Editor’s note: This is the second article in a series of articles about application of the group audits standard. For the first article in the series, see “The Scoop on Group Audits: You May Have Them, Even Though You Think You Don’t.”
There is a lot to consider when evaluating the allocation of materiality to components in a group audit.
An auditor may ask: “If I am the only auditor involved, how do I allocate materiality to significant components? After all, I am auditing everything in the group-reporting entity, so why can’t I just use group materiality?”
Fortunately, the answers to these questions can be found in the clarified auditing standards and related AICPA guidance.
The concept of applying materiality in an audit is not new. In both the preclarity and clarified audit standards, materiality is determined at the financial statement level; followed by various decisions about how to apply materiality in the context of planning the audit, performing audit procedures, and forming an opinion as a result of those audit procedures.
For example, performance materiality is set by the auditor at less than materiality for the financial statements as a whole to reduce aggregation risk (i.e., “the risk that the aggregate of uncorrected and undetected misstatements in the financial statements exceeds materiality for the financial statements as a whole”) to an acceptably low level.
Performance materiality also refers to the amount or amounts set less than the financial statement materiality level for purposes of applying procedures to particular classes of transactions, account balances, or disclosures.
In addition, auditors have long wrestled with the question of how to allocate materiality among decentralized subsidiaries included in the financial statements of large consolidated companies. In some instances, if the systems are centralized and risks of material misstatements among subsidiaries are similar, the auditor may be able to perform audit procedures at the consolidated level.
However, in many instances, the systems are decentralized and the risks of material misstatements among subsidiaries are different, so the auditor is not able to apply audit procedures at the consolidated level. Instead, the auditor has to design procedures to audit the consolidated amounts in disaggregated (or separate) parts, such as at the subsidiary, regional, or divisional level.
Both performance materiality and the determination of whether to audit at the consolidated level or subsidiary level are based on the concept of minimizing aggregation risk. The same is true when applying the component materiality guidance provided in AU-C Section 600, Special Considerations—Audits of Group Financial Statements (Including the Work of Component Auditors).
In essence, the more pieces that one divides a class of transactions, account balance, or disclosure into for the purpose of applying audit procedures, the more allowance that should be made for the risk that, when the results of those procedures are aggregated together, the sum of the uncorrected and undetected misstatements in the financial statements exceeds materiality for the financial statements as a whole.
This is true regardless of whether there is one engagement team auditing a single legal entity with two divisions qualifying as components or multiple engagement teams auditing numerous separate legal entities from the United States to China. The terms “component” and “group audits” may be new in the clarified standards, but the situation is not.
Paragraph .32(c) of AU-C Section 600 requires the group engagement team to establish or approve appropriate materiality levels for significant components for which the team is assuming responsibility.
The group engagement team is not required to determine materiality for those components for which the group auditor is referring to the work of a component auditor. In such cases, the component auditor is taking responsibility for determining the materiality of the component.
Nor is the group engagement team required to determine materiality for those components for which only analytical procedures at the group level will be performed.
To determine materiality for components, AU-C Section 600 provides the following requirements and guidance:
- Individual component materiality and individual component performance materiality should be lower than group materiality and group performance materiality, respectively, to reduce aggregation risk.
- All components (regardless of whether the group auditor is referring to the work of a component auditor) should be considered when determining component materiality.
- Different materiality levels may be established for different components.
- The aggregate component materiality (the sum of individual component materiality amounts) may exceed group materiality since component materiality need not be an arithmetical portion of the group materiality threshold.
- Individual component materiality thresholds in a group audit may differ from the materiality threshold established for a separate audit of the stand-alone financial statements of a component.
How to determine component materiality
Ultimately, determining component materiality is a matter of professional judgment. Similar to other areas requiring the exercise of professional judgment, the audit standards do not provide specific quantitative guidance or thresholds for setting component materiality.
However, a December 2008 JofA article, “Component Materiality for Group Audits,” provides illustrative quantitative approaches for allocating materiality to components.
That article suggests that component materiality should be set at a level that is neither too conservative (e.g., proportional amount of group materiality based on size) nor too aggressive (e.g., component materiality set near group materiality, resulting in a large aggregate component materiality in relation to group materiality). Instead, the article’s authors developed a top-down approach, which calculates “maximum aggregate component materiality” from which individual component materiality is assigned.
Appendix D, Example 2, of the AICPA Audit Risk Alert, Understanding the Responsibilities of Auditors for Audits of Group Financial Statements—2013, provides an illustration of the quantitative application of the model. The example notes that the group auditor determines “based on risk factors in specific components, the final allocation of group materiality.” This raises the question, “what factors could be considered when allocating group materiality to components?”
Impact of aggregation risk on component materiality
As with any area requiring the exercise of professional judgment, consideration of qualitative factors is important to making an informed judgment. While not intending to provide a single set of definitive criteria, the following discussion illustrates factors that may be useful for the group auditor to consider when setting component materiality.
Factors that impact aggregation risk are qualitative characteristics the group auditor could consider when determining component materiality. The aggregation risk principle that guides the group auditor in whether or not the financial statements can be audited at the group level versus the component level is a similar principle that can guide the auditor in determining how much less than group materiality to set component materiality.
The following table illustrates the general impact of various factors on aggregation risk and the resulting impact on the magnitude of component materiality relative to group materiality.
For example, take a group with one legal entity that has two divisions, each qualifying as a component under AU-C Section 600. If the product lines between the divisions are diverse, that may be an indicator that aggregation risk exists and, correspondingly, component materiality would decrease some order of magnitude in relation to group materiality. If additional factors in the table are present, then the decrease in component materiality relative to group materiality may become even greater.
When to use group materiality vs. component materiality
Because aggregation risk is the key reason that component materiality must be lower than group materiality, is it possible to use group materiality as the basis for applying audit procedures or must component materiality always be used when applying audit procedures in a group audit? In other words, is aggregation risk present in all classes of transactions, account balances, and disclosures reported in a group financial statement?
AU-C Section 600 is clear that a lower component materiality should be determined by the group engagement team for those components for which the group engagement team is assuming responsibility, but it also allows for the application of audit procedures at the group level using the higher group materiality.
TIS Section 8800.23 addresses this question:
Use of component materiality when the component is not reported on separately
Inquiry—Is it necessary to use a component materiality lower than group materiality when the component will not be reported on separately, and the audit of the entire group is being performed by the group engagement team as one audit?
Reply—If the component is a significant component on which the group engagement team will be performing audit procedures, the group engagement team is required to determine component materiality. (See paragraph .32 of AU-C Section 600.) To reduce the risk that uncorrected and undetected misstatements in each component’s financial statements, when aggregated, exceeds the materiality for the group’s financial statements as a whole, component materiality should be less than the materiality for the group financial statements as a whole. In circumstances when appropriate responses to assessed risks of material misstatement for some or all accounts or classes of transactions may be implemented at the group level, for example when accounts receivable for the parent and subsidiaries use the same system and the consolidated accounts receivable are audited as one aggregated amount, there is no risk of aggregation error and, therefore, no need to allocate materiality to components.
[Issue Date: November 2012; Revised: February 2013.]
Auditing at the group level
While affirming that the group engagement team is required to determine component materiality, TIS 8800.23 also raises the possibility of performing audit procedures at the group level using group materiality.
Determining whether to audit at the group level versus the component level involves judgment. The example given in TIS 8800.23 of auditing at the group level indicates that factors to consider are whether all the components use the same system and whether the group financial statement line item is audited as one aggregated amount, which indicates there is no aggregation risk and, therefore, no need to allocate materiality to components.
For example, when accounts receivable uses the same system at all components and the risks of material misstatement relating to accounts receivable are similar among components, the group engagement team may be able to audit the accounts receivable of all components as one aggregated amount.
In contrast, if accounts receivable uses different systems at different components, it is more likely that aggregation risk is present and materiality would likely need to be allocated to significant components.
This determination becomes more difficult when certain financial statement line items are audited at the group level and others are audited at the component level. For example, when accounts receivable uses the same system at all components relating to accounts receivable, the group engagement team may be able to audit the accounts receivable of all components as one population.
In contrast, if inventory management is decentralized and uses different systems at different components, then aggregation risk is present and the group engagement team may not be able to audit inventory of all components as one aggregated amount.
The approach considers audit procedures by audit area. Even though materiality has been allocated to components, the group engagement team may decide to test certain areas (e.g., accounts receivable) at the group level using group materiality if there is no aggregation risk as it relates to that financial statement line item, while testing other audit areas (e.g., inventory) at the component level using each component’s materiality. In other words, the auditor can use different approaches in the same group audit for different line items.
When planning the nature and extent of audit procedures, the group engagement team should design an audit plan that is responsive to the risks of material misstatement to the group financial statements.
Additional factors to consider when determining whether audit procedures can be applied at the group level are included in the response to the inquiry in TIS 8800.39, Disaggregation of Account Balances or Classes of Transactions.
TIS 8800.39 indicates that when the risks of material misstatements become less similar at the group and component level, it may be less appropriate to perform audit procedures for some or all financial statement line items at the group level.
In addition, as the complexity of the group increases (e.g., decentralized systems, fewer groupwide controls, differing jurisdictions, or diverse product lines), it is less likely that testing at the group level will sufficiently and appropriately respond to the risks of material misstatements of the group financial statements.
As the risk factors change to indicate that the group and the components are less homogenous, the aggregation risk increases. And as noted in the table above, as aggregation risk increases, component materiality decreases relative to group materiality.
Even though the term “group audit” has historically been equated with the use of another auditor, the clarity standards expanded the concept of a group audit to focus on whether or not the financial statement being reported on is comprised of components.
This paradigm shift brings with it new guidance and, in some cases, different challenges. However, many of the challenges are conceptually similar to judgments that practitioners have been making for years.
—Daniel Sanders is a senior manager in the Professional Standards Group of Dixon Hughes Goodman LLP and a member of the AICPA PCPS Technical Issues Committee.
- AU-C Section 600, Special Considerations—Audits of Group Financial Statements (Including the Work of Component Auditors), AICPA Professional Standards, as of June 1, 2013 (Volume 1) (#APS13P, paperback; #WPS-XX, one-year online subscription)
- Understanding the Responsibilities of Auditors for Audits of Group Financial Statements, AICPA Audit Risk Alert, 2013 (Appendix A of this publication also includes Technical Practice Aids 8800.01-.41 issued through March 2013) (#ARAGRP13P, paperback; #ARAGRPO, one-year online subscription; and #ARAGRP13E, ebook)
- AICPA TIS Section 8800.01-.43, Audits of Group Financial Statements and Work of Others, AICPA Technical Practice Aids, as of June 1, 2013 (#ATPA13P, paperback; #WTP-XX, one-year online subscription)
Group Audits: Clarifying the Complexities (#736510)
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AICPA Financial Reporting Center, SAS Clarity—Group Audits