A new auditing standard for less complex entities?

The IAASB has, after much lobbying from different countries, produced a draft ISA for the audit of less complex entities (LCEs). The growing calls from this arise from the increasing length and complexity of the full suite of ISAs, with many auditors of SME businesses saying that they are disproportionate and not easy to scale.

The proposed new standard has a strict scope – either entities fit within the LCE scope, or they do not. If the latter then the full suite of ISAs must be used, it is not possible to top up the LCE requirements with fuller ISA requirements. For instance, if an entity has a complex accounting estimate, which is not covered by the LCE standard, then none of this standard can be applied. The LCE standard is still designed to give reasonable assurance that the financial statements are true and fair or fairly presented. So in this respect, it is not so much as an ‘audit-lite’ but more akin to a pre-tailored audit.

Scope

The LCE standard cannot be used if the audit:

• Is of a listed entity
• Is in a jurisdiction where the LCE standard is prohibited
• Is of an entity with public interest characteristics (such as banking, insurance or pension companies)
• Is a group audit

It can also not be used if the firm’s procedures prohibit it, or if the audit exhibits qualitative characteristics that would make the standard inappropriate for use. 

There was considerable debate as to whether group audits would be in or out of scope for the LCE with the current conclusion being that they are inherently complex and therefore excluded. This might mean that a large number of entities that may otherwise be regarded as less complex cannot use the standard. Having said that, in the UK small groups are exempt from the requirement to prepare group accounts and so at least small groups voluntarily having an audit would be in scope. The IAASB is particularly interested in feedback on whether the exclusion of group audits for otherwise less complex entities will be a major deterrent in uptake of the standard. 

The trickier bit will be determining whether there are qualitative characteristics that mean the standard isn’t appropriate. The ED explains that it would be inappropriate to use the LCE standard where the entity exhibits:

• Complex matters or circumstances relating to the nature and extent of the entity’s business activities, operations and related transactions and events relevant to the preparation of the financial statements;

• Topics, themes and matters that increase, or indicate the presence of, complexity, such as those relating to ownership, corporate governance arrangements, policies, procedures or processes established by the entity.

The draft goes onto provide some examples of such characteristics including, for example, that the entity operates in an emerging market, that the organisational structure is complex, with multiple reporting lines or special purpose vehicles, or there is a high degree of regulation or complex transactions or IT systems. As already mentioned, accounting estimates which are subject to a higher degree of estimation uncertainty or where the measurement basis is complex would also be regarded as matters of complexity rendering the LCE standard inapplicable (See A.9.)

Flow

The LCE standard is set out in terms of the flow of the audit, rather than topics. The parts are therefore as follows:

• Fundamental concepts, general principles and overarching requirements
• Audit evidence and documentation
• Engagement quality management
• Acceptance or continuance of an engagement
• Planning
• Risk identification and assessment
• Responding to assessed risks
• Concluding 
• Forming an opinion and reporting.

There is a useful diagram in Appendix 2 of the ED which summarises the flow and the various elements at each stage.

The standard still takes a risk-based approach to auditing and still requires an audit report that provides reasonable assurance. The key requirements of relevant ISAs are either included as is, or are modified to take into account the less complex nature of an LCE. Where the entire ISA is deemed not relevant, such as ISA 610 Using the work of internal audit, it is excluded.

The ED includes Essential Explanatory Material (EEM) which is shown in blue boxes and italic type. The black type is for the basic requirements. For instance, the ED requires that the auditor shall exercise professional judgment in planning and performing the audit. The EEM explains a little about why professional judgment is essential, what it is, and what must be documented (see 1.4.4).

The sections of the audit will all seem very familiar to those that currently conduct audits. You have the same fundamental concepts and principles, and audit evidence must be gathered and documented. It is still necessary for the auditor to obtain an understanding of the control environment of the entity, as this is felt essential in ascertaining its risk, even though it is often regarded as a bugbear in smaller audits. 

Detailed mapping documents are available which show how each aspect of the existing ISAs have been dealt with and why. If you are considering whether the ED would be useful for the types of audits you conduct it will probably be helpful to work out where you think the current ISAs require more than is really necessary for an LCE and look this up in the mapping documents to see what differences there are. 

Pros and cons

There is no guarantee that the UK regulators will allow the use of an LCE standard, but even supposing that they do, there are some important questions to consider for practitioners:

• Will my partners and staff just have to learn two sets of standards, the LCE and full ISAs as clients will be a mix of these?
• How will training be done where the standard is not, or has not been covered, during qualification?
• Will running two sets of standards increase the risk of errors as personnel may get confused between the two requirements?
• Will applying judgment to determine whether the LCE standard is appropriate increase the risk that errors will be made (by using it when not appropriate)?
• Will the LCE standard reduce costs that can either be passed onto the client or increase margins where this is needed?
• Will clients regard an LCE audit as less valuable? 
• Will my audit software/programme be updated to include a new LCE standard?

Conclusions

It is not clear at this stage, whether the ED, at around 115 pages, will meet the expectations of the SME auditors that might seek to use it. Given that many LCE auditors generally refer to a purchased audit manual, rather than the ISAs directly in most circumstances, there is a real question as to whether this standard significantly simplifies things. Whilst ideally ISAs would have been written on a principles basis, with a ‘think small first’ approach, it is possible to do a reasonable amount of tailoring of the existing standards, though this takes time. So does the LCE standard go far enough? Is its scope wide enough? And what will the regulator and practitioners think of a two-tier approach to auditing standards?