Group audits II: component auditors, consolidation and reporting

Lesson 2 set the scope of the Tamarack group audit: full audits of parent operations, distribution and the Mexican subsidiary, specified procedures at the snacks subsidiary, and analytical procedures on the equity-method investee. Most of that work will be done by Hollis Ward's own teams, but the Mexican subsidiary will be audited by a local firm, Ortega Ruiz y Asociados, which also performs the statutory audit required in Mexico. This lesson covers how the group engagement team evaluates and directs a component auditor, how it audits the consolidation, and how the auditor's report on the group statements deals with the work of others.

Understanding the component auditor

Before using a component auditor, the group engagement team must determine whether that auditor understands and will comply with the ethical requirements relevant to the group audit, including independence, and whether the auditor has the competence and capabilities needed, including enough time and resources. These are not formalities. Inspection findings repeatedly show group teams accepting a one-line confirmation of independence from a component auditor that, on examination, held investments in the client or provided prohibited services.

The independence requirements that apply are those of the group audit, not only local rules. For Tamarack, a Canadian reporting issuer, the Mexican firm must comply with the independence rules in the CPA codes that apply to Hollis Ward, which follow the IESBA Code for listed entities. Hollis Ward sends a questionnaire that asks specific questions about non-audit services, fees, relationships with management and financial interests, rather than a general confirmation.

Competence covers knowledge of the auditing standards and the group's financial reporting framework, industry experience and, for the Tamarack audit, an understanding of the conversion from Mexican Financial Reporting Standards to the group framework. The group team can gather evidence from previous experience with the firm, inspection reports by its regulator, discussions with the component engagement partner, and the firm's membership in a network that applies common quality management. A component auditor that operates in a jurisdiction with active independent audit oversight, and whose recent inspection results are good, gives more comfort than one whose work has never been inspected.

Direction, supervision and review

The revised standards emphasize that component auditors are part of the engagement team, so the group engagement partner is responsible for their direction, supervision and the review of their work. The depth of involvement depends on the component's risks, the auditor's competence and the group team's previous experience. For a component with significant risks, such as Tamarack's Mexican plant, which carries risks of inventory valuation and revenue cut-off, the group team is expected to be closely involved in the component auditor's risk assessment and in the response to significant risks.

Instructions should be specific about what the component auditor must report. Typically they include: confirmation of compliance with ethical and independence requirements; the work performed and conclusions; misstatements above the clearly trivial threshold, corrected and uncorrected; deficiencies in internal control; non-compliance with laws and regulations; indications of fraud or suspected fraud; related parties and related party transactions; events or conditions that may cast doubt on going concern; and significant matters discussed with management. Reporting deadlines should leave the group team time to evaluate the results before the group report is dated.

Review of the component auditor's working papers is a judgment. It is expected where the group team is responsible for direction and supervision and a component carries significant risks, and the standards contemplate that it may be done remotely through technology rather than by travel. What matters is that the group team obtains evidence on how the component auditor responded to the risks, not only the conclusions.

Auditing the consolidation

The consolidation process combines the components' financial information into the group statements. It is a frequent source of error because many adjustments are made at head office, often manually, by a small team at year end. The group engagement team must understand the process, including group-wide controls over it, and design procedures to respond to the risks it creates. Typical risks include incomplete elimination of intercompany transactions and balances, unrealized profit in inventory bought from other group companies, incorrect foreign currency translation, inconsistent accounting policies at components, and manual consolidation journals posted without review.

Intercompany balances should agree between counterparties, after allowing for items in transit. The program reconciles Tamarack's main intercompany pairs at December 31, 2026, translating the Mexican subsidiary's peso payable at the closing rate, and then checks the translation of the Mexican income statement and net assets.

# Intercompany reconciliation at December 31, 2026 (invented balances, thousands of dollars).
# Mexican balances are recorded in pesos and translated at the closing rate.
closing_rate = 0.0560          # dollars per peso at year end (illustrative)
trivial = 70

pairs = [   # (counterparty A, A's receivable, counterparty B, B's payable as recorded by B)
    ("Parent -> Distribution", 18_420, "dollars", 18_420),
    ("Parent -> Mexico", 6_150, "pesos", 109_700),       # Mexico records its payable in pesos
    ("Distribution -> Snacks", 2_960, "dollars", 2_745),
    ("Mexico -> Parent", 1_380, "dollars", 1_380),
    ("Snacks -> Parent", 870, "dollars", 702),
]
explained = {"Distribution -> Snacks": ("Goods in transit shipped Dec 30", 215)}

print(f"{'Pair':<24}{'Receivable':>11}{'Payable':>10}{'Difference':>12}  Status")
for pair, recv, cur, pay in pairs:
    pay_dollars = pay * closing_rate if cur == "pesos" else pay
    diff = recv - pay_dollars
    if abs(diff) <= trivial:
        status = "within clearly trivial"
    elif pair in explained and abs(diff - explained[pair][1]) <= trivial:
        status = "explained: " + explained[pair][0]
    else:
        status = "INVESTIGATE"
    print(f"{pair:<24}{recv:>11,.0f}{pay_dollars:>10,.0f}{diff:>12,.0f}  {status}")

# Translation check for Mexico's income statement and balance sheet (pesos in thousands).
avg_rate = 0.0565
revenue_mxn, pretax_mxn, net_assets_mxn = 1_026_500, 72_570, 523_000
print(f"\nMexico revenue at average rate: {revenue_mxn * avg_rate:,.0f}")
print(f"Mexico pre-tax income at average rate: {pretax_mxn * avg_rate:,.0f}")
print(f"Mexico net assets at closing rate: {net_assets_mxn * closing_rate:,.0f}")
wrong = revenue_mxn * closing_rate
print(f"Revenue if the closing rate were used in error: {wrong:,.0f} (difference {wrong - revenue_mxn*avg_rate:,.0f})")

Pair                     Receivable   Payable  Difference  Status
Parent -> Distribution       18,420    18,420           0  within clearly trivial
Parent -> Mexico              6,150     6,143           7  within clearly trivial
Distribution -> Snacks        2,960     2,745         215  explained: Goods in transit shipped Dec 30
Mexico -> Parent              1,380     1,380           0  within clearly trivial
Snacks -> Parent                870       702         168  INVESTIGATE

Mexico revenue at average rate: 57,997
Mexico pre-tax income at average rate: 4,100
Mexico net assets at closing rate: 29,288
Revenue if the closing rate were used in error: 57,484 (difference -513)

Three pairs agree within the clearly trivial threshold. The distribution-to-snacks difference of 215,000 dollars is explained by goods shipped on December 30 and received in January, which the team verifies by examining the shipping documents and the January receiving report, and then confirms that the inventory is included in the consolidated statements once and only once. The snacks-to-parent difference of 168,000 dollars has no explanation yet and is above clearly trivial, so the team investigates; it turns out to be a management fee charged by the parent in December that the snacks subsidiary did not record. Because the parent recorded income and receivable, the elimination still nets to zero on consolidation, but the snacks subsidiary's own statements are misstated, which matters for its standalone reporting and for the specified procedures there.

Translation follows the group framework. Income and expense items of the foreign operation are translated at average rates for the period, where averages approximate the actual rates, and assets and liabilities at the closing rate, with the difference recognized in other comprehensive income. The last lines of the program show that using the closing rate for Mexican revenue in error would change revenue by about half a million dollars this year, because the peso moved only slightly between the average and the year end; in a year with a large currency movement the same error could be material.

Accounting policy alignment needs its own procedures. The Mexican subsidiary's local books follow Mexican Financial Reporting Standards, and head office converts them in the consolidation package with adjustments for leases, inventory costing and employee benefits. The group team tests the conversion adjustments directly, because the component auditor's statutory work addresses the local framework, not the group framework, unless the instructions require otherwise.

Evaluating the work and communicating findings

At the end, the group engagement team evaluates whether sufficient appropriate evidence has been obtained from the work at components, the consolidation and group-level procedures. It accumulates misstatements from all sources, including those reported by component auditors, and evaluates them against group materiality, considering both their individual size and their total. It considers whether control deficiencies reported by component auditors are deficiencies of group-wide controls that need to be communicated to group management and those charged with governance.

The group team must also communicate with group management and those charged with governance about the group audit: an overview of the work to be performed at components; the nature of the group team's involvement with component auditors; concerns about the quality of a component auditor's work; any limitations on the group audit; and fraud or suspected fraud involving group or component management. For Tamarack, the audit committee receives a scoping summary at planning and a report at completion that includes the Mexican findings and the unrecorded management fee.

The auditor's report on group financial statements

Under CAS 600 (Revised), the group engagement partner takes sole responsibility for the group audit opinion. The auditor's report on the group financial statements does not refer to a component auditor unless law or regulation requires it. If it does, the report must make clear that the reference does not reduce the group engagement partner's responsibility. This approach places the full burden on the group team to direct, supervise and review component work; there is no option to share responsibility by reference.

Whatever the reporting approach, the group auditor's responsibilities for planning and evaluating the overall audit remain. A group partner who signs an opinion without understanding how the work at a material foreign component was performed has not met them, whether or not the report mentions another firm.