(a)    Hyacinth Co – internal controls and results of control testing
(i) Audit planning and performance
Where assessment of internal controls at the initial stage of the audit concludes that controls are ineffective there is no necessity to perform tests of controls, which was an incorrect response in the Group audit. Tests of controls should not be performed in order to confirm that controls are not effective as, in line with ISA 330 The Auditor’s Response to Assessed Risks, the auditor should only use tests of control as a method of gathering evidence where there is an expectation that controls are operating effectively.
The correct response should have been to increase substantive audit procedures around the area of intra-group transactions. Given that the Group companies supply each other with chemical products to use in their manufacturing processes, the volume and monetary amount of the intra-group transactions could be significant. Related party transactions are often an area of significant risk and intra-group balances can be an easy way to manipulate the individual company accounts.
The comment made by the audit manager that ‘no further work is necessary’ on the intra-group transactions seems to be based on the concept that intra-group balances are cancelled in the Group financial statements at consolidation. This is true, but audit work should be performed on these transactions because they will still be recognised in the individual financial statements and audit evidence should be obtained to support the value of the transactions and balances. Further, if these balances have not been appropriately reconciled, this could create significant issues on consolidation.
In addition, if no audit work is performed on the intra-group transactions then no assurance can be obtained over the value of adjustments made during the consolidation process to eliminate them. Also audit work should be performed to determine the validity of any provision for unrealised profit recognised in the Group financial statements. There does not appear to be any audit evidence at all to support the necessary consolidation adjustments which is a significant deficiency in the quality of the group audit. It seems that the communications between Group and component auditors is not robust. The instructions given by Crocus & Co to the component auditors seem to lack detail, for example, Crocus & Co should be instructing the component auditors to carry out specific procedures on intra-group balances and transactions.
In relation to controls over capital expenditure, it is not appropriate to conclude that controls will be effective across the Group just because they are effective in one of the Group components. Testing the controls in one component cannot provide assurance that the control risk in the other components is at the same level. This is particularly the case for Geranium Co, which is a recent acquisition, and Crocus & Co has no previous knowledge of its control environment and processes.
It is possible that the audit of capital expenditure in the Group components other than Hyacinth Co is not of acceptable quality due to over-reliance on controls over which no assurance has been obtained. The instructions given to the component auditors may not have been based on an appropriate audit strategy in relation to the audit of capital expenditure. Crocus & Co, in its evaluation of the work performed by the component auditors, should have assessed the level of testing which was performed on Daisy Co and Geranium Co’s internal controls over capital expenditure, and the conclusions which were drawn. Sufficient and appropriate audit evidence may not have been obtained, leading to a risk of material misstatement of property, plant and equipment.
(ii) Further actions to be taken
The deficiencies in internal control over intra-group transactions should be brought to the attention of Group management. ISA 600 Special Considerations – Audits Of Group Financial Statements (Including the Work of Component Auditors) requires that the group engagement team shall determine which identified deficiencies in internal control to communicate to those charged with governance and group management. This should include group-wide controls and controls over the consolidation process.
The audit working papers for the component companies should be reviewed to establish if any audit procedures on intra-group balances and transactions have been performed at the company level.
Further audit procedures should be performed on intra-group transactions including:
– Discuss with the Group finance director the process used to determine the value of intra-group transactions and balances which are adjusted at consolidation
– Using computer assisted audit techniques (CAATs), determine the monetary value of intra-group balances and agree to the finance director’s estimate and amounts in the consolidation schedule
– Perform substantive analytical procedures to form an evaluation of the expected level of intra-group sales and purchases
– Obtain copies of the individual company accounts and agree all relevant group balances and disclosures
– Agree a sample of intra-group sales and purchases to source documentation including orders and invoices
– Determine the basis of any provision for unrealised profit recognised through review of the finance director’s calculations, and re-perform the relevant calculations
In respect of the audit work on capital expenditure, the Group audit team should firstly determine the materiality of capital expenditure in each component and if material ensure that further substantive audit procedures are performed or have been performed by the component auditor, including:
– Agreeing a sample of capital expenditure items to source documentation including capital expenditure budget, supplier invoice and order or requisition form
– Physical verification of a sample of items
– Obtaining relevant insurance documents for significant assets acquired
(b)    Geranium Co – new subsidiary
(i) Audit planning and performance
The audit manager’s conclusion that Geranium is immaterial to the Group financial statements is based on the profit to be consolidated, which amounts to 2% of Group profit before tax. However, the assets of Geranium Co amount to 23·1% of Group total assets and therefore the subsidiary is material to the Group on that basis.
The Group audit team should give further consideration to whether Geranium Co is a significant component of the Group. It is likely that representing nearly one quarter of Group assets makes the company a significant component. According to ISA 600, depending on the nature and circumstances of the group, appropriate benchmarks for determining whether a component is a significant component might include a threshold based on group assets, liabilities, cash flows, profit or turnover. For example, the group engagement team may consider that components exceeding 15% of the chosen benchmark are significant components.
Assuming therefore that Geranium Co is a significant component of the group, obtaining audit evidence purely based on analytical procedures is not sufficient. ISA 600 allows that for components which are not significant components, the group engagement team can perform analytical procedures at group level. However, for a component which is significant due to its individual financial significance to the group, the group engagement team, or a component auditor on its behalf, shall perform an audit of the financial information of the component using component materiality.
The audit evidence obtained by the group audit team in respect of Geranium Co therefore needs to be more robust in order for the Group audit manager to reach a conclusion on its balances which will be consolidated.
The lack of audit working papers indicates that there has been no communication with the component auditors. This is a significant quality control problem and a breach of ISA 600 which requires that the group audit team obtain an understanding of the component auditor, and be involved with the component auditor’s risk assessment to identify risks of material misstatement. This is especially the case given that Geranium Co is a new component of the group, and this is Crocus & Co’s first experience of working with their auditors.
(ii) Further actions to be taken
The component auditor’s independence and competence should be evaluated and procedures should be performed to evaluate whether the component auditor operates in a regulatory environment which actively oversees auditors. These could be achieved through a discussion with the component auditor and requesting them to complete a questionnaire on these matters for evaluation by the group audit team.
The Group audit team should liaise with the component auditor as soon as possible in order to discuss their audit findings, obtain access to their working papers, and ultimately decide on the specific nature of the further procedures to be performed, which should be based on component materiality.
(c)    Daisy Co – restriction on international trade
(i) Audit planning and performance​​​​​​​
Based on monetary values, Daisy Co does not appear to be a significant component, its assets represent 6·2% of consolidated assets, and its profit is less than 1% of group profit and immaterial on that basis. As discussed above, a normal threshold for a significant component is 15% of group assets or profit.
However, due to the new government regulations and their potential impact on the operations of Daisy Co, the component could be evaluated as significant due to its specific circumstances which may create a risk of material misstatement at group level.
One risk arises in relation to the goodwill balance, which is material at 2·3% of group assets. The government regulation is an indicator that goodwill could be impaired, but an assessment of goodwill is required regardless of the existence of such indicators. The audit working papers will need to be carefully reviewed to ascertain the extent of work, if any, which has been performed on the goodwill of Daisy Co. The audit manager’s comment that the issue has no impact on the consolidated accounts implies that this matter may not have been factored into any goodwill assessment which has taken place as part of audit procedures. Therefore the quality of the audit evidence to support the goodwill balance of $3 million is in doubt.
It is not sufficient to rely solely on the audit opinion issued by Foxglove & Co. ISA 600 requires that for a component which is significant because it is likely to include significant risks of material misstatement of the group financial statements due to its specific nature or circumstances, the group engagement team, or a component auditor on its behalf, shall perform one or more of the following:
– An audit of the financial information of the component using component materiality
– An audit of one or more account balances, classes of transactions or disclosures relating to the likely significant risks of material misstatement of the group financial statements
– Specified audit procedures relating to the likely significant risks of material misstatement of the group financial statements
There is a risk that not all of the implications of the government regulations have been addressed by Foxglove & Co during their audit. For example, they should have considered the overall going concern status of the company, and the impact on the valuation of property, plant and equipment as well as inventories.
There is also a risk that does not appear to have been considered by the Group audit manager in that the government regulation may affect other components of the group due to Daisy Co’s role in the group of developing and providing products to the other group companies, and therefore any restrictions on Daisy Co’s operations may affect all the other components of the group. This issue may also raise concerns over the work which has been conducted in relation to ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements and there is a risk that the Group auditor’s assessment of the legal and regulatory framework that affects the Group has not been sufficiently understood or documented.
The fact that the Group’s board members have not mentioned the regulation to the Group audit manager could indicate that the Group’s management is trying to hide the situation from the auditor. The audit manager should exercise professional skepticism and enquire further into the matter, as discussed below. If the Group’s management were genuinely unaware of the new regulations then corporate governance, especially in relation to risk monitoring and assessment would appear to be deficient. This impacts on the audit by increasing the risk of management bias and actions of management which may deliberately mislead the auditor.
In summary, this situation indicated a lack of quality in the group audit due to the over reliance on the audit findings of the component auditor. In addition, the group audit manager seems not to have considered the wider implications of the government regulation on the risk assessment for the group as a whole.
(ii) Further actions to be taken
Request the audit working papers from Foxglove & Co and review the work performed on the government regulation and its impact on the financial statements and going concern. The group audit team should confirm the materiality level which was used in audit procedures is in line with their assessment of an appropriate component materiality, and should ensure that appropriate methods were used to identify and respond to the risks of material misstatement.
The group audit team may decide that additional audit procedures are necessary, for example:
– Obtain the assessment of going concern performed by the management of Daisy Co and review the reasonableness of the assumptions used, especially those relating to future revenue streams and cash inflows
– Obtain a copy of the government regulation to understand the exact nature of the restrictions imposed and implications for the going concern of Daisy Co
In addition, the group assessment of going concern will need to be re-evaluated, taking into account the impact of the government regulation on the other Group companies. Given that the Group sells products in over 50 countries, it is likely that it is not just Daisy Co which is affected by this new regulation, and additional audit work should be performed on evaluating the going concern status of each company and of the Group as a whole.
Additional procedures should be performed on the $3 million goodwill balance recognised in respect of Daisy Co, to include a determination of the value in use of Daisy Co, based on future cash flows taking into account the likely impact of the government regulations.
Conclusion
​​​​​​​Overall, the problems noted in the Group audit indicate that the Group audit manager lacks competence, and that inappropriate judgements have been made. There are several instances of ISA requirements not being followed and the audit has not been performed with sufficient due care for professional standards. The Group audit manager should receive training on Group accounting and Group audit issues in order to resolve the deficiencies identified in the planning and performance of this audit, and to ensure that future audits are managed appropriately​​​​​​​.