LEARNING OBJECTIVES

After completing this chapter, you should be able to do the following:

• Determine when to apply the group audit standard.
• Differentiate among a component, component unit, and an opinion unit.
• Identify the responsibilities of the group auditor when taking responsibility for the component auditor or making reference to the component auditor.

GROUP AUDITS

Group audits include the financial information of more than one component. AU-C section 600, Special Considerations—Audits of Group Financial Statements (Including the Work of Component Auditors) (AICPA, Professional Standards) addresses special considerations that apply to group audits. An audit of group financial statements involves identifying the components that are part of the group and considering the effect of the components on the overall group audit strategy and group audit plan, including the extent to which the group engagement team will use the work of component auditors.

The applicability of AU-C section 600 depends on whether more than one component is identified, regardless of whether there is another auditor involved. On the other hand, if only one auditor is responsible for all of the opinion units in the financial reporting entity and no components are included, the requirements of AU-C section 600 may not apply.

AU-C section 600 always applies if the government has an equity method investment or when a component is audited by other auditors.

The purpose of this standard is to help define the responsibilities of the group auditor which is to provide direction, supervision, and performance of the group audit as well as for the appropriateness of the group audit report. The group auditor's overall requirements are discussed later in this chapter.

DEFINITION OF A COMPONENT

A component is an entity or a business activity for which group or component management prepares financial information that is required to be included in the group financial statements. A component may include (but is not limited to) subsidiaries, geographical locations, divisions, investments, products or services, functions, processes, or component units of state or local governments.

The term component is different from the term component unit as defined by GASB. GASB defines component units as legally separate organizations for which elected officials of the primary government are financially accountable; GASB also provides for the inclusion of these organizations in the basic financial statements of a primary government as component units, where appropriate.

Although a component unit, as defined by GASB, will meet the definition of a component under AU-C section 600, the governmental reporting entity may include additional components because the definition of a component is much broader than the definition of a component unit.

COMPONENTS AND OPINION UNITS

Governmental financial statements usually include multiple opinion units that have their own performance materiality calculation.

Each opinion unit could be considered to be its own group and probably have no additional requirements. However, there would likely be additional requirements if the opinion unit contains components or is audited by other auditors.

DECISION TREE FOR APPLYING AU-C SECTION 600

Opinion units that commonly have more than one component include the aggregate remaining fund information and aggregate discretely presented component units.

• The aggregate remaining fund information often includes (1) pension trust funds, (2) investment trust funds, (3) and similar activities for which there is a separate governance structure (board), management, and accounting for the different activities.
• The aggregate discretely presented component units often have more than one component unit. Each component unit, by definition, is legally separate and usually has a separate governance structure.

The following decision tree will help the auditor determine whether AU-C section 600 applies.

KNOWLEDGE CHECK

1. AU-C section 600 will never be applicable when
   1. The governmental entity has an equity method investment.
   2. There are no component auditors engaged by the components within the opinion unit.
   3. No opinion units contain more than one component (excluding the government-wide financial statements), and, for any opinion unit audited by other auditors, the work of the other auditor will not be used as evidence for the group audit.
   4. Different auditors are auditing component financial statements.

DEVELOPING THE GROUP AUDIT STRATEGY

Once you have made the determination that you have a group engagement, the team will need to develop a group audit strategy. Among other things, the audit guidance requires the group auditor to further enhance its understanding of

• the business environment in which the group and its components operate;
• any group-wide controls important to the prevention or detection of errors in component financial information or in the consolidation process that may be material to the group financial statements; and
• the consolidation process, including controls and group reporting instructions.

This understanding is the basis for identifying and evaluating the significance of components and for assessing the risks of material misstatements of the group financial statements, whether due to error or fraud, and thereby developing the planned audit procedures to appropriately assess risks.

RISK OF MISSTATEMENT IN GROUP FINANCIAL STATEMENTS

The risk that an individual component within a primary government's financial statements will contain misstatements that are material to the group financial statements is largely a function of the size of the component in relation to the group and the nature and other characteristics of the component. In addition to the considerations in assessing these risks for a specific component discussed in AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (AICPA, Professional Standards) and AU-C section 320, Materiality in Planning and Performing an Audit (AICPA, Professional Standards), there are additional risks that result from activities involved in managing a group that can be classified into the following categories:

• Risks related to managing complex, diverse, or decentralized business operations. These might result, for example, from overseas operations in difficult environments, decentralized trading operations, or significant joint venture operations.
• Risks related to processes involved in obtaining and consolidating or combining financial and other required information into group financial statements. These risks include, for example, the failure to identify events occurring after the date of completion of component financial information that may require adjustment or disclosure and risk of misunderstanding of relevant GAAP by component personnel.

The new standard contains explicit requirements for the group auditor that are intended to address these risks, in particular, risks related to the consolidation process and risks related to identifying subsequent events.

The group audit process is depicted in the flow chart in exhibit 8.1.

RESPONSIBILITIES OF THE GROUP AUDITOR WHEN THERE IS A COMPONENT AUDITOR

The group engagement partner is responsible for the direction, supervision, and performance of the group audit engagement; and for deciding for each component whether to

1. assume responsibility for, and be involved in, the work of a component auditor; or
2. not assume responsibility for the work of a component auditor and make reference to the component auditor in the auditor's report on the group financial statements.

When the group engagement team has serious concerns about the professional competence of the component auditor or the component auditor does not meet the independence requirements that are relevant to the group audit, the group auditor cannot use the work of the other auditors or make reference to the other auditors in their report.

The auditor of the group financial statements is responsible for obtaining sufficient appropriate evidence that the group financial statements are free from material misstatement, regardless of whether reference is made to the audit of a component auditor.

Relevant factors include the following:

• Individual financial significance of the components for which the auditor of the group financial statements will be assuming responsibility.
• The extent to which significant risks of material misstatements of the group financial statements are included in the components for which the auditor of the group financial statements will be assuming responsibility.
• The extent of the group engagement team's knowledge of the overall financial statements.

THE ROLE OF THE COMPONENT AUDITOR

As part of developing the audit strategy, the group engagement team is required to identify any other component auditors that will be involved in the audit and, for each of them, obtain an understanding of

• the component auditor's understanding and willingness to comply with relevant ethical requirements, particularly those related to independence;
• the component auditor's professional competence;
• the extent, if any, to which the group engagement team will be able to be involved in the component
• auditor's work;
• whether the component auditor can make information affecting the consolidation process available to the group engagement team; and
• whether the component auditor operates in a regulatory environment that actively oversees auditors.

The group engagement team's assessment of these factors provides a basis for determining whether to take responsibility for the work of the component auditor and, when taking responsibility, the nature and extent of involvement in component audit work. In some cases, this assessment may indicate, because of lack of independence or competence, that the group auditor should not use the component auditor's work for any purpose. The guidance in QC section 10, A Firm's System of Quality Control (AICPA, Professional Standards), could be useful to the group auditor in assessing of the independence and competence of component auditors.

MAKING REFERENCE TO THE WORK OF COMPONENT AUDITORS

AU-C section 600 permits the group auditor not to assume responsibility for component auditors' work by making reference, in the group audit report, to component auditors' reports on component financial statements. The standard also permits reference by the group auditor to the report of a component auditor when the component's financial statements are prepared using a different financial reporting framework than that of the group financial statements, as long as the group auditor audits the component's conversion adjustments. The standard does not, however, permit reference unless the component auditor has performed an audit in accordance with GAAS in the United States and has issued an unrestricted auditor's report on those financial statements.

Even when these conditions are met, it may be impractical to obtain access to the information that would be required for the group auditor to be sufficiently involved in the component auditor's work to assume responsibility for that work such as follows:

• The group financial statements may include an equity interest in an investee that is audited by another auditor and where group management, because of its lack of control over the investee, is unable to arrange access to the work of the other auditor.
• Components may operate in countries or locations where the group auditor does not operate and group management has elected to use a local auditor.
• Laws and regulations may specify that other auditors are to audit components of group financial statements of governmental entities and operations.

The standard illustrates how the group engagement team could refer to component auditors' work in the group audit report. If the group auditor, in its discretion, decides to name specific component auditors in the group audit report, the component auditor's report (with the component auditor's permission) is required to be presented together with the group auditor's report on the group financial statements.

REQUIREMENTS AND RESPONSIBILITIES OF THE GROUP AUDITOR

The group auditor is required to design and implement audit tests that appropriately address identified risks of material misstatements in the group financial statements as discussed earlier in this chapter. Some of these risks are related to the activities involved in managing the group and in consolidating or combining the financial information of its components. The standard requires the group auditor to specifically address the design and operation of group-wide controls, including those related to the consolidation process. The group engagement team also has the responsibility to perform procedures designed to identify and evaluate subsequent events that occur between the date of the group financial statements and the date of the group audit report that may require adjustment or disclosure (see paragraphs .05, .09, and .10 of AU-C section 560, Subsequent Events and Subsequently Discovered Facts [AICPA, Professional Standards]).

To assume responsibility for the work of a component auditor, the group auditor is required to do the following:

1. Specify the type of work to be performed by the component auditor.
2. Be involved in the component auditor's work by performing additional procedures that are described in paragraphs .50–.64 of the standard.

The following flow chart helps group auditors understand their responsibilities when assuming responsibilities for the component auditor's work.

KNOWLEDGE CHECK

2.     When is it appropriate to make reference to a component auditor in the auditor's report on the group financial statements?

1. When explicit permission is obtained.
2. When the other auditor is not professionally competent.
3. When the component auditor's report is restricted as to use.
4. When the component auditor is not subject to peer review.

3.     Who is responsible for determining the effect of subsequent events through the group auditor's report date?

1. The component auditor.
2. The group auditor.
3. Management of the group.
4. The audit committee of the primary government.

WORK TO BE PERFORMED BY THE GROUP AUDITOR ON THE COMPONENTS

The type of work to be performed on the financial information of a component is, generally stated, a result of the assessed risk that the component may generate a material misstatement in the group's financial statements.

For components identified as significant because they are individually financially significant to the group, the group engagement team, or a component auditor on its behalf, should perform an audit of the component's financial information, adapted as necessary to meet the group engagement team's needs. In this context, adapting the component audit to meet the needs of the group engagement team may include, for example, not performing procedures on accounts or disclosures that will be audited by the group engagement team, or communicating the results of the audit in a form that differs from the normal auditor's opinion.

For components identified as significant because they are likely to include specific risks of material misstatement of the group financial statements due to their specific nature or circumstances, the group engagement team, or a component auditor on its behalf, should perform one or more of the following:

• An audit of the financial information, adapted as necessary to meet the needs of the group engagement team.
• An audit of one or more account balances, classes of transactions, or disclosures relating to significant risks of material misstatement of the group financial statements.
• Specified audit procedures relating to the significant risks of misstatement of the group financial statements.

For components that are not significant, the group engagement team should perform analytical procedures at the group level. If the results of applying these procedures do not result in sufficient appropriate audit evidence to develop a group audit opinion, the group auditor should select additional non-significant components and perform one of the procedures outlined in the previous paragraph or a review of the financial information of the component.

When a component auditor performs procedures related to a significant component, the group engagement team should be involved in assessing the component's impact on risks of material misstatement of the group financial statements. At a minimum, this involvement should include discussions with the component auditor or management of the business activities of the component that are significant to the group, as well as the susceptibility of the component to misstatement. The group auditor should also review the component auditor's documentation of identified significant risks. In certain cases, the group auditor may choose to become more involved in the work of the component auditor or may itself perform additional procedures on the component financial information.

MATERIALITY

The group engagement team is required to determine materiality, including performance materiality, for (a) the group financial statements as a whole, and (b) particular account balances, classes of transactions, or disclosures in certain circumstances.

In addition, the group engagement team is required to determine materiality for components on which the group engagement team will perform, or for which the auditor of the group financial statements will assume responsibility for the work of a component auditor who performs an audit or a review.

If the group auditor decides to make reference to the component auditor, then the group engagement team is not required to communicate the component materiality to the component auditors.

COMMUNICATION BETWEEN GROUP AND COMPONENT AUDITORS

The group engagement team should clearly communicate its requirements to component auditors on a timely basis. AU-C section 600 requires timely communication between the group engagement team and the component auditor of certain specific items and also requires that the communications about the group engagement team's requirements be documented in writing.

These requirements include the scope of work to be performed by the component auditor and the required form and content of communications from the component auditor to the group auditor. Communications from component auditors are particularly important because they constitute all, or a substantial portion of, the evidence used by the group auditor in forming the group audit opinion.

In the past, effective two-way communication has been challenging for auditors of governmental entities due to the numerous auditors involved, the competitive selection process, and various governance structures.

SUBSEQUENT EVENTS

Group management is responsible for determining the effect, if any, subsequent events will have on the group financial statements through the date of the group auditor's report. This extends to subsequent events affecting group financial statements related to components.

This is particularly challenging for state and local governments considering the nature of their components (that is, a separate governance structure) which may the limit the control that group management (primary government) has over the component. Additionally, there are often significant differences between the dates of the auditors' reports on the group and one or more of the components.