Discussion of standards for SME audits has been heightened by the Financial Reporting Council adopting ISA 540 for audits of financial statements for periods beginning on or after 15 December 2019. But the debate about the scalability of International Standards on Auditing (ISAs) for smaller entity audits has been going on for a while.
Auditors applying ISAs to UK SMEs must ensure that a sufficient body of documentation exists to demonstrate ISA compliance for audits of entities which, due to their size, structure and sector, mean potential risks perceived by the ISAs are either low or do not exist. At the same time, key stakeholders might not perceive value in an annual audit, notes Blick Rothenberg partner, David Hough.
“There is a risk that the approach to audits of UK SMEs becomes driven by regulatory compliance needs on both the auditor and company side, rather than developing an understanding of risk and meaningful reporting to management on their business,” he explains.
Many SMEs are owner-managed businesses for whom the ISAs are, in general, thought to be overly complex and have been set up with the protection of shareholders in much larger companies in mind. Non-audit services will often be provided to an SME (particularly around statutory accounts and corpora - tion tax) and this means firms increase their costs as staff members outside the audit are required to get involved to cover the self-review threat.
Gary Flatt, corporate services partner at Lovewell Blake, also observes that the ISAs are based on the assumption that most areas of a business are dealt with by different people in different areas. “In an SME, many of these areas are dealt with by the same person,” he explains.
“So in almost every audit carried out on SMEs, a substantive-based approach is used as no reliance can be placed on the internal controls. It also means that some information may not be documented as it is governed and run by the same individuals on a day-to-day basis.”
These issues generally mean more work during the fieldwork stage when gathering evidence and also impact on completion with both the letter of representation and audit completion documentation often needing to cover conversations with the owner-manager where there is no other evidence. Inevitably, most of the additional cost is hard to pass on, which can put pressure on staff within audit firms to work longer hours. Another example is ISA 600, which requires the review of audit working papers by the group audit team.
“SMEs may have significant components overseas, but it may not be economical for a member of the audit team to travel overseas to review the working papers and hence in some SME audits this may result in disproportional costs for the overseas subsidiary,” explains Craig Burton, audit and advisory services partner at Hawsons Chartered Accountants. Companies choosing an audit want to be able to demonstrate that their financial statements can be relied upon and an audit is the benchmark for this, adds Rob Cadwallader, general practice partner at Milsted Langdon.
“We have not seen significant take up of the limited assurance review engagement, perhaps since clients are familiar with audit and are prepared to pay for this, whereas they are reluctant to pay less for something less well-known and established.” Katharine Bagshaw, technical manager, auditing standards at ICAEW, says that the IAASB has made efforts to make the standards more efficient for small businesses, although more needs to be done.
It suggested two possible standards-based actions to address the challenges of implementing the ISAs where the entity being audited is less complex, in addition to other possible actions such as developing guidance. These options are to revise the suite of ISAs; or develop a separate standard specifically for audits of smaller entities. A new standard for the audit of less complex entities sounds attractive and appears to mirror the situation with accounting standards, which strikes many outside the profession as a sensible solution, says Bagshaw.
“However, there are risks associated with this approach, not least the crea - tion of a two-tier profession where those working in small firms may be precluded from working for bigger firms because they have not trained in the ‘full’ standards,” she adds. There is also no precedent or template for reducing the ISAs from the current 1,000 or so pages.
Bagshaw suggests that changing the way in which new standards are developed merits consideration, involving a new style of standard more workable for the audit of less complex entities developed on an incremental basis. “Whether this results in a separation of the auditing standards is difficult to say at this time,” says Caroline Monk, executive partner at Beever and Struthers. “There is always a danger that such a project – which is inevitably complicated and will draw on many stakeholders across the world – will just prove too large to scale. Perhaps the better approach would be to look at the current standards and how they can be revised.”
A similar view is expressed by Martin Rooney, senior partner at FW Smith, Riches & Co, who reckons the challenges involved in applying the ISAs to the audits of smaller entities would not necessarily be resolved by introducing a different standard. “This could lead to, in perception if not in reality, two different sets of audit with the smaller entity audits being seen as less rigorous and less valuable than audits of larger entities,” he says.
“However, further guidance on the implementation of the ISAs for smaller entities would be welcome.” Cadwallader suggests that the IAASB should look at differentiating between private companies and listed companies by developing auditing standards aimed at the smaller companies first but with add-on standards to build up ISAs for more complex organisations. “This would enable firms to offer an efficient and effective audit to organisations at both ends of the spectrum without the need to create a different set of standards, which would other - wise be perceived differently as some sort of ‘audit-lite’,” he says.
Burton believes different standards for non-public interest entities will be introduced eventually. He suggests it would be useful if the IAASB produced guidance on the application of the standards to SMEs, including how greater application of professional judgement can be used to reduce disproportional costs in areas, which do not contribute to the audit opinion. However, Flatt cautions that greater application of professional judgement may further exacerbate different interpretation of similar issues.
In June 2018 the FRC withdrew Practice Note 26: Guidance on Smaller Entity Documentation, suggesting that it was incompatible with principles-based standards and guidance and that it “no longer supported the documentation requirements of a high quality audit”. Monk says this move was not a welcome development and described the practice note as an invaluable guide as to the level of documentation required on an audit of an SME.
“The encouragement to remove the interminable checklists was always well received,” she adds. The FRC’s observation around PN26 documentation was seen as particularly contentious. However, David Gallagher, partner at MacIntyre Hudson and head of an ICAEW working group on this issue, observes that the approach advocated in the note (including the possible use of a free-form memo rather than lots of checklists) remains acceptable.
He also believes there is merit in the FRC’s view that further guidance around smaller entity audits would be more appropriate coming from the professional accountancy bodies. The ICAEW working group intends to produce content on topics relating to audit documentation.
“Some of these articles will include practical examples and links to other guidance, including (we hope) webinars on issues such as ‘transitioning to paperless’ and ‘effective review’,” says Gallagher. “The intention is not to produce a PN26 by another name.”
Not all practitioners share this view, though. “The suggestion that guidance for smaller entity audits should be provided by accountancy bodies creates the potential for a varied approach, which I do not believe would help ensure all UK audits are of a consistently high quality,” concludes Rooney.