also ensures that they are not disadvantaged in the negotiation of employment contracts. These types of agreements are more likely to be negotiated with large employers.

9.5 These users derive a direct benefit to the extent that they act on the information in the annual report and an indirect benefit because they derive confidence in the knowledge that they can access the information if they desire it. It is arguable that all companies should be required to prepare and lodge annual reports because companies, unlike other business entities, have the benefit of limited liability. However, it is considered that the costs of imposing financial reporting obligations on small proprietary companies would outweigh the benefits given their operations are not economically significant.

Problem identification

9.6 The issue that is being addressed is that under the current thresholds, 5,030 proprietary companies are required to prepare and lodge annual reports. The thresholds for a large proprietary company have not been adjusted since 1995. As a result, the current thresholds are set at too low a level to determine economic significance. This means that financial reporting obligations are unnecessarily being imposed on a proportion of the proprietary companies that are currently preparing annual reports. As outlined in the analysis of the impact of options section, it is estimated that, on average, it costs $60,000 for a company to produce an annual report.

Objectives

9.7 The objective is to ensure that all economically significant proprietary companies are required to prepare and lodge annual reports. Economically significant entities are publicly accountable because of their size and potential to affect the community and the economy. Adjusting the thresholds to an appropriate level will reduce the compliance cost burden for proprietary companies that are not economically significant as they would no longer be required to prepare and lodge audited annual reports.

Identification of options

9.8 Outlined below are the options that have been identified for addressing the problems identified above.

Option 1

9.9 Under this option, the monetary thresholds for the definition of a large proprietary company would be increased to reflect changes in inflation (as measured by movements in the gross domestic product deflator) since they were introduced in 1995. This would mean that the thresholds increase to:

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consolidated gross operating revenue for the financial year of the company and the entities it controls of $13 million or more; and

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consolidated gross assets at the end of the financial year of the company and the entities it controls of $6.5 million or more.

9.10 In addition, the employee threshold would be removed because the revenue and asset tests provide the most relevant indicators of company size. A proprietary company would be large if it satisfies either of the monetary tests above.

Option 2

9.11 Under this option, the monetary thresholds for the definition of a large proprietary company would be doubled to account for nominal economic growth (as measured by changes in nominal gross domestic product) since they were introduced in 1995. Adjusting the thresholds for nominal economic growth (instead of real economic growth) means that the increase in the thresholds will include a component for inflation as well as economic growth. Under this option, the thresholds increase to:

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consolidated gross operating revenue for the financial year of the company and the entities it controls of $20 million or more; and

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consolidated gross assets at the end of the financial year of the company and the entities it controls of $10 million or more.

9.12 In addition, the employee threshold would be removed because the revenue and asset tests provide the most relevant indicators of company size. A proprietary company would be large if it satisfies either of the monetary tests above.

Option 3

9.13 Under this option, the monetary thresholds would be increased by a multiple of 2.5 (that is, 150 per cent). This would result in increases to the revenue and assets thresholds of $5 million and $2.5 million respectively in addition to adjusting the thresholds for nominal economic growth. Under this option, the thresholds increase to:

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consolidated gross operating revenue for the financial year of the company and the entities it controls of $25 million or more; and

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consolidated gross assets at the end of the financial year of the company and the entities it controls of $12.5 million or more.

9.14 In addition, the employee threshold would be removed because the revenue and asset tests provide the most relevant indicators of company size. A proprietary company would be large if it satisfies either of the monetary tests above.

Option 4

9.15 Under this option, proprietary companies would not be required to prepare an annual report. Outlined below are the options that have been identified for addressing the problems identified above.

Analysis of the impact of the options

9.16 These options are being evaluated against each other as well as the status quo. The following discussion of costs and benefits of the options is largely qualitative, with some estimates where information is available. The draft Regulatory Impact Statement, which was released in conjunction with the Proposals Paper, sought to gain an insight into the costs and benefits of requiring proprietary company financial reporting.

Option 1

Benefits

9.17 Under this option, approximately 134 fewer large proprietary companies would be required to prepare and lodge annual reports. This means that there would be 4,896 large proprietary companies that meet the new thresholds lodging annual reports with ASIC.

9.18 It is estimated that the average cost of preparing an annual report is $60,000. This figure is based on the assumption that the average cost to audit the financial report of a large proprietary company is $40,000 (this figure would vary depending on the size and complexity of the audit) and it costs a large proprietary company, on average, $20,000 to prepare a financial report and directors' report (this figure attempts to take into account that companies will already be preparing some financial information for internal reporting and taxation purposes). The saving to business as a result of this option would be approximately $8.0 million per year.

Costs

9.19 Users would no longer be able to access the annual reports of 134 proprietary companies. This is a cost for direct users of the annual reports and an indirect cost to the market as a whole as people no longer have the confidence in knowing that annual reports are available. It will also disadvantage people who benefited from the information being disseminated in the market as identified in the background section (for example, a credit-rating agency would no longer be able make recommendations on these companies because they will not have access to the necessary financial information). The benefit that users would lose because they are no longer able to access those reports is difficult to estimate. However, it is expected that the costs will not be significant because the 134 companies that would no longer be required to report are not economically significant, so it is unlikely that the public would be currently accessing their annual reports.

Option 2

Benefits

9.20 Under this option, 645 fewer large proprietary companies would be required to lodge annual reports with ASIC. This means that there would be 4,385 large proprietary companies that meet the new thresholds lodging annual reports with ASIC. Using the assumptions presented under Option 1, the benefit to business would be approximately $38.7 million per year.

Costs

9.21 Users would no longer be able to access the annual reports of 645 proprietary companies. This is a cost for direct users of the annual reports and an indirect cost to the market as a whole as people no longer have the confidence in knowing that annual reports are available. It will also disadvantage people who benefited from the information being disseminated in the market as identified in the background section (for example, a credit-rating agency would no longer be able make recommendations on these companies because they will not have access to the necessary financial information). The benefit that users would lose because they are no longer able to access those reports is difficult to estimate. However, the costs will be greater than the costs for Option 1, but are still unlikely to be significant because the additional 511 companies (645 less the 134 excluded as a result of Option 1) that would no longer be required to report are also not economically significant. As these companies are no longer considered to be economically significant, the public is unlikely to require access to this information.

Option 3

Benefits

9.22 Under this option, 1,006 fewer large proprietary companies would be required to lodge annual reports with ASIC. This means that there would be 4,024 large proprietary companies that meet the new thresholds lodging annual reports with ASIC. Using the assumptions presented under Option 1, the benefit to business would be approximately $60.4 million per year.

Costs

9.23 Users would no longer be able to access the annual reports of 1,006 proprietary companies. This is a cost for direct users of the annual reports and an indirect cost to the market as a whole as people no longer have the confidence in knowing that annual reports are available. It will also disadvantage people who benefited from the information being disseminated in the market as identified in the background section (for example, a credit-rating agency would no longer be able make recommendations on these companies because they will not have access to the necessary financial information). The benefit that users would lose because they are no longer able to access those reports is difficult to estimate. However, the costs will be greater than the costs for Options 1 and 2, but are still unlikely to be significant because the additional 361 companies (1006 less the 645 excluded as a result of Option 2) that would no longer be required to report are also not economically significant. As these companies are no longer considered to be economically significant, the public is unlikely to require access to this information.

Option 4

Benefits

9.24 This option would result in 5,030 fewer large proprietary companies being required to prepare and lodge annual reports. Using the assumptions presented under Option 1, the benefit to business would be approximately $301.8 million per year.

Costs

9.25 Under this option, all large proprietary companies would be exempt from the requirements to prepare and lodge annual reports. On top of the costs outlined in options 1, 2 and 3, removing the mandatory requirements is likely to result in additional costs that could affect the wider economy through the loss of confidence and by constraining the ability of large proprietary companies to access capital (see analysis below). These costs are unlikely to be relevant for options 1, 2 and 3. However, they are likely to be substantive for large proprietary companies with revenues in excess of $25 million.

Economy wide effects

9.26 Under the current regime, economically significant proprietary companies are required to prepare and lodge annual reports. The reports provide a means to access and understand the company's economic behaviour and bring together fragmented sources of information into a more informed medium. The information contained in these reports can provide valuable signals to the market, particularly about the underlying state of the business, which could affect its on going operations or financial viability.

9.27 Removing the mandatory requirements would restrict information flows. The preparation of financial reports provides confidence in this market sector by providing greater financial transparency. For example, investors may obtain comfort in knowing the specific factors behind a company going into administration that can be derived from the company's annual report. This will help ensure that the collapse of one company does not reduce confidence in the market more generally. The effects from any market wide loss of confidence could have a significant impact on the economy and future economic growth. For example, investors may divert their savings into other investment forms which are less productive, reduce liquidity and the depth of the domestic capital markets and lead to volatility in asset prices. This may also have a flow on effect of reducing consumption and investments.

9.28 In addition, having annual reports publicly available through ASIC is likely to significantly lower the search costs for direct users.

Large proprietary companies - accessing capital

9.29 Removing the obligations to prepare financial reports may limit immediate access to alternative forms of capital and therefore restrict a company's ability to expand. For example, in order to list on a stock exchange, a company must provide audited accounts for the last three financial years. The absence of statutory requirements to produce financial reports will not in itself prevent an entity from raising capital from a public listing as they could voluntarily start producing this material in anticipation of any public listing. However, the advantage of the statutory financial reporting requirement is that it enables entities to gain more immediate access to new capital.

9.30 If entities were unable to access capital through a public listing, they would have to rely on more traditional forms of financing facilities, such as bank financing. Access to capital markets enables them to expand their operations beyond that which would normally be available through bank finance and pursue innovative ideas. Therefore, removing the requirements to prepare financial reports could restrict access to varying forms of capital, leading to a sub-optimal allocation of resources.

Total costs

9.31 The total cost associated with large proprietary companies not preparing financial reports for all purposes is difficult to estimate. However, given the wider economic effects, the potential impact on large proprietary companies accessing capital and general user concerns, these costs would be significantly greater than the costs under Options 1, 2, and 3. It is expected that the costs of this Option would be considerable and outweigh the benefits.

Consultation

9.32 The Australian Government released a consultation paper Corporate and Financial Services Regulation Review Proposals Paper on 16 November 2006, which contained initiatives to simplify the regulatory system and reduce compliance costs on business. One of the proposals contained in the Proposals Paper canvassed increasing the reporting thresholds used to define a large proprietary company to ensure that only economically significant companies prepare and lodge their financial reports. The period for public submissions closed on 19 January 2007.

9.33 Submissions were generally supportive of large proprietary companies preparing and lodging their financial reports with ASIC. In the main, respondents recognised that economically significant proprietary companies were publicly accountable with financial reporting obligations. For example, one respondent noted that the requirement for large proprietary companies to prepare audited financial reports significantly enhances the governance of these entities. Most of the submissions from respondents focussed on the monetary thresholds used to define a large proprietary company.

9.34 Overall submissions were largely supportive of the proposed 150 per cent increase in the revenue and asset thresholds. There was broad acceptance that the higher monetary thresholds would ensure that only genuine economically significant entities would be captured under the new reporting framework.

9.35 However, some respondents raised concerns about the proposal to remove the employee limb. They claimed that removing the employee limb would lead to a larger number of asset-rich entities that have few employees and limited revenue streams being required to report for the first time. They argued that the removal of the employee limb would lead to higher compliance and administration costs, which was inconsistent with the Government's objective to reduce the regulatory burden on business. A number of respondents argued that this anomaly could be addressed by retaining the employee limb, that is, a return to the 'two out of three' test.

9.36 The majority of respondents observed that a mechanism for the periodic review of the thresholds was necessary to ensure that the thresholds continue to accurately reflect genuine economic significance during period and long and sustained economic growth. They also noted that this would ensure that as the economy expands, entities that are no longer economically significant would not be captured.

Conclusion and recommended option

9.37 The Government recognises that there is a cost to proprietary companies in preparing their financial reports. Therefore, it only seeks to impose these reporting requirements on economically significant proprietary companies. However, the existing size test has not kept pace with economic growth and inflation because it has not been adjusted since 1995. This has increased the regulatory burden on proprietary companies as more companies exceed the threshold.

9.38 There is significant public interest in the annual reports of proprietary companies that are economically significant. This discounts the adoption of Option 4 as the overall costs of not requiring the preparation of annual reports will significantly outweigh the benefits that would flow to these companies from reducing the compliance burden. As identified in the background section, potential users of annual reports include trade creditors, employees, credit-rating agencies, journalists and the wider community. In addition, requiring economically significant proprietary companies to report promotes greater confidence in the market place and facilitates the public listing of large proprietary companies as a means of access alternative forms of capital. A size test provides a simple objective test which a company can apply to determine whether it is required to lodge an annual report.

9.39 However, submissions to the Proposals Paper raised a concern about the removal of the employee limb. Submissions noted that the removal of the employee limb would result in asset-rich entities with few employees and limited revenue streams being captured whereas in the past these entities were not required to report.

9.40 Following analysis of this issue, the Government has decided to retain the employee limb (at 50 employees) and return to the 'two out of three' test. Unlike the monetary thresholds, the number of employees is not influenced by economic growth or inflation. In addition, productivity improvements have also meant that businesses can produce higher output levels with the same level of employees than in the corresponding period in 1995.

9.41 Under the recommended option, the new thresholds are:

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consolidated revenue for the financial year of the company and the entities it controls of $25 million or more;

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consolidated gross assets at the end of the financial year of the company and the entities it controls of $12.5 million or more; and

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the company and the entities it controls (if any) have 50 employees at the end of the financial year.

9.42 A proprietary company would be large if it satisfies 'two of the three' tests above.

9.43 There would be 1,646 fewer large proprietary companies that would be required to lodge their annual reports with ASIC under this option. This means that there would be 3,384 large proprietary companies that meet the new thresholds. Using the same assumptions that were presented under Option 1, the benefit to business would be $98.9 million. The main cost associated with this option is related to the fact that 1,646 proprietary companies are no longer preparing and lodging their financial reports. Similar to previous options, the costs relate to direct users losing confidence in knowing that annual reports were no longer available or loss of information that was previously disseminated. Given that these entities are not considered to be economically significant, the costs are unlikely to be significant.

9.44 There was widespread support from stakeholders, including the three professional bodies (Institute of Chartered Accountants, CPA Australia and the National Institute of Accountants) for the recommended option.

Implementation and review

9.45 It is anticipated that the required legislation to enable the changes to the reporting thresholds would form part of the Simpler Regulatory System Bill, which is expected to be introduced in the 2007 sittings.

9.46 The Government recognises that the thresholds need to be reviewed on a regular basis to ensure that only economically significant entities are captured under the reporting framework. The Government has decided in corporate a mechanism to regularly assess the thresholds through the Corporation Regulations.

Financial impact statement

9.47 Large proprietary companies are currently required to lodge their financial statements with ASIC. Direct users of the reports are allowed to access them for a prescribed fee. This fee is applied to recover ASIC's administration costs for making the report available to the public. As a result, implementation of the proposed thresholds will have no financial impact on the Commonwealth.