Brief facts of the enquiry

Company A holds 18.49 percent shares in ABC Limited. Company A has accounted for this as investment in associate under equity method. The financial information of ABC Limited was used to determine the carrying amount of investment in associate as at June 30, 2020.

In context of the audit of Company A, does ABC Limited meet the definition of component under ISA 600, and hence audit procedures required under ISA 600 are applicable on the auditor of Company A i.e. the investor company as the group auditor.

The Auditing Standards and Ethics Committee’s comments and conclusion

1.This section provides the Committee’s analysis and comments to the enquired matter which are based on the understanding of:

▪the fact pattern submitted by the enquirer; and

▪the scope and application of International Standard on Auditing 600, Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors)’ (ISA 600).

It is also important to highlight that the Committee’s analysis does not include ascertainment of facts relating to the enquired matter, including the completeness of the comments of the engagement partner provided in the enquiry.

2.The Committee noted that the enquired matter relates to the statutory audit of an entity (i.e. Company A).

Section 249 (1) of the Companies Act, 2017 requires the statutory auditor to conduct the audit and prepare auditor’s report in compliance with the requirements of ISAs as adopted by ICAP.

The Committee also observed that enquired matter primarily relates to the scope and applicability of ISA 600. This standard deals with the special considerations that apply to the group audits. ISA 600 defines ‘group audit’ as the audit of group financial statements.

Paragraph 1 of ISA 600 explains its scope, as under:

The International Standards on Auditing (ISAs) apply to group audits. This ISA deals with special considerations that apply to group audits, in particular those that involve component auditors.

In the context of section 249(1) of the Companies Act, 2017, ICAP has adopted ISA 600 (effective for audits of group financial statements for periods beginning on or after December 15, 2009). A statutory auditor, accordingly, is required to consider the scope and requirements of ISA 600 when auditing the financial statements of an entity.

3.The Committee observed that the key question in the enquired fact pattern is:

a)whether, under ISA 600, the financial statements of Company A that contain the financial information about its investment in associate will be the ‘group financial statements’.

The Committee noted that for understanding and reaching a conclusion on the above-mentioned key aspect, the definitions and explanatory paragraphs of ISA 600 relating to the following concepts are relevant:

▪Component

▪Group

▪Group financial statements

▪Group audit

▪Significant component.

ISA 600 defines these terms as under (underline is ours)

“Component – An entity or business activity for which group or component management prepares financial information that should be included in the group financial statements.”

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

“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 have no parent but are under common control.”

“Group audit – The audit of group financial statements”.

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

The explanatory paragraph A2 of ISA 600 further explains and provides guidance about the ‘‘component’. It is reproduced below:

“The structure of a group affects how components are identified. For example, the group financial reporting system may be based on an organizational structure that provides for financial information to be prepared by a parent and one or more subsidiaries, joint ventures, or investees accounted for by the equity or cost methods of accounting; by a head office and one or more divisions or branches; or by a combination of both. Some groups, however, may organize their financial reporting system by function, process, product or service (or by groups of products or services), or geographic locations. In these cases, the entity or business activity for which group or component management prepares financial information that is included in the group financial statements may be a function, process, product or service (or group of products or services), or geographic location.”

4.The Committee observed that the above-noted definitions and explanatory guidance contained in ISA 600 clarify that:

a)ISA 600 is applicable to the group audits i.e. audit of group financial statements.

b)In context of the group financial statements:

▪A group always has one or components.

The group can be organized in many different ways (e.g. branches, business units, legal entity, investment). ISA 600 explains this organization as ‘component(s)’ of the group.

▪The group financial statements contain the financial information of the component(s).

▪The ‘group audit’ is an audit of group financial statements that includes the financial information of component(s).

ISA 600 also explains that the financial information about a component is included in the group financial statements through a consolidation process. The concept of consolidation Auditing Standards & Ethics Committee’s Opinion Enquiry relating to the Component and Group Audit as per ISA 600 Page 4 of 5 process is driven by the concept of component (entity or business unit). The consolidation process refers not only to the preparation of consolidated financial statements in accordance with the applicable financial reporting framework, but also to the presentation of combined financial statements, and to the aggregation of the financial information of entities or business units such as branches or divisions.

5.The Committee also noted that the financial reporting framework (e.g. IAS 27, Separate Financial Statements) defines ‘consolidated financial statements’ as the financial statements of a group in which the assets, liabilities, equity, income, expenses and cashflows of the ‘parent’ and ‘its subsidiaries’ are presented as those of a single economic activity.

On the other hand, in ISA 600, the ‘group’ and ‘group financial statements’ are not confined to the financial reporting concept of the parent and its subsidiaries. In ISA 600, the term ‘group financial statements’ is more more-wider. It contains the financial information of the components. Components, in addition to the subsidiaries, may include other entities and business units whose financial information is included in the group financial statements.

Further, as explained in paragraph (4) above the concept of consolidation process of ISA 600 is driven by the concept of component (entity or business unit). The term “consolidation process” used in ISA 600 is not intended to have the same scope as “consolidation” or “consolidated financial statements” that are defined or described in financial reporting frameworks. This aspect has also been further clarified in the ISA 600 (Revised) issued by the International Auditing and Assurance Standards Board (IAASB) in April 2022 (ISA 600 (Revised) which will be applicable for financial statements audits beginning on or after 15 Dec, 2023). ISA 600 (Revised) has not changed the scope of extant ISA 600, however, it has further clarified the scope and other concepts of extant ISA 600.

The ‘Group financial statements’ has been defined in ISA 600 (Revised) as under (underline is ours):

“Group financial statements – Financial statements that include the financial information of more than one entity or business unit through a consolidation process.

For purposes of this ISA, a consolidation process includes: (Ref: Para. A26–A28)

(i) Consolidation, proportionate consolidation, or an equity method of accounting;

(ii) 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; or

(iii) The aggregation of the financial information of entities or business units such as branches or divisions.”

4.The Committee noted that ISA 600 in paragraph A15 discusses the ‘access to information’. A reading of this paragraph transpires that component includes entities or business that are accounted for by the equity method of accounting (in the enquired fact pattern the investment in associate is accounted for by the equity method of accounting). Paragraph A15 is reproduced below:

“Where access to information is restricted by circumstances, the group engagement team may still be able to obtain sufficient appropriate audit evidence; however, this is less likely as the significance of the component increases. For example, the group engagement team may not have access to those charged with governance, management, or the auditor (including relevant audit documentation sought by the group engagement team) of a component that is accounted for by the equity method of accounting. If the component is not a significant component, and the group engagement team has a complete set of financial statements of the component, including the auditor’s report thereon, and has access to information kept by group management in relation to that component, the group engagement team may conclude that this information constitutes sufficient appropriate audit evidence in relation to that component. If the component is a significant component, however, the group engagement team will not be able to comply with the requirements of this ISA relevant in the circumstances of the group audit. For example, the group engagement team will not be able to comply with the requirement in paragraphs 30–31 to be involved in the work of the component auditor. The group engagement team will not, therefore, be able to obtain sufficient appropriate audit evidence in relation to that component. The effect of the group engagement team’s inability to obtain sufficient appropriate audit evidence is considered in terms of ISA 705.”

7.The Committee noted that ISA 600 also explains that for the group audit the group engagement partner is responsible for the direction, supervision, and performance of the group audit engagement in compliance with professional standards and applicable legal and regulatory requirements and the auditor’s report on the group financial statements. The group engagement partner is responsible for the group audit opinion. The effect of the group engagement team’s inability to obtain sufficient appropriate audit evidence is considered in terms of ISA 705 (Revised), Modifications to the Opinion in the Independent Auditor’s Report.

ISA 600 also defines ‘significant component’ and requires the group engagement team to determine, whether a component is significant (or not). Paragraphs A5-A6 of ISA 600 explain that the group engagement team may apply a percentage to a chosen benchmark, for example, group assets, liabilities, cash flows, profit or turnover, as an aid to identify components that are of individual financial significance. Identifying a benchmark and determining a percentage involve the exercise of professional judgment. Further, with the increase of the financial significance of a component, the risks of material misstatement of the group financial statements also increase. The group engagement team should identify a component which is likely to include significant risks of material misstatement of the group financial statements due to its specific nature or circumstances.

The Committee’s conclusion

8.The Committee, based on the understanding of the enquired fact pattern and the above discussion, concluded that in accordance with ISA 600:

a)the statutory financial statements of Company A containing financial information of its associate (i.e. XYZ Limited) will be the ‘group financial statements’. This is because the financial statements of Company A contain the financial information about its component i.e. an associate (accounted for under the equity method);

b)the audit of the above-noted group financial statements of Company A will be a ‘group audit’; and

c)the group engagement partner is responsible for the direction, supervision, and performance of the group audit engagement. The responsibilities include, determining whether a component is ‘significant’ (or not), obtaining sufficient appropriate audit evidence about the component, forming an audit opinion on the group financial statements, and considering the effect on the auditor’s report in case of inability to obtain sufficient appropriate audit evidence about the component (in terms of ISA 705 (Revised)).

(Issued in October, 2022)