What Is the Small Company Audit Exemption?
Explore the regulations allowing small companies to avoid a statutory audit and understand the alternative reporting responsibilities directors must fulfill.
An audit provides an independent opinion on whether a company’s financial statements are presented fairly and according to accounting principles. While no single federal law requires all private companies to undergo an annual audit, exemptions exist for smaller entities to avoid the significant expense and time involved. This framework recognizes that for many small businesses, the costs of a full audit can outweigh the benefits. Instead of an audit, these companies may provide a lower level of assurance through services like a review or a compilation.
Qualifying for the Exemption
A private company’s need for an audit is not dictated by a single federal statute but by external pressures. Qualifying for an exemption is less about meeting a legal definition and more about whether stakeholders will accept financial statements without an audit opinion before engaging in transactions like providing a loan or making an equity investment. The criteria they use often mirror thresholds related to a company’s revenue, assets, and employee count to gauge its size and complexity.
Some companies are automatically ineligible for an audit exemption due to their regulatory environment. Publicly traded companies governed by the Securities and Exchange Commission (SEC) must have their financial statements audited annually. Entities in highly regulated industries like banking and insurance are also subject to audit requirements. Companies that receive substantial federal funding or have specific contractual obligations may be compelled to undergo an audit regardless of their size.
The Department of Labor has specific rules for employee benefit plans like 401(k)s. Plans with 100 or more participants are considered “large plans” and must have an audit attached to their annual Form 5500 filing. A 2023 change modified the counting method to only include participants with an account balance, exempting many small businesses from this requirement. The “80-120 Participant Rule” also allows plans with between 80 and 120 participants to file as a “small plan” and avoid an audit if they did so in the prior year.
Partnerships have specific considerations under the centralized partnership audit regime. Eligible partnerships with 100 or fewer partners can elect out of this regime, which streamlines how the IRS handles audits. To be eligible, all partners must be individuals, C corporations, S corporations, or estates of deceased partners. A partnership becomes ineligible if its partners include other partnerships or trusts.
Required Statements and Filings
When a company forgoes a formal audit, it substitutes it with a different engagement from a Certified Public Accountant (CPA), most commonly a review or a compilation. A review provides limited assurance and involves the CPA performing analytical procedures and making inquiries of management. A review is narrower in scope than an audit but offers a basic level of scrutiny.
A compilation provides no assurance. In this engagement, the CPA takes the client’s financial data and presents it in the form of financial statements without performing verification procedures. The choice between a review and a compilation depends on the requirements of third parties, such as a bank, who will use the statements. The cost of a review is less than an audit, and a compilation is less expensive than a review.
Whether a review or compilation is performed, the CPA issues a report attached to the financial statements. An auditor’s report gives an opinion on whether the statements are fairly presented, in all material respects, according to Generally Accepted Accounting Principles (GAAP). In contrast, a review report states the accountant is not aware of any needed material modifications. A compilation report states the accountant has not audited or reviewed the statements and expresses no assurance.
Circumstances Requiring an Audit Despite Eligibility
A company small enough to avoid a mandatory audit may still be compelled to have one performed. One common trigger is a demand from its own shareholders. Depending on a company’s bylaws, a certain percentage of shareholders, sometimes as low as 10%, can formally require an audit. This allows minority owners to gain assurance about the company’s financial management.
External agreements are another source of audit requirements. Banks and other lending institutions often include covenants in loan agreements that mandate the borrower provide annual audited financial statements. Failure to comply can result in a default on the loan, as the lender requires this verification to assess the company’s financial health and ensure the safety of its loan.
A company’s own governing documents can create an audit requirement. The articles of association, operating agreement, or shareholder agreements may contain a provision stating the company must undergo an annual audit. This internal rule is often established at the company’s formation and overrides any eligibility for an exemption.
Specific business circumstances can necessitate an audit. A company planning to go public, seeking venture capital funding, or preparing for a sale or merger will need audited financial statements. Potential buyers and investors require the high level of assurance an audit provides to conduct due diligence and accurately value the company.