If subsidiary 1 were audited by another firm using the same materiality calculation method as the parent, an unadjusted error of $10m would correctly result in issuance of an unmodified audit opinion on the financial statements of that individual company. However, the effect of losses elsewhere in the group would mean that although this error would not be material at the component level, it would be material at the group level. Since it is only likely to be the parent auditor who has this overview of the group, the group engagement team must communicate materiality figures to component auditors in advance of audit work commencing. In this example, the maximum component materiality figure that the group auditor could communicate to the component auditors would be 600, but it would be wise to select a lower figure than this, in order to reduce to a tolerable level the risk of errors in both component companies together exceeding 600.
In the exam, if you are given extracts from draft financial statements, it’s often a good start to recommend and briefly explain a figure for materiality.
Communication between auditors
ISA 600 in its revised form contains extensive new requirements on the communication between parent and component auditor. In addition to practical matters such as materiality, the required format of the consolidation package, deadlines and contact details, the group auditor must communicate a number of matters at the planning to the component auditor, including:
- related party relationships known anywhere around the group
- identified significant risks, whether due to error or fraud
- methodology to be used for impairment testing of goodwill. Audit of estimates is subjective and so it’s essential that the group auditor’s preferred method is used throughout the group. Be prepared to explain this in Paper P7.
Matters that the component auditor must communicate to the group auditor will include:
- any known related party relationships and related party transactions
- any indications of management bias
- any significant risks to the truth and fairness of the component financial statements, work done on these risks and the conclusions reached
- all intra-group transactions, period end balances and allowances for unrealised profit
- any observed non-trivial failure to observe relevant laws and regulations
- all observed control weaknesses, flagging significant weaknesses separately
- any known events after the reporting date.
Audit of the consolidation process
Once the group engagement partner is satisfied that the individual financial statements within the group are free from material misstatement, attention can now shift to audit of the consolidation process.
The good news for exam purposes is that this stage of the audit is very similar regardless of the specific company, so good marks can be obtained largely by memorising the risks and responses below.
Principal risks arising in the consolidation process include errors or omissions arising during:
- transcription of figures from individual financial statements to consolidation workings
- classification of components (eg associate, subsidiary)
- cancellation of intra-group trading, cancellation of intra-group balances and allowance for unrealised profit on intra-group transfers
- recognition of impairment of purchased positive goodwill
- determination of fair values being used on acquisition
- arithmetical inaccuracy in the consolidation process
- identification and disclosure of related party relationships and transactions
- foreign currency translation from functional currency of components to reporting currency of the group.
The most reliable evidence on completeness and accuracy of consolidation adjustments in a large group is likely to be determining whether the client’s accounting systems adequately flags transactions with fellow group companies. The process is still likely to be highly substantive in nature and will probably include these tests of detail:
- line-by-line agreement of all items from audited component financial statements (or consolidation packages submitted to head office) to the consolidation schedules
- detailed discussion with management on the reason for classification of each component
- sample testing of known intra-group transactions to ensure that they have been eliminated in the client’s consolidation
- recalculation of all significant workings, such as goodwill, non-controlling interests and foreign currency translation.
Final review of financial statements
The group audit opinion may be signed on some date on or after the audit opinions on material components are signed. Once the component auditor has issued their opinion, their responsibility for reporting on the impact on events after the reporting date is greatly diminished, yet there may be material events that could be material in the group financial statements. The group engagement team will normally agree in advance with the auditor of significant components that an update on events is given by the component auditor to the group engagement partner immediately before the group audit opinion is signed. It is the responsibility of the group engagement team to ensure that material events are reported.
Reporting to management and the board
In addition to the usual requirements for reporting to those charged with governance (the ‘management letter’), ISA 600:49 requires the group engagement partner also to report to management on any concerns that they had about possible fraud anywhere in the group, any restrictions on information made available by component management and any concerns that they had about the quality of work performed by any component auditor.
In addition to the audit report to shareholders, the group auditor is required by ISA 600 to report on a group-wide basis to group management and separately to those charged with governance at a group level, such as the audit committee of the board. This split communication echoes the requirements of ISA 260 Communication with Those Charged with Governance to produce different letters to different levels of management.
The report to management will include details of all observed instances of non‑trivial fraud and all non-trivial deficiencies in internal controls around the group.
The report to those charged with governance, most probably the audit committee, will include:
- an overview of the audit approach insofar as it affects component auditors
- any doubts that the group auditor may have about the quality of work performed by the component auditor, giving the group auditor a potentially awkward need to publicly question the skills of a fellow professional.
- any limitations on audit scope anywhere within the group
- any suspected fraud where management is suspected of involvement.
ISA 600 represents a significant extension of the responsibilities of both group auditor and component auditor compared with the previous ISA. It is likely to be a controversial standard in practice, and it is therefore likely to be in many Paper P7 exams.
Understanding and memorising the key points of the standard is a very good use of study time when preparing for the Paper P7 exam.
Graham Fairclough is group technical director at the ExP Group