ICAS response to SME audit market study

We submitted our response to the Financial Reporting Council (FRC)’s small and medium-sized enterprises (SME) market study on 25 April 2025. This was informed by insights from our Audit and Assurance Panel and views expressed by several of our audit registered firms at a joint FRC/ICAS virtual roundtable held on 1 April 2025. The key points raised in our response are set out below.

SME market contains various types of entity

The SME audit market covers a lot of different entities, including companies, limited liability partnerships and other entities such as charities and co-operative and community benefit societies. Generally, many of these entities have access to a sufficient supply of audit firms, however, that isn’t the case for all SMEs, like charities. 

For charities the applicable audit thresholds are much lower than those for companies. This will still be the case despite plans for increasing the charity audit exemption thresholds being proposed by both the UK and Scottish governments. The UK government is likely to increase the gross income criterion of the audit exemption threshold for charities in England and Wales from £1m to £1.2m or £1.5m shortly, following the launch of a consultation on charity law financial thresholds. Having presented the argument for an increase in the threshold over a number of years, we’re also pleased to note the recent announcement by the Scottish government of its commitment to raise the gross income criterion of the audit exemption threshold for Scottish charities from £500k to £1m.

It's also likely that the recent increase in the Companies Act 2006 (’the Act’) audit exemption threshold will have an impact on the number of firms in the SME audit market.

Challenges SMEs experience in relation to audits 

Reduced pool of audit firms

Most SMEs don’t currently appear to have any difficulty in finding an auditor although there is a gradually shrinking pool of audit firms. However, there are audit procurement issues facing certain SMEs in certain sectors e.g., the charity sector. It is also noticeable that over time, the extent of choice of audit firms in the SME audit market has decreased due to: 

• Increases in the company size thresholds.
• Increased regulation.
• The exit of smaller firms from the market.
• A trend of increasing consolidation of audit firms operating in the SME audit market, including where there is private equity investment, leading to reduced choice for SMEs due to a reduction in the number of audit firms. 

Indeed, many small firms have merged with larger ones, leading to fewer independent auditors, especially in the charity sector. This creates a challenge for SMEs in finding affordable audit services, particularly for charities that have lower audit exemption thresholds. Smaller firms with only a few responsible individuals are more likely to exit the market due to the burdens of maintaining an audit practice versus the perceived benefits.

Cost of audit

Despite, there generally being sufficient supply of audit firms, SMEs may still face other challenges in relation to audit. These include high costs that can be seen as disproportionate when compared to the respective business complexity of the SME concerned. The regulatory burden, particularly for smaller audit firms, has increased their operational costs and complicated the audit process for SMEs. Recently revised auditing standards, in particular ISA (UK) 315 (Revised July 2020) ‘Identifying and Assessing the Risks of Material Misstatement’, ISA (UK) 540 (Revised December 2018) ‘Auditing Accounting Estimates and Related Disclosures’ and the introduction of International Standard on Quality Management (UK) 1 have driven up audit related costs. 

Lack of understanding/perception of audit/value of audit

Many SME owners lack knowledge about what an audit entails, often viewing it as a mere compliance cost rather than a valuable process. 

SMEs prefer to engage with accountancy firms that provide broader business support rather than just specific services like tax advice or auditing. They desire a trusted advisor who can assist them in various aspects of their business growth. 

Complexity of financial reporting

SMEs often struggle with the financial reporting requirements due to limited expertise in-house, particularly in understanding complex accounting topics. In this regard, the recent change to the company size thresholds may benefit those smaller entities who will now be able to claim micro-entity status. However, we believe that the micro-entity regime requires a review to ensure that the information needs of stakeholders are met, as the required disclosures for such entities are extremely limited. 

Having limited in-house expertise is a particular challenge for charities who are unable to take advantage of the micro-entity regime and must comply with FRS 102 in full as well as the Charities Statement of Recommended Practice (SORP). The challenges SMEs face with regards to financial reporting can have a knock on effect on the role of auditors and possibly create challenges to their independence.

Timing of audit tenders

The timing for SME audit tender exercises is very important, and it is critical that SMEs, including charities, need to be aware of the lead time needed when running a tender exercise. 

Technological developments

The impact on the SME sector of technological advancements, including AI tools, on reporting and related assurance thereon, has not yet become clear but undoubtedly there will be an impact for both preparers and auditors.

Charity specific issues

Charities often face difficulties due to lower audit thresholds compared to incorporated non-charitable entities, which can lead to unexpected audit requirements e.g. when charities receive a large donation in a particular year which may lead to them having to have an audit for one year only. 

For a Scottish charity receiving a legacy near the year end which pushes them over the audit threshold, it may not be feasible for them to plan ahead with sufficient lead time for a tender exercise, and accordingly procuring an auditor with sufficient staffing flexibility to accommodate the audit within the applicable filing deadlines can prove a challenge and place the charity’s trustees in difficulties not of their making. 

Challenges audit firms experience in relation to audits for SMEs 

Applying ISAs (UK) in a proportionate manner

The biggest challenge is applying the ISAs (UK) in a proportionate manner. This is particularly the case in relation to the application of ISA (UK) 315 (Revised July 2020) and ISA (UK) 540 (Revised December 2018) ‘Auditing Accounting Estimates and Related Disclosures’. 

Financial reporting

Another issue is that a lack of qualified accountants within SMEs and charities in particular, complicates compliance with accounting standards, leading to challenges for auditors in managing risk, ensuring accurate financial reporting and in complying with auditing standards. Some clients might not have the necessary financial knowledge to provide the required information. The use of fair values in financial reporting is a case in point as many SMEs neither appreciate the need to use financial models to value certain financial instruments nor the benefit obtained from doing so, and there is a concern that the same will apply to roll out of the leasing requirements in FRS 102 of the IFRS 16 ‘right of use’ asset approach. 

SMEs may therefore need more support from their auditor than large entities. For smaller entities the complexity of judgements about accounting estimates and going concern will be disproportionate to the entity, but nevertheless, these issues need to be considered when deciding whether to take on an engagement. This can make it challenging at the smaller end both to comply with the FRC’s Ethical Standard and provide the client with the support they need, which can add to commercial pressures. 

Staffing

Another challenge being experienced by audit firms is that increasing regulatory demands make the audit profession less attractive, contributing to difficulties in staffing and retention. Firms have been struggling to recruit and retain audit staff, particularly at the senior and manager levels, which impacts their ability to meet client needs effectively. While there are still a fair number of accountants qualifying each year, many choose to enter industry roles rather than remain in practice, exacerbating the recruitment issue within auditing. 

Societal and technological developments

Post-COVID, the shift to remote and hybrid working environments has complicated audit processes, affecting communication and the quality of information exchanged between auditors and SMEs. If audit firms are employing greater use of technological tools, including AI on their audits, then for this to be utilised on SMEs, such entities need to have a good control environment and reliable data. This may result in certain audit firms not seeking to audit SMEs if they have to adopt an alternative, more substantive based audit approach. 

Charity-specific issues

For audit firms currently auditing charities and other similar specialist entities they face:

• Increased regulatory requirements leading to an increase in the level of audit work.
• Increased opportunities in the corporate audit market which has increased demand for audit services.

Firms are also looking more closely at opportunities for commercial return and it has become more difficult to make a recovery on the audits of small charities compared to medium-sized charities. 
For firms which do have a focus on charities, a decision to tender for a charity audit needs to balance commercial considerations with making sure that audit quality can be maintained through having the appropriate staff resources. 

Possible changes in relation to SME audits

ISA for LCEs/proportionality

We believe that there is a need for the FRC to consult on the International Standard on Auditing (ISA) for Less Complex Entities for possible introduction in the UK. We acknowledge that there are mixed views across the profession and indeed other stakeholders, but the best way forward would be for the FRC to consult on this to properly gauge market sentiment. Whilst presenting certain challenges, a UK standard for less complex entities could be seen as beneficial in making the audit process more accessible for smaller clients

There’s potentially a need to also explore more innovative solutions in the market place.to better support SMEs. The need for a better understanding from regulators that "one size does not fit all" in terms of audit requirements for SMEs is a common theme. More flexible or "audit light" frameworks tailored for SMEs, which could alleviate some of the burdens of full statutory audits, including potential further reliefs within the FRC’s Ethical Standard could be considered in this regard. 

Qualitative approach to setting thresholds

There would be merit, although practical challenges presented, in government adopting a more qualitative approach regarding the SME audit thresholds to better address the unique challenges these businesses face.

Forthcoming developments for FRC to consider as part of this market study

Digital reporting and emerging technologies could play a role in transforming audit practices. 
Furthermore, current reporting standards may not adequately reflect the needs of smaller businesses. 

Therefore, there is a need for a re-evaluation of how businesses engage with stakeholders in a digital age. While technology like AI has the potential to enhance audit efficiency and effectiveness, it may also create barriers for smaller firms due to the costs involved in its implementation.

Read our full response