AU-C 600: Special Considerations—Audits of group financial statements (including the work of component auditors)

AU-C EFFECTIVE DATE AND APPLICABILITY

AU-C EFFECTIVE DATE AND SUMMARY OF CHANGES

SAS No. 122, Codification of Auditing Standards and Procedures, is effective for audits of group financial statements with periods ending on or after December 15, 2012.

The effort to converge US generally accepted accounting standards (GAAS) with international standards on auditing resulted in the introduction of the “Group Audit” standard. This standard is based on ISA 600, The Work of Related Auditors and Other Auditors in the Audit of Group Financial Statements. AU 543 contains only limited guidance in this area.

AU-C 600 introduces several new concepts (see also the definitions section below):

• Component—performs work on the financial auditor—no longer referred to as “other auditor”
• Group
• Group engagement—this term replaces “principal auditor”
• Group engagement team
• Group financial statements—encompasses not only consolidated or combined financial statements, but also business activities in addition to separate entities. This standard applies regardless of whether or not different auditors are involved.

AU-C 600 creates significant changes in the scoping of multilocation audits. In its risk alert, Understanding the Responsibilities of Auditors for Audits of Group Financial Statements—2012, the AICPA identifies the following items that may have the most impact on current practice:

• Acceptance and continuance considerations
• The group engagement team’s process to assess risk
• The determination of materiality to be used to audit the group financial statements
• The determination of materiality to be used for procedures related to components
• The selection of components, account balances, or both; classes of transactions; or disclosures for testing
• Identification of significant component
• Communications between the group engagement team and component auditors
• Assessing the adequacy and appropriateness of audit evidence by the group engagement team in forming an opinion on the group financial statements

AU-C 600 DEFINITIONS OF TERMS

Source: AU-C 600.11

Component. An entity or business activity for which group or component management prepares financial information that is required by the applicable financial reporting framework to be included in the group financial statements.

Component auditor. An auditor who performs work on the financial information of a component that will be used as audit evidence for the group audit. A component auditor may be part of the group engagement partner’s firm, a network firm of the group engagement partner’s firm, or another firm.

Component management. Management responsible for preparing the financial information of a component.

Component materiality. The materiality for a component determined by the group engagement team for the purposes of the group audit.

Group. All the components whose financial information is included in the group financial statements. A group always has more than one component.

Group audit. The audit of group financial statements.

Group audit opinion. The audit opinion on the group financial statements.

Group engagement partner. The partner or other person in the firm who is responsible for the group audit engagement and its performance and for the auditor’s report on the group financial statements that is issued on behalf of the firm. When joint auditors conduct the group audit, the joint engagement partners and their engagement teams collectively constitute the group engagement partner and the group engagement team. This section does not, however, address the relationship between joint auditors or the work that one joint auditor performs in relation to the work of the other joint auditor.

Group engagement team. Partners, including the group engagement partner, and staff who establish the overall group audit strategy, communicate with component auditors, perform work on the consolidation process, and evaluate the conclusions drawn from the audit evidence as the basis for forming an opinion on the group financial statements.

Group financial statements. Financial statements that include the financial information of more than one component. The term group financial statements also refers to combined financial statements aggregating the financial information prepared by components that are under common control.

Group management. Management responsible for the preparation and fair presentation of the group financial statements.

Group-wide controls. Controls designed, implemented, and maintained by group management over group financial reporting.

Significant component. A component identified by the group engagement team (a) that is of individual financial significance to the group, or (b) that, due to its specific nature or circumstances, is likely to include significant risks of material misstatement of the group financial statements.

OBJECTIVES OF AU-C SECTION 600

AU-C Section 600 states that:

. . . the objectives of the auditor are to determine whether to act as the auditor of the group financial statements and, if so, to

FUNDAMENTAL REQUIREMENTS

The clarified SAS articulates the degree of involvement required when reference is made to component auditors in the auditor’s report. If the group engagement partner does not make reference to a component auditor in the auditor’s report, all of the requirements of the clarified SAS apply. If the group engagement partner does make reference to the component auditor in auditor’s report, some of the requirements do not apply.

For reference to the component auditor to be made in the auditor’s report on the group financial statements, the component financial statements need to be prepared using the same financial reporting framework as the group financial statements and the component auditor has performed an audit on the financial statements of the component in accordance with GAAS or, when required by law or regulation, with auditing standards promulgated by the Public Company Accounting Oversight Board. The Accounting Standards Board (ASB) believes that this requirement makes explicit what is implicit in extant AU Section 543.

Responsibilities

The group engagement partner is responsible for:

• Direction, supervision, and performance of the group audit engagement in compliance with professional standards and regulatory and legal requirements and
• Determining whether the auditor’s report that is issued is appropriate in the circumstances

The group engagement team or the firm may assist the group engagement partner in fulfilling the group audit responsibilities. The clarified SAS provides guidance on when such assistance is permitted. Reference the definitions section of this chapter for more on roles and responsibilities.

Engagement Acceptance and Continuance

Auditors must base their determination on whether or not to accept an engagement or continue with a client on whether the auditor believes they believe they will be able to obtain sufficient appropriate audit evidence over the group financial statements, including whether the group engagement team will have appropriate access to information.

Risk Assessment Standards

The extant SAS was written prior to the risk assessment standards. The clarified SAS incorporates application of the risk assessment standards into the performance of group audits and discusses specific applications.

Involvement with Component Auditors

The clarified SAS requires the group engagement team to gain an understanding of the component auditor, including:

• Professional competence
• Ethical requirements, particularly independence, and
• The extent to which the group engagement team will be able to be involved in the work of the component auditor (a new requirement)

After gaining an understanding of the component auditor, the group engagement partner may choose to either:

• Assume responsibility for, and thus be required to be involved in, the work of component auditors, insofar as that work relates to the expression of an opinion on the group financial statements, or
• Not assume responsibility for, and accordingly make reference to, the audit of a component auditor in the auditor’s report on the group financial statements

Involvement in the work performed by a component auditor involves the group engagement team:

• Establishing component materiality to be used by the component auditor.
• Performing risk assessment procedures, and
• Participating in the assessment of risks of material misstatement and the planned audit response

These may be performed together with the component auditor or by the group engagement team.

Materiality

The clarified SAS requires the group engagement team to determine:

• Materiality, including performance materiality for the group as a whole,
• Component materiality—determined by the group engagement team, whether or not the group engagement partner is making reference to the audit of a component auditor, and
• Thresholds for recording passed adjustments.

Component materiality, including performance materiality, must be lower than group materiality.

Assessed Risks

The clarified SAS includes requirements and guidance relating to work to be performed on all components for which the group engagement partner is assuming responsibility for the work of the component auditor, whether that work is performed by the group engagement team or component auditors. The clarified SAS includes requirements and guidance specifying the nature, timing, and extent of group engagement team’s involvement in the work of the component auditors.

The auditor must audit components that are financially significant. For components considered significant due to their likelihood of including significant risks of material misstatements, an audit or other audit procedures are performed. For components that are not significant, the group engagement team performs analytical procedures at the group level.

The clarified SAS also includes requirements and guidance related to:

• Internal controls,
• The consolidation process, and
• Subsequent events.

Communication with Others

The group engagement team is required to

• Communicate specific items to the component auditor,
• Request that the component auditor communicate with the group engagement team about certain matters, and
• Communicate specific items to group management or those charged with governance of the group, or both.

Documentation

The clarified SAS requires specific documentation, including:

• An analysis of the components indicating the significant components and the type of work performed on the components.
• Nature, timing, and extent of involvement of group team with component auditors.
• Written communications between the group team and component auditors.
• The financial statements and audit reports of those components to which the group auditor is making reference.

ILLUSTRATIONS

The following Appendices and Exhibits are from AU-C 600.

• Appendix A. Understanding the Group, Its Components, and Their Environments—Examples of Matters about Which the Group Engagement Team Obtains an Understanding
• Appendix B. Examples of Conditions or Events That May Indicate Risks of Material Misstatement of the Group Financial Statements
• Appendix C. Required and Additional Matters Included in the Group Engagement Team’s Letter of Instruction
• Exhibit A. Illustrations of Auditor’s Reports on Group Financial Statements
  • Illustration 1—A Report with a Qualified Opinion When the Group Engagement Team Is Not Able to Obtain Sufficient Appropriate Audit Evidence on Which to Base the Group Audit Opinion
  • Illustration 2—A Report in Which the Auditor of the Group Financial Statements Is Making Reference to the Audit of a Component Auditor
    • Illustration of Potential Component Auditor Representations in Governmental Entities and Not-for-Profit Organizations
• Exhibit B. Illustrative Component Auditor’s Confirmation Letter
• Exhibit C. Sources of Information

Appendix A. Understanding the Group, Its Components, and Their Environments—Examples of Matters about Which the Group Engagement Team Obtains an Understanding

The examples provided cover a broad range of matters; however, not all matters are relevant to every group audit engagement, and the list of examples is not necessarily complete.

Group-Wide Controls

Group-wide controls may include a combination of the following:

• Regular meetings between group and component management to discuss business developments and review performance
• Monitoring of components’ operations and their financial results, including regular reporting routines, which enables group management to monitor components’ performance against budgets and take appropriate action
• Group management’s risk assessment process (that is, the process for identifying, analyzing, and managing business risks, including the risk of fraud, that may result in material misstatement of the group financial statements)
• Monitoring, controlling, reconciling, and eliminating intragroup account balances, transactions, and unrealized profits or losses at group level
• A process for monitoring the timeliness and assessing the accuracy and completeness of financial information received from components
• A central IT system controlled by the same general IT controls for all or part of the group
• Control activities within an IT system that are common for all or some components
• Monitoring of controls, including activities of internal audit and self-assessment programs
• Consistent policies and procedures, including a group financial reporting procedures manual
• Group-wide programs, such as codes of conduct and fraud prevention programs
• Arrangements for assigning authority and responsibility to component management

Internal audit may be regarded as part of group-wide controls, for example, when the internal audit function is centralized. The Auditor’s Consideration of the Internal Audit Function in an Audit of Financial Statements addresses the group engagement team’s evaluation of the competence and objectivity of the internal auditors when it plans to use their work.

Consolidation Process

The group engagement team’s understanding of the consolidation process may include matters such as the following:

• Matters relating to the applicable financial reporting framework, such as the following:
  • The extent to which component management has an understanding of the applicable financial reporting framework
  • The process for identifying and accounting for components, in accordance with the applicable financial reporting framework
  • The process for identifying reportable segments for segment reporting, in accordance with the applicable financial reporting framework
  • The process for identifying related party relationships and related party transactions for reporting, in accordance with the applicable financial reporting framework
  • The accounting policies applied to the group financial statements, changes from those of the previous financial year, and changes resulting from new or revised standards under the applicable financial reporting framework
  • The procedures for dealing with components with financial year-ends different from the group’s year-end
• Matters relating to the consolidation process, such as the following:
  • Group management’s process for obtaining an understanding of the accounting policies used by components and, when applicable, ensuring that uniform accounting policies are used to prepare the financial information of the components for the group financial statements and that differences in accounting policies are identified and adjusted, when required, in terms of the applicable financial reporting framework. Uniform accounting policies are the specific principles, bases, conventions, rules, and practices adopted by the group, based on the applicable financial reporting framework, that the components use to report similar transactions consistently. These policies are ordinarily described in the financial reporting procedures manual and reporting package issued by group management.
  • Group management’s process for ensuring complete, accurate, and timely financial reporting by the components for the consolidation
  • The process for translating the financial information of foreign components into the currency of the group financial statements
  • How IT is organized for the consolidation, including the manual and automated stages of the process and the manual and programmed controls in place at various stages of the consolidation process
  • Group management’s process for obtaining information on subsequent events
• Matters relating to consolidation adjustments, such as the following:
  • The process for recording consolidation adjustments, including the preparation, authorization, and processing of related journal entries and the experience of personnel responsible for the consolidation
  • The consolidation adjustments required by the applicable financial reporting framework
  • Business rationale for the events and transactions that gave rise to the consolidation adjustments
  • Frequency, nature, and size of transactions between components
  • Procedures for monitoring, controlling, reconciling, and eliminating intragroup account balances, transactions, and unrealized profits or losses
  • Steps taken to arrive at the fair value of acquired assets and liabilities, procedures for amortizing goodwill (when applicable), and impairment testing of goodwill, in accordance with the applicable financial reporting framework
  • Arrangements with a controlling interest or noncontrolling interest regarding losses incurred by a component (for example, an obligation of the noncontrolling interest to compensate such losses)

Appendix B. Examples of Conditions or Events That May Indicate Risks of Material Misstatement of the Group Financial Statements

The examples provided cover a broad range of conditions or events; however, not all conditions or events are relevant to every group audit engagement, and the following list of examples is not necessarily complete:

• A complex group structure, especially when there are frequent acquisitions, disposals, or reorganizations
• Poor corporate governance structures, including decision-making processes, that are not transparent
• Nonexistent or ineffective groupwide controls, including inadequate group management information on monitoring of components’ operations and their results
• Components operating in foreign jurisdictions that may be exposed to factors such as unusual government intervention in areas such as trade and fiscal policy, restrictions on currency and dividend movements, and fluctuations in exchange rates
• Business activities of components that involve high risk, such as long-term contracts or trading in innovative or complex financial instruments
• Uncertainties regarding which components’ financial information requires incorporation in the group financial statements, in accordance with the applicable financial reporting framework (for example, whether any special-purpose entities or nontrading entities exist and require incorporation)
• Unusual related-party relationships and transactions
• Prior occurrences of intragroup account balances that did not balance or reconcile on consolidation
• The existence of complex transactions that are accounted for in more than one component
• Components’ application of accounting policies that differ from those applied to the group financial statements
• Components with different financial year-ends, which may be utilized to manipulate the timing of transactions
• Prior occurrences of unauthorized or incomplete consolidation adjustments
• Aggressive tax planning within the group or large cash transactions with entities in tax havens
• Frequent changes of auditors engaged to audit the financial statements of components

Appendix C. Required and Additional Matters Included in the Group Engagement Team’s Letter of Instruction

The following matters are relevant to the planning of the work of a component auditor: [Required matters are italicized.]

• A request for the component auditor, knowing the context in which the group engagement team will use the work of the component auditor, to confirm that the component auditor will cooperate with the group engagement team
• The timetable for completing the audit
• Dates of planned visits by group management and the group engagement team and dates of planned meetings with component management and the component auditor
• A list of key contacts
• The work to be performed by the component auditor, the use to be made of that work, and arrangements for coordinating efforts at the initial stage of and during the audit, including the group engagement team’s planned involvement in the work of the component auditor
• The ethical requirements that are relevant to the group audit and, in particular, the independence requirements
• In the case of an audit or review of the financial information of the component, component materiality
• In the case of an audit or review of, or specified audit procedures performed on, the financial information of the component, the threshold above which misstatements cannot be regarded as clearly trivial to the group financial statements
• A list of related parties prepared by group management and any other related parties of which the group engagement team is aware and a request that the component auditor communicates on a timely basis to the group engagement team related parties not previously identified by group management or the group engagement team
• Work to be performed on intragroup account balances, transactions, and unrealized profits or losses
• Guidance on other statutory reporting responsibilities (for example, reporting on group management’s assertion on the effectiveness of internal control)
• When a time lag between completion of the work on the financial information of the components and the group engagement team’s conclusion on the group financial statements is likely, specific instructions for a subsequent events review

The following matters are relevant to the conduct of the work of the component auditor:

• The findings of the group engagement team’s tests of control activities of a processing system that is common for all or some components and tests of controls to be performed by the component auditor
• Identified significant risks of material misstatement of the group financial statements, due to fraud or error, that are relevant to the work of the component auditor, and a request that the component auditor communicate on a timely basis any other significant risks of material misstatement of the group financial statements, due to fraud or error, identified in the component and the component auditor’s response to such risks
• The findings of internal audit, based on work performed on controls at or relevant to components
• A request for timely communication of audit evidence obtained from performing work on the financial information of the components that contradicts the audit evidence on which the group engagement team originally based the risk assessment performed at group level
• A request for a written representation on component management’s compliance with the applicable financial reporting framework or a statement that differences between the accounting policies applied to the financial information of the component and those applied to the group financial statements have been disclosed
• Matters to be documented by the component auditor

Other information, such as the following:

• A request that the following be reported to the group engagement team on a timely basis:
  • Significant accounting, financial reporting, and auditing matters, including accounting estimates and related judgments
  • Matters relating to the going concern status of the component
  • Matters relating to litigation and claims
  • Material weaknesses in controls that have come to the attention of the component auditor during the performance of the work on the financial information of the component and information that indicates the existence of fraud
• A request that the group engagement team be notified of any significant or unusual events as early as possible
• A request that the matters listed in be communicated to the group engagement team when the work on the financial information of the component is completed

Exhibit A. Illustrations of Auditor’s Reports on Group Financial Statements