Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement

The auditor needs to obtain an understanding of the entity and its environment and assess the risks of material misstatement in a financial report audit in accordance with ASA 315 Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement. The auditor needs to perform risk assessment procedures to obtain an understanding of the entity and its environment, including its internal control.

If the auditor assesses significant risks in the area of investments in associates, this will impact all areas of the audit including planning, audit testing and gathering of appropriate audit evidence to mitigate these risks.

Planning an Audit of Investments in Associates

The audit of equity accounting balances and adjustments requires adequate attention during the planning of the audit. The auditor develops the audit plan in accordance with ASA 300 Planning an Audit of a Financial Report and ASA 330 The Auditor’s Responses to Assessed Risks to ensure that sufficient appropriate audit evidence concerning the investment in associates is made available to the auditor of the investor. The auditor considers materiality and its relationship with audit risk in accordance with ASA 320 Materiality and Audit Adjustments and in conjunction with the auditor’s risk assessments, in the planning and conduct of the audit.

The investor’s auditor may meet with the management of the investor and plan in relation to such matters as:

1. the provision of evidence to support identification of associates;
2. the nature and the adequacy of policies and adjustments between the investor and the associate for dissimilar accounting policies, transactions, balances, and reciprocal shareholdings;
3. the accounting timetable and the availability of the associate’s financial reports (especially in relation to the provision of information required for the application of equity accounting), and any other information considered necessary;
4. the procedures to identify events subsequent to balance date for the associate; and
5. contact with the associate’s auditor where necessary, when the associate is not audited by the investor’s auditor.

The investor’s auditor also considers whether there are any legal restrictions that may affect the availability of information from an associate. There may be legal restrictions applicable to the communication of confidential information by those charged with governance, to third parties. However, representatives of the investor on the investee’s governing body may make available information to the investor they represent. This is normally subject to the condition that it is done with the knowledge of the investee governance body, and is in the best interests of the investee. If the investor is not able to obtain necessary information from the investee, the presumption of significant influence requires further clarification. The refusal by the investee may demonstrate a lack of significant influence by the investor or may be the result of a legal restriction on the investee as to the information it can make available. Legal restrictions may also apply to the investor publishing information about the associate which has not been made available to the other equity holders of the associate.

Identification of Associates

The responsibility for establishing whether or not significant influence exists rests with those charged with governance of the investor. The evidence used to determine significant influence is obtained by the auditor and documented in the audit working papers.

Generally, where an investor holds directly or indirectly, 20 per cent or more of the voting power in an investee, in the absence of evidence to the contrary, there could be the presumption of significant influence. However, this percentage is not an absolute cut-off point. In certain cases, an investee will qualify as an associate, notwithstanding that the investor’s voting power in the investee is less than, or has fallen below, 20 per cent. The converse also applies. Hence, voting power in an investee comprises only part of the audit evidence to support significant influence.

AASB 128 provides examples of factors which individually, or in combination, may indicate the existence of significant influence. In cases where those charged with governance of the investor are asserting that the provisions of AASB 128 apply, the auditor would expect to be provided with evidence to support the assertion. The auditor examines and evaluates that evidence in accordance with ASA 500 Audit Evidence.

Examples of the evidence that the auditor examines, depending on the assertions being made, are:

1. the investee’s constituent document. This may indicate that the remainder of the voting power of the investee is concentrated with a limited number of equity holders, which precludes the investor from exercising significant influence, or alternatively, that the remainder of the voting power is so widely dispersed that the investor is able to exercise significant influence;
2. the composition of the investee governance body, and if available, extracts of documents indicating that policy decisions made by the investor concerning the investee have been implemented by the investee, with particular reference to control over the distribution or retention of the investee’s profits;
3. the agreements and actual level of technical and/or physical facility dependence by the investee on the investor, and an evaluation of that dependence in terms of the investee’s overall technical and physical facilities;
4. the type and volume of transactions between the investor and the investee and the terms of trading between the entities, the status and details of loans and current accounts with the investee, and details of any guarantees to third parties provided by or on behalf of the investee, with an evaluation, in terms of the investee’s overall position, of the level of financial dependence by the investee on the investor; and
5. the agreements and actual level and type of staff interchange or staff services between the investor and investee.

The auditor evaluates the information presented by the management or governing body of the investee, and applies a combination of procedures appropriate to the circumstances, to form an opinion on the assertion of significant influence, or otherwise, made by those charged with governance. Such procedures could include:

1. an examination and evaluation of the investor’s system of internal control over transactions between the investor and investee as a basis for understanding the type and volume of transactions between the investor and investee;
2. inspection of relevant contracts and agreements between the investor and investee;
3. inspection of the investor’s minutes of meetings for details of decisions made concerning the relationship between the investor and the investee, and the activities of both parties;
4. discussions with relevant investor personnel, and where possible, relevant investee personnel, and/or examination of a statement from the investee stating that it accepts the investor is in a position to exercise significant influence over it;
5. confirmation of transactions and balances with the investee;
6. confirmation and enquiry with external parties, for example: solicitors as to the existence and interpretation of agreements; banks as to the existence and details of guarantees; and credit agencies as to enquiries that cannot be dealt with directly by the auditor;
7. computation and checking of details with supporting accounting records; and
8. analysis of the financial reports of the associate.

Information from Associates

To audit equity accounting adjustments, relevant information about an associate is required for the auditor to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions. AASB 128 requires the investor to use the most recent financial information available to the equity holders of the associate and if the reporting dates of the associate and that of the investor are different; the difference shall be no more than three months. The auditor ascertains whether this information is adequate, and in form and content appropriate for the purpose of accounting for the equity interests of an investor. This aspect of the audit emphasises the need for adequate planning as detailed in paragraphs 13 and 14.

Adjustments are required to:

1. address differences in the accounting policies adopted by an associate to achieve consistency with the accounting policies of the investor;
2. eliminate intra group balances, transactions, income and expenses in full between the associate and:
   1. the investor and its controlled entities (the economic entity);
   2. another associate of the investor.

Using materiality and knowledge of internal controls, the auditor assesses the risk attached to these adjustments.

In some cases unaudited financial information is provided by the associate for equity accounting purposes. Unaudited financial reports or other information and data provide evidential matter which is not of itself sufficient appropriate audit evidence for the investor’s auditor to evaluate the accounting for investments in associates. In this respect, the auditor needs to consider the impact of matters noted in the following paragraphs to assess whether there is a limitation of scope.