31 March 2020

Following on from our previous article regarding the Audit of Less Complex Entities (LCEs), we spoke to a number of our user firms and, along with 78 others stakeholders globally, responded to the IAASB request for submissions.

The LCE discussion has tended to focus on smaller for-profit entities that make a direct economic contribution, but in New Zealand the LCE field is dominated by not-for-profits. We estimate that NFP/LCE jobs done using Audit Assistant outnumber LCE for-profit jobs by about 4:1.

From user feedback, the mismatch of International Auditing Standards (ISAs) with the audit requirements of the humble but exceedingly numerous garden-variety NZ not-for-profit (charities, clubs, associations etc) seems to be the major issue. 

At a social level it is critical that small charities, clubs and other not-for-profits remain viable and accountable, as these entities create a disproportionate amount of social cohesion which flows down into all sorts of positive social (and therefore ultimately also economic) outcomes. If the herbs that nurture society are neglected we not only lose our flavour but our health. So the social cost of inappropriate audit standards may well be an overlooked factor in this discussion.

Obtaining an audit is a significant but necessary overhead if an entity is seeking funding. Funders won’t include the cost of audit in grants and the funding is not guaranteed just because the audit is done. So this is a great burden. 

There are an estimated 110,000 of these types of entities in NZ – most of which would be LCEs. If we assume that a half of these are subject to or want an audit we have about 55,000 LCE NFP audits. If the real cost of audits has increased by say $1500/entity under the ISAs, that is a cost of $82m p.a. to an already struggling sector. 

Industrial grade standards

Internationally applicable standards focussing mainly on large for-profit entities were developed in the context of globalism and the GFC.  Although these international issues had little direct effect or relevance to LCEs in general, the result was highly technical standards lacking clear help or relevance for smaller non-profits and a crippling audit fee increase without any real quality gain. We have taken an industrial approach to standards.

This may be necessary for industrial-scale entities, but there is no room for the combine harvester in the back-yard herb garden.

No wonder then that in New Zealand many smaller and provincial accounting firms that carried out perfectly adequate audit work at a scale appropriate to LCEs have dropped out because they do not have the time, staff or resources to carry out ISA-compliant audits.

In turn the entities they previously audited have either had to pay much higher fees to large city firms, stop being audited voluntarily (if under the threshold for compulsory audit) or potentially close because they are already financially pressed and dependant on overstressed volunteers. So the garden withers.

What can be done?

As part of my research and reflection I reviewed the pre-ISA New Zealand Auditing Standards and Guidelines (March 1996). These were an attempt to set some basic markers and guidance for audit work in New Zealand based on best auditing practice applied to our context. In my opinion they actually read very well in many respects, explaining concisely the key issues of risk-based auditing.

The obvious observation after reading through these older standards (as noted in the LCE discussion paper) is the sheer bulk of the ISAs (approximately 1200 pages) compared to the 1996 standards (265 pages including guidance).

At the risk of sounding like an old guy longing for the “good old days”, I was surprised how clear the 1996 standards were and imagined how easy and useful it would be just to go back to those for New Zealand LCEs (with some appropriate updates of course for the changing business environment since the 1990s).

The barrier to this kind of approach is the insistence by the international standard setters that to maintain audit quality and consistency the LCE approach must be international. My question is why?

Do we need international standards for LCEs?

The discussion paper includes a working definition of LCEs as: 

“An entity which typically possesses qualitative characteristics such as:

  1. Concentration of ownership and management in a small number of individuals (often a single individual – either a natural person or another enterprise that owns the entity provided the owner exhibits the relevant qualitative characteristics); and
  2. One or more of the following:
    i. Straightforward or uncomplicated transactions; ii. Simple record-keeping; iii. Few lines of business and few products within business lines; iv. Few internal controls; v. Few levels of management with responsibility for a broad range of controls; or vi. Few personnel, many having a wide range of duties.”

ISAs were made to respond to global realities, buts most LCEs discussed above operate at a local level. So why do we actually need an international standard or standards for LCEs? 

If we added to the above criteria “that the entity has limited or no overseas interests” this would effectively remove the need for compliance with international standards at all. This changes the whole discussion. If an entity has any sort of overseas ownership or subsidiaries or significant trade whereby suppliers or customers relied on the audit work they would be required to produce audit reports in terms of the ISAs. 

In New Zealand this would probably remove the majority of our audit work from the ISA net without any risk to our international reputation, at the same time enhancing our charity and social services sector. Why not apply the same criteria to for-profits, also relieving them of the same burden?

It could actually be a good thing for these standards to not be international as the audit requirements may be more effective if localised for the context. It would also be easier to maintain these standards without a full international approval and adoption process. 

Could we return to nurturing these humble but necessary small-holdings with appropriately scaled, locally nurtured standards? I’d love to hear your feedback