Group Audits
1 Introduction
Generally, each separate company in the group will have been audited as normal, as though it were a stand-alone company. This chapter deals with auditing the group financial statements, for example the consolidated financial statements. The audit of group financial statements requires some additional steps and considerations not seen in the audit of individual companies.
The task is simpler if the auditor of the group financial statements also audits all components of the group. Otherwise, the group auditor will have to be involved in the work of component auditors.
2 The additional work in summary
Broadly the additional work relates to the following:
What is the proper way to deal with a company’s investments in other companies?
A simple investment
An associated company
A company that must be consolidated (ie subsidiary)
The general name for a part of a group is a component.
What happens if the auditor of the group is not the auditor of all components?
Care is needed with intra-group balances that must be reconciled (for good-in-transit, cash-in-transit, etc) and eliminated on consolidation.
Unrealised profits in inventory (and perhaps on the transfer of non-current assets) must be eliminated.
The process of consolidation has to be carefully checked ie that the amounts in each category are added up properly to give the group totals.
The goodwill figure(s) have to be verified and checked for possible impairment.
If a company has been acquired part-way through the year then the profits will have to be apportioned: profits prior to acquisition are bought; profits after acquisition are earned.
Uniform accounting policies must be applied in the preparation of consolidated financial statements.
The financial statements of group companies would be expected to have the same reporting date if consolidated.
3 The proper accounting treatment of investments
Type of investment | Test | Appropriate treatment |
|---|---|---|
Subsidiary | Control: the power to govern the financial and operating policies of an entity. The investor has the right to variable returns and these are affected by the exercise of power by the investor. Generally presumed to exist if at least 50% of the equity is owned. However, owning less than 50% can sometimes be enough to give control (eg if there is a right to appoint board members). | Consolidation i.e: |
Associate | One company has significant influence over another. Usually the shareholding is 20 to 50% | Equity accounting. The investment is initially recognised at cost and the carrying amount is then increased or decreased to recognise the investor’s share of the retained profit or loss post acquisition (ie the post-acquisition change in the investor's share of the associate's net assets.) |
Joint venture | A contractual arrangement in which two or more parties undertake an economic activity that is the subject of joint control. | Equity accounting |
4 Responsibility for the group auditor's report
The group auditor has the sole responsibility for expressing an audit opinion on the group financial statements. This is so even if the group auditor is not the auditor of all the components.
Definition: Component – an entity, business unit, function or business activity, or some combination thereof, determined by the group auditor for purposes of planning and performing audit procedures in a group audit.
The group engagement partner is responsible for all aspects of the group audit: planning, setting materiality levels, review, seeking more information where necessary and for forming an opinion on the group financial statements. Indeed, the group auditor is not allowed to even comment that some components of the group were audited by another firm.
5 Materiality
An important part of the group engagement partner’s responsibility is to consider materiality. A matter is material with reference to the group financial statements - not the financial statements of a component. Usually this will mean that the materiality limits are higher for group financial statements than for component financial statements (simply because the figures in the group financial statements are usually the sum of the figures in the components). However, it is possible to construct a scenario where materiality levels are smaller in the group financial statements. For example:
$m | Group | Parent | Subsidiary A | Subsidiary B |
|---|---|---|---|---|
Profit/(loss) | 15 | 5 | 20 | (10) |
Materiality level 10% for each component | 1.5 | 0.5 | 2.0 | 1.0 |
So, the auditor of Subsidiary A will be working to a materiality level of $2m (possible ignoring misstatements up to that amount) but the group materiality level is only $1.5m. In addition, a subsidiary might not be a public interest company but the group might be and, generally, the audit of public interest entities is carried out more strictly and this could again give rises to conflicts in materiality levels.
Therefore, usually the materiality levels for each component will be set substantially lower than the group materiality limit. This has to be at a level determined by the group auditor as only that auditor has the necessary overview of the group results.
The group auditor must therefore communicate to component auditors a threshold above which misstatements must be communicated to the group auditor.
6 Other information required for the group audit
The group auditor will also require some information about components which is of no relevance to the components. For example:
Subsidiary A has sold goods at a mark-up to Subsidiary B and these are in closing inventory. Unrealised profits are a group issue, but not an issue in the financial statements or audit of the individual subsidiaries. The component auditor will have to supply this information to the group auditor. Similarly, if non-current assets had been transferred.
Differences in payables/receivables accounts in the separate subsidiaries are not an issue, but on consolidation current accounts will have to be reconciled.
If the acquisition took place part way through the year, then the results of the acquired company will have to be split into pre- and post- acquisition. This is usually done on a time basis, but significant differences in trading before and after acquisition (eg trading is seasonal) could mean that another approach is preferred.
Goods in transit or cash in transit between components will have to be sorted out upon consolidation.
Other matters concerning components that may give risk to risks of material misstatement in the consolidated financial statements include:
Events after the reporting date.
Significant control weaknesses.
Any known related party transactions.
Suspicions of management bias.
Adjustments that might be necessary for non-uniform accounting policies or non-coterminous reporting dates.
7 Component auditor
Component auditor – an auditor who performs audit work related to a component for purposes of the group audit. A component auditor is a part of the engagement team for a group audit.
Where the component is subject to a statutory audit, the component auditor is responsible for the auditor’s report on the component’s financial statements.
When component auditors are involved, the group engagements partner must:
evaluate whether the group auditor will be able to be sufficiently and appropriately involved in the work of the component auditor (including whether the component auditor will perform the work requested by the group auditor);
make component auditors aware of relevant ethical requirements and confirm that they will comply with them;
determine that component auditors have appropriate competence and capabilities, including sufficient time.
The group engagement partner is responsible for the nature, timing and extent of direction and supervision of component auditors and the review of their work.
8 Group’s system of internal controls
The group auditor’s understanding of the group should include the group’s system of internal control, including:
the nature and extent of commonality of controls;
whether, and if so, how, activities relevant to financial reporting are centralised; and
the consolidation process, including sub-consolidations and consolidation adjustments
Common controls – controls designed by group management that are intended to operate in a common manner across multiple entities or business units.
Common controls might be designed for inventory management, for example and may be direct or indirect controls.
The group auditor may involve component auditors in testing the operating effectiveness of common controls or controls related to centralised activities.
9 The consolidation process
The term “consolidation process” as used in ISA 600 Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors) is not intended to have the same meaning as “consolidation” or “consolidated financial statements” as defined or described in financial reporting frameworks.
Definition: Consolidation process – includes:
Consolidation, proportionate consolidation, or an equity method of accounting;
The presentation in combined financial statements of the financial information of entities or business units that have no parent but are under common control or common management;
The aggregation of the financial information of entities or business units such as branches or divisions.
Nowadays, much of this will involve transcribing component financial statements onto a spreadsheet then adding like balances to like balances throughout the group. Of course, some groups will have a financial accounting package which will automatically perform most of the consolidation process. However, you will understand that simply the amount of data that has to be dealt with correctly on a consolidation will introduce a high risk that errors are made: transcribing a figure incorrectly or onto the wrong row or having an error within the spreadsheet formulae.
Therefore, an important part of the group auditor’s work is to check that the correct amounts from each component company have been identified and included in the consolidation schedules and that these are arithmetically accurate.
The group auditor then has to check that the appropriate consolidation adjustments have been made. The principal adjustments are:
Goodwill and pre-acquisition reserves.
Eliminate unrealised intra-group profits.
Reconcile intra-group balances.
Adjustments to align the components' financial statements for the purposes of consolidation.
Fair values to be used where appropriate.
For any acquisition that happened in the year, any goodwill arising will have to be audited.
The calculation should be checked:
Consolidated good will = Fair value of consideration + fair value of the non-controlling interest – fair value of the subsidiary’s net assets
Often this becomes:
Consolidated goodwill = Fair value of consideration – Acquirer’s share of the net assets.
Audit evidence will involve checking the bank account to see that the acquisition amounts have been paid and inspecting the financial statements of the new subsidiary as at the date of acquisition and substituting in the fair value of assets and liabilities. The proportion of shares bought also needs to be checked and ownership of the acquired shares must be verified.
Subsequently, the goodwill figure will have to be tested for impairment. For example, if a component had begun to make a series of losses it would be difficult to sustain the idea that the goodwill on its acquisition was still intact.
Costs of acquisition must be treated as an expense and not capitalised (IFRS 3).
10 Deferred and contingent consideration
Both in practice, and in exam questions, deferred and contingent consideration is often part of an acquisition deal. For example:
Deferred: $20m paid now and another $10m to be paid in 3 years
Contingent: $20 paid now and another $10m to be paid in 3 years IF profits achieve a certain target.
Obviously, the group auditor must inspect the acquisition agreements so that the acquisition terms are fully understood. The appropriate accounting treatment of these type of consideration is:
Deferred: the deferred amount must be discounted to its present value and included as part of the acquisition cost eg for the calculation of goodwill. Auditing this figure will mean that, as well as inspecting the acquisition agreement, the auditor will have to verify that the discount rate used is appropriate. Each year, as the date of payment of the deferred consideration approaches, the goodwill figure and provision for the deferred payment have to be altered as the amount will be discounted by one less year.
Contingent: IFRS 3 requires that contingent consideration is includes as part of the consideration for acquisition measured at its fair value as at the acquisition date. An exam question will either tell you what this fair value is or how it should be calculated.
11 Letter of support (‘comfort letters’)
If a subsidiary has a going concern issue and is not confident of support from outside lenders, then its parent might offer support (ie make a loan to the subsidiary) to enable it to continue trading for the foreseeable future. This would mitigate the subsidiary's going concern problem.
In these circumstances, the group board must provide the group auditor with a ‘letter of comfort’ or ‘support letter’ in which they set out their intentions. But, of course, this letter is a relatively weak form of evidence and the group auditor should look for other evidence that the support for the subsidiary is real. For example:
Ensure that the group has the cash resources available to support to subsidiary.
Inspect board minutes for evidence that support has been agreed.
Inspect correspondence between the parent and the subsidiary or the parent and the relevant bankers.
Inspect cash flow budgets to see if the transfer of funds has been incorporated.
12 Joint audits and transnational audits
12.1 Joint audits
A joint audit is when two firms of auditors are both appointed and are both responsible for the audit opinion. It is a relatively unusual arrangement and has probably come about through the merger of two companies with different auditors as there can then be benefits in the joint approach:
Auditor knowledge about each part of the group is retained
A larger pool of resources available to carry out the audit. This might allow the audit to be carried out more quickly.
Geographical considerations might make a joint audit more efficient (eg to benefit from the insights of a local auditor).
However, there are certain disadvantages:
Both firms of auditors will require a fee and these will probably total to more than the fee of only one firm doing the whole audit.
Different approaches, methods and documentation can cause difficulties.
They might clash over the audit opinion.
Coordination over the parts of the audit that each carries out might be poor eg there could be a gap in coverage.
Obviously, before agreeing to be a member of a joint audit arrangement, any auditor should be happy about their fellow-auditor: competence, ethics, experience, reputation.
Almost certainly, each one of the joint auditors will hope to oust the other auditors and end up as the sole auditor. Auditing firms should beware of ethical risks to their objectivity and integrity arising from their attempts to be the client’s favourite auditor.
Note that in some countries, joint audits may be a legal requirement (eg in France). Also, joint audits help facilitate the transition from one audit firm to another where mandatory rotation is required.
12.2 Transnational audits
Transnational audits are NOT the same as international audits. International audits simply refer to the audit of a company or group that has operations in more than one country so that auditing has to take place in more than one country.
A transnational audit is the audit of financial statements where those financial statements will be relied upon outside the audited entity’s home jurisdiction for the purposes of significant lending, investment or regulatory decisions.
For example, there could be a large company whose operations were entirely within the UK, but whose shares are listed both in London and New York.
The international use of the financial statements causes some potential problems:
Different (and unexpected) auditing standards might be used.
Different (and unexpected) accounting standards might be accepted.
Different ethical and quality standards might have been applied.
Different corporate governance standards
In short, there is a danger that the financial statement are misunderstood when looked at by someone from a different country.
The Forum of Firms (FoF) is an independent association of international firms of accountants who carry out transnational audits. The aim is to promote consistent and high quality standards of financial reporting and auditing practices. The IFAC Transnational Auditors’ Committee (TAC) is the official link between IFAC and the FoF. It can promote the FoF’s objectives and operations and also it encourages members of the FoF to conduct high quality audits.