FRC market study into SME audit - our response

Summary of our response

Benefits of audit for SMEs

High quality, proportionate audits for SMEs are essential for confidence in the UK economy and we believe that it is incumbent on both auditors and the FRC to clearly explain the benefits of SME audits to owners, management and other stakeholders of those entities, which often work under tight resource constraints, who may not fully appreciate the value of an audit.

Auditing standards

Concerns around the cost of SME audit arise, at least in part, through disproportionate requirements in the auditing standards. We, and many auditors, do not believe that the current ISAs are scalable and proportionate to SME audits. The ISAs are increasingly seen as prescriptive, rather than scalable, as are the interpretations of regulators and file inspectors.

It is important that the FRC considers and addresses its own contribution to the challenges in achieving proportionate SME audits, most particularly in considering whether current audit and ethical standards are genuinely fit for purpose for SME audits and identifying a truly scalable, proportionate set of standards.

An appropriate standard-setting solution is needed for SME audits, and we believe that the FRC should undertake a root cause analysis of the challenges in applying the ISAs to audits of SMEs, including workshops with a wide range of audit firms and other stakeholders, to really explore the issues with application of the ISAs. Only once the root causes are known can the most appropriate solutions be identified.

The FRC has apparently decided not to adopt the ISA for Less Complex Entities (ISA for LCE) published by the IAASB. We believe that the FRC should set out its views on the adoption of the ISA for LCE published by the IAASB, or at least an amended UK version, to address the scalability and proportionality of the ISAs when auditing less-complex entities, explaining why it does not believe that such a standard might be appropriate.

Financial reporting standards

We believe that any review of SME audits should begin with consideration of the financial reporting framework which, in many cases, drives the complexity of the audit, adding further to the challenges around scalable, proportionate application of the ISAs.

FRS 102 was originally more aligned with IFRS for SME when it was introduced. However, in our view, the increasing alignment of UK GAAP with the full IFRS standards is adding unnecessary complexity to the financial statements, and in turn the audit, of many SMEs. For example, does Fair Value accounting add value to the financial statements of a typical SME?

Most SMEs struggle to produce meaningful fair value disclosures, and it is unlikely that users of SME accounts require fair values in many instances. Fair value accounting in business combinations, financial instruments, fixed assets and other similar areas can require the consideration of specialist input which adds to the cost and complexity of an audit within this sector.

Developing a solution - addressing the needs of stakeholders

The starting point for a review of SME audits should be to obtain a full understanding of what the needs of stakeholders in SMEs are. Stakeholders include owners, lenders/investors, suppliers, regulators and HMRC.

Only by understanding the needs of users can an appropriate financial reporting and audit framework be developed to deliver the high-quality financial information required. This may, in turn, lead to more radical solutions.

The FRC should consider whether the current financial reporting and auditing framework for SMEs is appropriate. In doing so, the FRC should ask itself “Who is relying on the financial statements?” and “What do those users need from the financial statements and audit/assurance?”.

For example, the needs of shareholders, which are often family members, and local bank managers who are not in large corporate teams, are likely to be less complex than for listed companies, and in that instance why are financial reporting requirements so complex and auditing standards so onerous? Is there a different solution?

Audit and assurance - time to think outside the box?

We question whether it is now time for more radical thinking on the audit and assurance needs of SMEs, asking questions like:

1. Who are the stakeholders for SME financial statements and audits, and what assurance do they really need?
2. Do all SMEs really need a full ISA audit, especially at the smaller end of the market?
3. Is there an alternative to full ISAs (e.g. a UK version of the ISA for LCE) to address scalability issues?
4. Are there other forms of assurance which might be fit for purpose for smaller, less complex SMEs - for example, does the newly issued ISSA 5000 (Sustainability Assurance) provide a basis for the development of some form of limited assurance standard suitable for some smaller and less complex entities?
5. We also note that the IAASB is commencing a project to enhance ISRE 2410 (interim reviews) - might that enhanced standard provide a basis for assurance for smaller SMEs, perhaps being the basis of a building blocks approach to meet assurance needs?
6. Could a building blocks approach be adopted in the ISAs? Many auditors advocated for such an approach in the development of the ISA for LCE, which may have provided a better basis for SME audit than the final standard.