How coordination enables compliance with the group audits standard

Editor’s note: This article is the third 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.” and for the second article in the series, see “Qualitative Considerations for Allocating Materiality to Components in a Group Audit.”

Good communication is the key to opening the door to successful interactions and outcomes when working with diverse groups. Below we will speak to next steps including compliance, communication, and effectiveness matters associated with the group audits standard, but first let’s discuss the change in focus of group audits briefly.

Change in focus

The former standard that predated AU-Section 600, Special Considerations—Audits of Group Financial Statements (Including the Work of Component Auditors), was AU Section 543, Part of Audit Performed by Other Independent Auditors. The titles alone tell you that there has been a change in focus from interaction between auditors to risk associated with auditing group financial statements.

The former standard focused on the principal auditor’s consideration of whether he or she would make reference to other auditors and division of responsibility. Under AU 543, the principal auditor was required to inquire of other auditors concerning matters such as professional reputation and standing, independence and the other auditor’s familiarity with U.S. GAAP and generally accepted auditing standards (GAAS). In addition, when the principal auditor determined that he or she would not make reference to the other auditor he or she would need to consider visiting the other auditor to discuss procedures, review audit programs, issue instructions, and review workpapers.

In accordance with AU-C 600, the term group auditor replaces principal auditor. The group auditor is responsible for expressing an opinion on the fair presentation of the group financial statements as a whole. The change in focus expands the considerations to also include identifying and evaluating components even when no other firm is involved. It also requires consideration of risk assessment at the group level, which clearly articulates the following requirements:

• Understand the group and assess risk at the group level. This includes understanding the consolidation process.
• Respond to this assessed risk including consideration of aggregation risk.
• Understand the composition of components.
• Identify significant components.
• Gain an understanding of component auditors.
• Be involved with work of component auditors.
• Determine group and component materiality.

The change in focus to risk associated with group financial statements does not imply that communication is no longer important. In fact communication is more crucial now. The group auditor is required to communicate with component auditors, group management, and those charged with governance of the group.

I believe that George Bernard Shaw put it quite nicely: “The single biggest problem in communication is the illusion that it has taken place.”

Have you ever played the game telephone? In this game, one person whispers a message to another, who then passes this on to a line of people until the last player announces the message to the entire group. Typically the message delivered by the last player is significantly different from the original message.

This is a risk we encounter during communication in a group audit. As group auditors, we may struggle with working with many parties, language barriers, time differences, and various miscommunications. This communication should be direct and continuous. During this process, clear communication is key to a successful audit in accordance with standards with effective results. This process includes continuous communication with component auditors during the planning, commencement, and conclusion of the audit.

After all, component auditors don’t know what they don’t know, and given the fact that risk of material misstatement at a component level may have a material impact on the group financial statements, it is important to make component auditors aware of risks affecting the group financial statements.

Group audit considerations

When auditing a set of financial statements that include financial information of more than one component, the group auditors will encounter some common scenarios. The audit will typically include a group auditor and one or more component auditors. The engagement can be made up of a single audit team, a multiple-office team, or other auditors outside of your firm. In some cases, you may make reference to the other auditor’s report; in others you may accept responsibility for the other auditor’s report.

The following table provides some group audit considerations related to four scenarios:

You can see from this table that, regardless of who the component auditor is, many of the considerations the group auditor is required to address and document are similar. In the next few sections, we will take you through group audit considerations by area.

Acceptance and continuance

In all four scenarios, the group auditor is required to agree upon the terms of the group audit engagement with management or those charged with governance, as appropriate, in accordance with AU-C Section 210, Terms of Engagement. During the acceptance phase, the group engagement partner also has to identify the significant components in the group. To do so, the engagement partner needs to obtain an understanding of the group, its components, and their environments.

The group engagement partner should also evaluate whether the group engagement team will have the ability to obtain sufficient appropriate audit evidence, through work of the group engagement team or use of the work of component auditors, to act as auditor of group financial statements, and to report as such on the group financial statements. In addition, the group auditor cannot accept restrictions imposed by group management that would prohibit the group auditor from obtaining sufficient audit evidence. If group management imposes any such scope restrictions, the group auditor should decline to accept the engagement or withdraw from a continuing engagement, when withdrawal is possible.

Understanding the group, its components, and their environments

During this phase, the group auditor should enhance the initial understanding of the group, its components and their environments, including groupwide controls. The group auditor is required to also gain an understanding of the consolidation process, including the instructions issued by group management to components.

Following are some procedures to perform related to the consolidation process:

• Understand the groupwide controls and the consolidation process.
• Test the operating effectiveness of those controls.
• Identify further audit procedures to respond to the assessed risk of material misstatement.
• Evaluate the appropriateness, completeness, and accuracy of consolidation adjustments and reclassifications.
• Evaluate whether any fraud risk factors or indicators of possible management bias exist.

After obtaining this understanding, the group engagement team should be in a position to confirm or refine its initial assessment of the components that are significant to the entity and to assess the risks of material misstatement of the group financial statements, whether due to fraud or error. These requirements apply to all four scenarios above, since each scenario involves group financial statements.

Considering conditions or events that may indicate risks of material misstatement of the group financial statements

Component identification and procedures should be baked into your planning and risk assessment audit procedures to ensure compliance with standards and efficiency of your audit engagement as well. Think about what could go wrong at a component level so that you can plan and communicate to obtain reasonable assurance that the group financial statements are free from material misstatement. The group engagement team should assess conditions or events that may indicate a risk of material misstatement of the group financial statements.

Following is a list of areas that may indicate higher risk:

• Complex group structure.
• Poor corporate governance.
• Ineffective groupwide controls.
• Foreign subsidiaries, including foreign currency translation.
• High-risk business activities.
• Unusual related party relationships.
• Complex transactions.
• Components with different accounting policies from the group.
• Components with different financial year-ends from the group.

Once the risks of material misstatement are identified, the group auditor should develop a plan to respond to these risks.

Gaining an understanding of the component auditor

If there is a component auditor and the group engagement team plans to perform procedures on the component, the group engagement team should gain an understanding of the items below related to the component auditor. These items should be considered regardless of whether reference will be made in the auditor’s report on the group financial statements to the audit of a component auditor.

• Ethical and independence compliance.
• Professional competence.
• Group engagement team’s involvement.
• Consolidation process for the component.
• Regulatory environment that oversees the component auditor.

These matters affect the group engagement team’s decision concerning its ability to use the work of a component auditor to provide audit evidence for the group audit. These matters will also affect whether they can make reference to the audit of a component auditor in the group audit report.

What is required if I am the group auditor and I use a component auditor from another office within my firm?

On certain engagements, firms have offices in multiple locations. So, to take advantage of these geographic locations, group engagement teams will use another office to audit certain components.

In this situation, it likely would not be difficult to gain an understanding of the component auditor. However, the same communication and documentation requirements that apply regarding external auditors apply regarding the component auditors in other offices of the group auditor’s firm.

Deciding whether to make reference to a component auditor in the group audit report

In order to make reference to the component auditor’s report, the group auditor should determine that the measurement, recognition, presentation, and disclosure criteria of the component are materially similar to the group. If the component auditor reports on financial statements prepared in accordance with a different financial reporting framework than the group financial statements, there are two additional requirements in Paragraph .26 of AU-C Section 600 to be addressed before the group engagement partner can make reference to the component auditor’s report:

1. The measurement, recognition, presentation, and disclosure criteria that are applicable to all material items in the component’s financial statements under the financial reporting framework used by the component are similar to the criteria that are applicable to all material items in the group’s financial statements under the financial reporting framework used by the group.
2. The group engagement team is required to obtain sufficient appropriate audit evidence for purposes of evaluating the appropriateness of the adjustments to convert the component’s financial statements to the financial reporting framework used by the group without the need to assume responsibility for, and thus be involved in, the work of the component auditor.

In addition, the group auditor should not make reference to the component auditor’s report unless:

• The component auditor has complied with the relevant ethical requirements of the group audit, including independence and professional competence.
• The report is unrestricted as to use.

When making reference to a component auditor, the group auditor should gain familiarity with the component auditor by making direct inquiries, performing background investigations, accessing the firm’s website, and determining whether the firm is a member of a professional service organization subject to oversight, such as the AICPA or a state society.

In addition, the group auditor should obtain and read the financial statements audited by the component auditor looking for completeness and competence indicators. Also, it is important to gain an understanding of related party transactions, to reconcile balances among related parties, and to identify significant findings and issues.

Keep in mind that communication with the component auditor should occur both in the preliminary and final stages of the audit.

Component analysis—materiality and work to be performed

Paragraph .32(c) of AU-C Section 600 requires the determination of materiality levels for significant components for which the group auditor is assuming responsibility. This is required regardless of whether there is one engagement team, multiple-office engagement teams, or multiple firms. Previous articles in this series addressed materiality considerations. So we will not speak to this again here other than to say when determining component materiality, consider aggregation risk. This is the risk that the collective uncorrected and undetected misstatements in the financial statements exceed materiality for the financial statements as a whole. Professional judgment is needed to ensure materiality levels are not too aggressive (set at the group level) or too simplistic (allocated proportionately based on the size of the component).

Additional requirements when assuming responsibility for the work of a component auditor

As part of the component analysis, in addition to determining group and component materiality as discussed in previous articles, the group auditor is required to determine and document additional work to be performed when assuming responsibility for the work of component auditors.

Following are some additional requirements when the group auditor is assuming responsibility for the work of the component auditor:

• Determine work to be performed by the group auditor or by the component auditors on its behalf.
• Determine the nature, timing, and extent of involvement in the work of component auditors.
• For significant components, evaluate the appropriateness of performance materiality at the component level.
• For components that are not significant, perform analytical procedures.

When assuming responsibility, the group auditor should communicate several matters with the component auditors during the planning phase through the conclusion of the group audit. This includes confirming cooperation of the component auditors; ensuring compliance with ethical requirements and independence requirements; making them aware of related parties and related party transactions; and informing them of significant risks of material misstatement in the group financial statements, due to fraud or error, that are relevant to the work of the component auditors.

The group auditor should obtain the following from component auditor:

• Independence and professional competence statement.
• Acknowledgement of reporting entity and level of service.
• Findings, conclusions, and opinion.

Communication with group management and those charged with governance

Communication with group management and those charged with governance is essential and required by standards. The group auditor should communicate the following:

• Type of work performed on the components.
• Basis for the decision to make reference to the work of the component auditor.
• Group engagement team’s planned involvement in the work to be performed by the component auditors on significant components.
• Concerns about the quality of work of the component auditor.
• Any limitations on the group audit.
• Material weaknesses and significant deficiencies in internal control relevant to the group (either identified by the group engagement team or brought to its attention by a component auditor during the audit).
• Fraud identified by the group engagement team or the component auditors.

These matters can typically be reported through governance communication in accordance with AU-C 260, The Auditor’s Communication With Those Charged With Governance.

Difficulties and adjustment considerations

Earlier we discussed certain situations that may cause risk associated with component financial statements. Following are some areas to consider that may require further consideration and adjustment:

• Issue: Component has different accounting policies.
  • Response: Was the component appropriately adjusted in accordance with the applicable financial reporting framework?
• Issue: Does the consolidating trial balance reconcile to the separate, audited financial statements of each component?
  • Response: In some cases, the component auditor may propose adjustments, but the trial balance consolidated with the group may be missing these adjustments. The group auditor should ensure the consolidated trial balance is the same as the one audited by the component auditor.
• Issue: The component has a different accounting period.
  • Response: Different periods should be appropriately adjusted, unless the corresponding period of the subsidiary corresponds or closely matches that of the parent. This is addressed in FASB ASC 810-10-45-12 and requires an accounting period difference of no more than three months.

Investments accounted for using the equity method of accounting

In previous articles, we addressed that investments accounted for using the equity method of accounting are considered a component in accordance with AU-C Section 600 and, as such, group audit standards apply.

In some cases, obtaining information about an equity method investee may be difficult because the group auditor may be unable to gain access to the component auditor. When such access is restricted, the group auditor should determine whether sufficient appropriate audit evidence can be obtained regarding the component. To make this determination, the group auditor should assess the significance of the equity method investee to the group financial statements. Significance should be considered in terms of financial significance as well as significant risk of material misstatement due to nature and circumstances.

If the component is not significant to the group and sufficient audit evidence is available from other sources, the lack of access may not be a scope limitation for the audit of the group financial statements. The group auditor should request a complete set of the audited financial statements of the component and, if available, read and consider the auditor’s report thereon. If the group auditor also has access to information kept by group management regarding that component, the group auditor may be able to obtain sufficient audit evidence regarding the equity method investee by performing analytical procedures at the group level. If the component is not significant and the group engagement team cannot gain sufficient evidence by performing analytical procedures at the group level, the group auditor should consider whether making reference to the component auditor is possible after applying the relevant requirements for gaining an understanding of and making reference to component auditors.

Conversely, when this component is significant and the group auditor decides not to make reference, thereby assuming responsibility for the component auditor’s work, having sufficient access to the component auditor is critical. The group engagement team should follow the requirements for gaining an understanding of the component auditor and should be involved in the risk assessment of the component to identify significant risk of material misstatement of the group financial statements. In some cases, cooperation of the component auditor can be difficult and the group engagement team may not be able to comply with these requirements. This can occur when an entity has over 20% ownership interests in another entity, but the entity does not have control of the equity method investee. This may be a larger entity with many other owners. Without this required involvement, the group engagement team cannot obtain sufficient appropriate audit evidence for the component and would be required to issue a modified opinion on the group financial statements.

When the equity method investee is significant and the group auditor intends to make reference to the component auditor’s report, the group auditor would be prohibited from doing so if the team cannot obtain the requisite understanding of the component auditor.

Subsequent events

The group engagement team is required to perform procedures designed to identify events at the component level that occur between the dates of the financial information of the component and the date of the auditor’s report on the group financial statements that may require adjustment to, or disclosure in, the group financial statements.

Following are some subsequent events areas to consider:

• Settlement of litigation matters.
• Events affecting realization of assets.
• Business combinations.
• Natural disasters.
• Significant matters brought to the attention of the board of the component from the report date of the component auditor to the report date of the group auditor.

It is important for the group auditor to come to an understanding with the component auditor during the planning stages of the engagement about additional subsequent event testing and procedures to be performed by the component auditor to ensure that these items are properly addressed. This will better ensure that delays are not encountered due to misunderstanding or that the group auditor will not be required to complete these procedures on the component auditor’s behalf.

Keep in mind that component auditors may succeed in planning and designing their audits without the assistance of and coordination with the group auditor, but the group auditor cannot succeed without proper coordination and planning with component auditors.

— Michael A. Westervelt is a partner in the National Assurance Technical Group of CliftonLarsonAllen LLP and a member of the AICPA PCPS Technical Issues Committee.