Audits of Group Financial Statements

Got these? Subsidiaries Divisions Different business activities/locations JVs Equity and cost method investments VIEs Investment in REITs

Can the auditor act as a principal? Decision based on the significance of the audit performed Coverage: how much of the revenue or how much of the balance sheet being audited by principal auditor SEC: Generally, the principal auditor is expected to have audited or assumed responsibility for reporting on at least 50% of the assets and revenues of the consolidated entity Many firms adopted this guidance as a threshold issue If other auditors are involved, two decision points: Make reference Do not make reference

In all cases: Determine professional reputation of other auditors Obtain representation as to independence Determine through communication with other auditor That they are aware their work on the component will be included in the financial statements That they are familiar with US GAAS and will conduct their audit in accordance with those standards Knowledge of relevant reporting requirement A review will be made with respect to the elimination of intercompany transactions and accounts and other matters

Decision to not make reference can be made when: Audit performed by associate firm whose work is deemed to be acceptable; or The other auditor was hired by the principal auditor and performed procedures at the direction of; or Principal auditor takes steps to satisfy himself that the work was adequately performed; or The portion of the financial statements audited by others was not material

When not making reference Meet with other auditor to discuss procedures Review programs, and provide additional instructions if necessary Review working papers of the other auditor In some cases, perform additional procedures on the accounts of the entity

When making reference Disclose in the report that certain components were audited by others Disclose the magnitude of the components audited by others Do not imply that the division of responsibility somehow is construed as a qualified opinion (i.e. somehow inferior to standard auditors report)

Current AICPA (AU 543) Focus: Auditors Basic Approach Principal Auditor Other Auditor Clarified AICPA AU-C 600 Focus: Group Risk Assessment & Effectiveness Group Auditor Component Auditor

New Concepts: A group all the components whose financial information are included in the group financial statements A component an entity or business activity, whose financial information should be included in group financial statements Group engagement partner replaces principal auditor and refers specifically to the individual responsible for the group audit performance and report Group engagement team partners and staff that establish audit strategy, communicate with component auditors, perform work on the consolidation and evaluate conclusions drawn from the audit evidence

Responsibilities of the group engagement partner: Direction, supervision and performance of the group audit engagement in compliance with audit standards and legal requirements Determining whether the auditors report is appropriate in the circumstances

Meeting the responsibilities The group engagement team can assist the group engagement partner in meeting the requirements However, if other auditors do not meet the definition of a member of the group engagement team, then they are considered component auditors Thus, a component auditor can be a network firm or even a different office of the same firm Example: National firm audits a consolidated financial statement which includes a subsidiary in LA. If the firm delegates the auditor of the subsidiary to its LA office, it is likely the LA office would be considered a component auditor and this standard would apply.

Change in Focus The group audit itself rather than the interactions with other auditors Moves toward a more unified approach focusing on the group financial statements rather than pieces of it. Moves away from the coverage concept. Changes the terminology from a decision whether to make reference to other auditor to one of responsibility.

Facts: Company X has inventory located at a remote location (e.g. warehouse in another state), but does not have prepare separate financial information for that remote location. Question: Does the use of another auditor to observe the inventory count mean the audit is a group audit?

Audit Report Holding Company Sub 1 Sub 2 Sub 3

Audit Report Company A Division 1 Division 2 Division 3

All facilities distribute the same product. No individual financial information prepared. Toronto Facility Company A (Roanoke) Roanoke Facility Audit Report Memphis Facility

All facilities distribute the same product. No individual financial information prepared. Toronto Facility Company A (Roanoke) Roanoke Facility Audit Report Memphis Facility Other Auditor performs inventory observation

All facilities distribute the same product. Individual financial information prepared. Toronto Facility Company A (Roanoke) Roanoke Facility Audit Report Memphis Facility

All facilities distribute the same product. Individual financial information prepared. Toronto Facility Company A (Roanoke) Roanoke Facility Audit Report Memphis Facility Other Auditor Audits & issues stand-alone statements

Pre-Clarified AICPA (AU 543) Focus: Auditors Basic Approach Principal Auditor Other Auditor Clarified AICPA AU-C 600 Focus: Group Risk Assessment & Effectiveness Group Auditor Component Auditor

Component materiality should be determined for all components regardless of whether reference is being made to component auditor Component materiality and performance materiality should be lower than group materiality and performance materiality A threshold for trivial misstatements should also be established for each component.

Different materiality may be established for different components The aggregate of component materiality may exceed group materiality Component materiality should be allocated to the components where reference is being made; this is likely to differ that what is actually used

Allocating component materiality can effectively lead to efficiencies No specific methodology provided in the SAS Helpful article in Journal of Accountancy, December 2008 Component Materiality for Group Audits http://www.journalofaccountancy.com/issues/2008/dec/c omponentmaterialityforgroupaudits.htm Uses probability concepts similar to theory for allocating materiality to elements of the financial statements

41 Technical Questions and Answers Nonauthoritative guidance Where can you find it? TIS Section 8800, Audits of Group Financial Statements and Work of Others On AICPA website http://www.aicpa.org/interestareas/frc/pages/recentlyissuedte chnicalquestionsandanswers.aspx

Questions and Answer Topics Applicability of AU-Section 600 Making Reference to Any or All Component Auditors Deciding to Act as Auditor of Group Financial Statements Factors to Consider Regarding Component Auditors Component Financial Statements Prepared in Accordance With International Financial Reporting Standards Governmental Financial Statements that Include a GAAP-Basis Component

Questions and Answer Topics Component Auditor Performed in Accordance with International Standards on Auditing Component Audit Performed with Government Auditing Standards Component Auditor Performed by Other Engagement Teams of the Same Firm Terms of the Group Audit Engagement Equity Method Investment Component Criteria for Identifying Components Criteria for Identifying Significant Components No Significant Components are Identified

Questions and Answer Topics Restricted Access to Component Auditor Documentation Responsibilities With Respect to Fraud in a Group Audit Inclusion of Component Auditor in Engagement Team Discussions Determining Component Materiality Understanding of Component Auditor Whose Work Will not be Used Involvement in the Work of a Component Auditor

Questions and Answer Topics Factors Affecting Involvement in the Work of a Component Auditor Form of Communication with Component Auditors Use of Component Materiality when the Component is Not Reported on Separately Applicability of AU-C Section 600 When Only One Engagement Team is Involved Applicability of AU-C Section 600 When Making Reference to the Audit of an Equity Method Investee Procedures Required When Making Reference to the Audit of an Equity Method Investee Circumstances in Which Making Reference is Inappropriate

Questions and Answer Topics Lack of Response from a Component Auditor Equity Investee s Financial Statements Reviewed, and Investment is a Significant Component Making Reference to Review Report Review of Component That is Not Significant Performed by Another Practitioner Issuance of Component Auditor s Report Structure of Component Auditor Engagement

Questions and Answer Topics Subsequent Events Procedures Relating to a Component Component and Group have Different Year-Ends Investments Held in a Financial Statement Presented at Cost or Fair Value Employee Benefit Plan Using Investee Results to Calculate Fair Value Using Net Asset Value to Calculate Fair Value Disaggregation of Account Balances or Classes of Transactions

Technical Information Service Questions and Answers

Inquiry Do the requirements of AU-C section 600, Special Considerations Audits of Group Financial Statements (Including the Work of Component Auditors) (AICPA, Professional Standards), apply only when the auditor makes reference to the audit of another auditor in his or her report on the group financial statements? Reply No. AU-C section 600 applies to all audits of group financial statements. Certain requirements (detailed in paragraphs.50.64 of AU-C section 600) are applicable to all components, except those for which the auditor of the group financial statements is making reference to the work of a component auditor. (See paragraph.08 of AU-C section 600.)

Inquiry What factors might the group engagement partner consider when deciding to use the work of a component auditor and whether to make reference to the component auditor in the auditor s report on the group financial statements? Reply In all group audits, the group engagement team is required to obtain an understanding of the component auditor, and the group engagement partner uses this and his or her understanding of the component when deciding to use the work of a component auditor and whether to make reference to the component auditor in the auditor s report on the group financial statements. Factors affecting this decision include (a) differences in the financial reporting framework applied in preparing the component and group financial statements, (b) whether the audit of the component financial statements will be completed in time to meet the group reporting schedule, (c) differences in the auditing and other standards applied by the component auditor and those applied in the audit of the group financial statements, and (d) whether it is impracticable for the group engagement team to be involved in the work of the component auditor.

Inquiry What matters are required to be included in the terms of the group audit engagement? Reply The auditor of the group financial statements is required to agree upon the terms of the group audit engagement. In addition to the matters identified in AU-C section 210, Terms of Engagement (AICPA, Professional Standards), other matters may be included in the terms of a group audit, including whether reference will be made to the audit of a component auditor in the auditor s report on the group financial statements. The terms of the engagement may also include arrangements to facilitate (a) unrestricted communication between the group engagement team and component auditors to the extent permitted by law or regulation and (b) communication to the group engagement team of important communications between (i) component auditors, those charged with governance of the component, and component management and (ii) regulatory authorities and components related to financial reporting matters. (See paragraphs.17 and.a28 of AU-C section 600.)

Inquiry What criteria might the group engagement team use to identify components? Reply A component is defined as "[a]n 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." The structure of a group and the nature of the financial information and the manner in which it is reported affect how the group engagement team identifies components. Components can be separate entities or may be identified on the basis of the group financial reporting system that may be (a) a parent, one or more subsidiaries, and so on; (b) a head office and one or more divisions or branches; or (c) both. (See paragraphs.11 and.a1 of AU-C section 600.) In audits of state and local governments, a component may be a separate legal entity reported as a component unit or part of the governmental entity, such as a business activity, department, or program. (See paragraph.a5 of AU-C section 600.)

Inquiry If the group engagement partner decides to make reference to a component auditor in the auditor s report on the group financial statements, does the group engagement team establish materiality for the component auditor to use in the separate audit of the component s financial statements? Reply No. Reference in the group auditor s report to the fact that part of the audit was conducted by a component auditor is intended to communicate that the group auditor is not assuming responsibility for the work of the component auditor. In that case, the component auditor is responsible for establishing materiality as part of performing the audit of the component s financial statements. However, if the group engagement partner assumes responsibility for the work of a component auditor, the group engagement team is required to evaluate the appropriateness of materiality at the component level. In addition, the group engagement team is required to communicate the relevant component materiality to that component auditor. The component auditor uses component materiality to evaluate whether uncorrected detected misstatements are material, individually or in the aggregate. (See paragraphs.31,.52.53,.55, and.a73.a74 of AU-C section 600.)

Inquiry Is the group engagement team required to obtain an understanding of a component auditor for a component that is not a significant component if the group engagement team does not plan to use the work of the component auditor and plans only to perform analytical procedures at a group level? Reply No. It is not necessary to obtain an understanding of the auditors of those components for which the group auditor will not be using the work of the component auditor to provide audit evidence for the group audit. (See paragraphs.22,.29, and.a41 of AU-C section 600.)

Inquiry When the group engagement partner decides to assume responsibility for the work of a component auditor, is the group engagement team required to be involved in the work of the component auditor? Reply Yes. The group engagement team is required to determine the type of work to be performed by the group engagement team (or a component auditor on behalf of the group engagement team) on the financial information of a component. The group engagement team is also required to determine the nature, timing, and extent of its involvement in the work of the component auditor. (See paragraph.51 of AU-C section 600.)

Inquiry What factors might affect the group engagement team s involvement in the work of a component auditor? Reply Factors that may affect the group engagement team s involvement in the work of a component auditor include (a) the significance of the component, (b) identified significant risks of material misstatement of the group financial statements, and (c) the group engagement team s understanding of the component auditor. (See paragraph.a84 of AU-C section 600.)

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.31 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.

Inquiry Are there any circumstances in which it would be inappropriate to make reference to the audit of a component auditor of an equity investee in the auditor s report on the group financial statements? Reply AU-C section 600 precludes the auditor of the group financial statements from making reference to the audit of the component auditor in the following circumstances: When the group engagement team has serious concerns about the component auditor s professional competency or independence. (In this circumstance, the group auditor is precluded from using the work of the component auditor at all.) The component auditor s report on the equity investee s financial statements is restricted regarding use. The audit of the component was not performed in accordance with the relevant requirements of GAAS or, if applicable, the standards promulgated by the Public Company Accounting Oversight Board (PCAOB). The financial statements of the component (that is, the equity investee) and group are prepared in accordance with different financial reporting frameworks, unless certain conditions are met.

Inquiry Company X has an equity investment in Entity A that is not considered a significant component. A review of the financial statements of Entity A has been performed by another practitioner. Can the group engagement team use the work of the practitioner as part of the audit evidence for the audit of the group financial statements? Reply Paragraphs.54.55 of AU-C section 600 discuss certain procedures to be performed on a component when the component is not a significant component. In certain circumstances, a review of a component s financial statements may be sufficient audit evidence. Therefore, a group auditor may use the work of another practitioner if the review meets the needs of the group auditor. Although the group auditor may use the review as part of the auditor s evidence for the audit of the group financial statements, the group auditor is not permitted to make reference to the practitioner s review report.

FURTHER QUESTIONS/COMMENTS