IAASB’s consultation on the proposed ISA for Less Complex Entities
This article highlights the IAASB’s consultation on the proposed ISA for Less Complex Entities.
In July 2021, the International Auditing and Assurance Standards Board (IAASB) issued an exposure draft (ED) of a proposed International Standard on Auditing (ISA) for audits of financial statements of less complex Entities (LCEs).
In recent years there has been a spotlight on the quality of audits through the results of audit inspections and recent high profile corporate failures, more commonly associated with more complex entities. This has contributed to the recent revision of ISAs such as ISA 540 (Revised) ‘Auditing Accounting Estimates and Related Disclosures’ and ISA 315 (Revised 2019) ‘Identifying and Assessing the Risks of Material Misstatement’, as well as revisions to the IAASB’s quality control standards, International Standard on Quality Management (ISQM) 1 ‘Quality Management For Firms That Perform Audits Or Reviews Of Financial Statements, Or Other Assurance Or Related Services Engagements’ et al. The FRC has subsequently issued almost identical standards in the UK.
These revisions had the objective of making the ISAs more relevant in the evolving environment, and are intended to support the consistent performance of quality audits. However, there has been growing concern about the length, complexity, and understandability of these revised standards and their application to audits of LCEs. Some stakeholders question whether the ISAs remain relevant and can be applied in a cost-effective manner to all audits. Various jurisdictions or regions have therefore undertaken initiatives targeted at audits of less complex (or smaller) entities. These developments increase the probability of fragmentation in standards for a large section of the audit market. The ED-ISA for LCE has therefore been developed as a separate, standalone standard, designed to be proportionate to the typical nature and circumstances of an LCE.
The proposed standard contains requirements for the auditor to obtain sufficient appropriate audit evidence that is intended to enable the auditor to provide reasonable assurance in the circumstances of an audit of the financial statements of an LCE (i.e., an LCE as contemplated in the proposed standard). Due to its stand-alone nature, it is separate from the ISAs with no intended need to directly reference back to the requirements or application material in the ISAs in its application. This means that if there is a circumstance that has not been contemplated in the design of the ED-ISA for LCE as addressed in the Authority of the proposed standard, relevant ISA requirements cannot be used to “top-up” the ED-ISA for LCE in order to address the circumstance.
Accordingly, the overall decision for the audit engagement is whether the ED-ISA for LCE is appropriate for use given the nature and circumstances of the entity; the proposed standard does not address complex matters or circumstances, and is not permitted to be used for audits that are not audits of financial statements of LCEs. For example, where an entity has an accounting estimate calculated using a bespoke, complex model that is not contemplated by the proposed standard, but is otherwise an LCE, an auditor may not use ED-ISA for LCE together with requirements from ISA 540 (Revised) to supplement what may not be addressed in ED-ISA for LCE when planning and performing the audit. Consequently, an auditor would then need to apply the ISAs because ED-ISA for LCE, in its design, does not address complex matters or circumstances.
If ED-ISA for LCE is used for engagements for which it has not been designed the requirements of the proposed standard will not be sufficient for the auditor to obtain sufficient appropriate audit evidence to support a reasonable assurance opinion. Therefore, a clear description of the types of entities (provisional) for which the ISA for LCE is not intended is set out in the Authority of the proposed
Standard and these are split into two categories:
- Specific classes of entities for which the use of the proposed standard is prohibited.
- Entities which exhibit qualitative characteristics which preclude the use of the proposed standard for the audit of the financial statements of that entity because they are indicators of, or proxies for, matters or circumstances for which the standard has not been designed.
1. Specific classes of entities
The IAASB has provisionally prohibited use of the proposed standard where:
(a) Law or regulation:
(i) Explicitly prohibits the use of the proposed ISA for LCE (i.e., the standard is not authorized for use in a particular jurisdiction); or
(ii) Specifies the use of auditing standards, other than the proposed ISA for LCE, for an audit of financial statements in that jurisdiction.
(b) The entity is a listed entity.
(c) An entity meets one of the following criteria:
(i) An entity one of whose main functions is to take deposits from the public;
(ii) An entity one of whose main functions is to provide insurance to the public;
(iii) An entity whose function is to provide post-employment benefits;
(iv) An entity whose function is to act as a collective investment vehicle and which issues redeemable financial instruments to the public; or
(v) A class of entities where use of the proposed ISA for LCE is prohibited for that specific class of entity by a legislative or regulatory authority or relevant local body with standard setting authority in the jurisdiction.
(d) The audit is an audit of group financial statements.
The IAASB recognizes that there may be different circumstances in some jurisdictions that need to be taken into account. For example, there may be entities within a local context that are scoped into the prohibitions (because the broad class is prohibited) when they, in fact, do not exhibit public interest characteristics. There may also be additional classes of entities within a jurisdiction that also exhibits public interest characteristics. Therefore, the proposed standard allows for the ability to ‘modify’ these classes of prohibited entities through:
(a) Explicitly permitting a specific sub-set within a class to be able to use the proposed standard (however, still having regard to the qualitative characteristics relevant to the appropriate use of the standard.)
(b) Introducing further classes of entities prohibited from using the proposed standard.
Such changes can only be made at a jurisdictional level and modifications can only be made within a specific class – a whole class cannot be removed.
2. Qualitative characteristics
It is inappropriate for an audit of the financial statements of an entity to be undertaken using ED-ISA for LCE if the entity exhibits the following:
- 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.
These are intended to be indicators of, or proxies for, matters or circumstances that are deemed complex for the purpose of the proposed standard (i.e., ED-ISA for LCE does not include requirements to address such matters or circumstances).
Consistent with an audit conducted in accordance with the ISAs, the intended outcome from using The ED-ISA for LCE is an audit opinion resulting for a quality audit engagement that would enhance the credibility of the financial statements for the users thereof. The basis for the design of the ED-ISA for LCE to achieve this outcome is a separate standard for an audit of the financial statements of an LCE that:
(a) Is proportionate to the nature and circumstances that would be typical of an audit of a less complex entity (as contemplated in the Authority).
(b) Can be used effectively and efficiently in those typical circumstances to obtain sufficient appropriate audit evidence to support a reasonable assurance audit opinion.
(c) Utilizes a risk-based approach to an audit, with requirements that are principles-based, so that the proposed standard can be applied to less complex entities with a wide range of circumstances and across sectors or industries.
Accordingly, many of the basic concepts used in the ISAs to support a risk-based approach have also been incorporated in the ED-ISA for LCE, including:
- The use of objectives;
- Using the core ISA requirements and concepts (such as professional scepticism and
professional judgment) as a base for establishing the work effort of the auditor when performing
an audit of an LCE; - The need to obtain sufficient appropriate audit evidence to support the audit opinion;
- The use of materiality to focus the auditor’s efforts and to evaluate misstatements; and
- Using the audit risk model, i.e., applying the concepts of inherent risk, control risk and detection risk.
As such, the ED-ISA for LCE would have the same overall objectives of an audit for the auditor, as well as the same inherent limitations as a full ISA audit. Therefore, to develop a standard that will achieve reasonable assurance, the IAASB has used the requirements in the ISAs as the basis for the requirements within the ED-ISA for LCE. This was accomplished by replicating and adapting requirements from the ISAs that are considered core to an audit, for the nature and circumstances of less complex entities as contemplated by the proposed standard. Audit procedures that are not relevant to an LCE, as contemplated by the proposed standard (e.g., procedures specific to listed entities), are not included within ED-ISA for LCE.
The auditor is required to comply with all relevant requirements in ED-ISA for LCE unless it is judged to be necessary to depart (and only in exceptional circumstances) to be able to achieve reasonable assurance.
The IAASB has undertaken an analysis of how the requirements in the ED-ISA for LCE ‘map’ against the equivalent ISA requirements. This mapping, includes commentary to explain any differences.
The ED-ISA for LCE has been developed on the basis that the auditor performing the engagement is a member of a firm that is subject to the IAASB’s Quality Management Standards (ISQMs), or national requirements that are at least as demanding.
A key objective of the design of the proposed standard was to keep the standard concise and succinct (as much as possible). The ED-ISA for LCE includes “essential explanatory material” (EEM) where it has been considered that explanatory material is crucial to support the requirements or concepts used. The EEM serves a similar purpose to application and other explanatory material in the ISAs, but is much more limited and is targeted at a higher level (i.e., a conceptual and contextual level), taking into account the typical nature and circumstances of audits for which the proposed standard has been designed.
The content (i.e., the requirements and related EEM) of ED-ISA for LCE have been grouped into nine “Parts” that follow the flow of an audit engagement (rather than by subject matter or topic like the ISAs) as follows:
Part 1: Fundamental Concepts, General Principles and Overarching Requirements
Part 2: Audit Evidence and Documentation
Part 3: Engagement Quality Management
Part 4: Acceptance or Continuance of an Audit Engagement and Initial Audit Engagements
Part 5: Planning
Part 6: Risk Identification and Assessment
Part 7: Responding to Assessed Risks of Material Misstatement
Part 8: Concluding
Part 9: Forming an Opinion and Reporting
Next Steps
The consultation closes on 31 January 2022. The IAASB will then determine its next steps following an analysis of the responses received.
ICAS will be responding to the consultation which has a deadline date of 31 January 2022. Any member who would like to share their views on the ED-ISA for LCE should send these to members@icas.com FAO James Barbour by 31 December 2021.
It would of course ultimately be a decision for the Financial Reporting Council to decide whether any future finalised standard would be introduced in the UK.
