Auditing Investment in Subsidiary: A Comprehensive Technical Article

Investment in a subsidiary refers to the ownership interest held by one company in another company. This investment can take the form of stocks, bonds, or other securities.

The purpose of this article is to discuss the audit procedures for investment in a subsidiary and provide a comprehensive understanding of the process.

Accounting Under IFRS

International Financial Reporting Standards (IFRS) provide a framework for the recognition, measurement, and disclosure of investment in a subsidiary. The accounting for investment in a subsidiary depends on the level of control that the parent company holds over the subsidiary.

IFRS 9 Financial Instruments recognizes two types of investments in subsidiaries: those that result in control and those that do not result in control. Investments that result in control are accounted for as a subsidiary, while investments that do not result in control are accounted for as an associate, joint venture, or as a financial asset.

The recognition of investment in a subsidiary is based on the initial cost of the investment, while the measurement of the investment is based on its fair value. The fair value of the investment should be updated at the end of each reporting period.

Audit Risks

The audit of investment in a subsidiary is subject to several risks, including the following:

  1. Valuation Risks: The valuation of the investment in a subsidiary can be complex, especially when the subsidiary operates in a different business sector or operates in a different currency.
  2. Control Risks: The risk of control over the subsidiary by the parent company can be difficult to assess, especially in situations where the parent company has limited access to the subsidiary’s financial information.
  3. Accounting Risks: The accounting for investment in a subsidiary can be complex, and the auditor must have a good understanding of the accounting principles and requirements of IFRS.
  4. Management Override Risks: The risk of management override refers to the possibility that management may manipulate the financial statements to meet their objectives.
  5. Compliance Risks: The auditor must ensure that the subsidiary complies with all applicable laws and regulations, including tax laws and financial reporting standards.
  6. Inaccurate Financial Information Risks: The risk of inaccurate financial information is a concern when the subsidiary provides the parent company with limited access to its financial information.
  7. Misstatement Risks: The auditor must be able to identify and correct any misstatements in the financial information provided by the subsidiary.
  8. Non-compliance with IFRS Risks: The auditor must ensure that the subsidiary complies with all applicable IFRS requirements, including those related to recognition, measurement, and disclosure.
  9. Fraud Risks: The risk of fraud is always present in any financial transaction and must be considered by the auditor when auditing investment in a subsidiary.
  10. Audit Evidence Risks: The auditor must obtain sufficient appropriate audit evidence to support the conclusion reached in the audit of investment in a subsidiary.
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Auditing investment in a subsidiary requires a comprehensive understanding of the accounting principles and requirements of IFRS, as well as a thorough knowledge of the audit risks involved in the process. The auditor must be able to identify and assess these risks and develop appropriate audit procedures to mitigate them.

Audit assertions

Audit assertions are representations made by management in the financial statements that are implicit or explicit. They are essentially the basis for the auditor’s assessment of the financial statement risk and the design of the audit procedures.

The objective of the auditor is to obtain sufficient evidence to support the audit assertions and thereby obtain reasonable assurance that the financial statements are free from material misstatement.

The following are the most common audit assertions for investments in subsidiaries:

  1. Existence: The subsidiary exists and has ownership rights over the assets it claims to have.
  2. Completeness: All transactions, events and balances that pertain to the subsidiary have been recorded and are reflected in the financial statements.
  3. Valuation and Allocation: Assets, liabilities and equity are valued and allocated correctly in accordance with the accounting policies and principles.
  4. Presentation and Disclosure: The presentation and disclosure of transactions, events, and balances related to the subsidiary in the financial statements are in accordance with IFRS and are consistent with the subsidiary’s financial records.
  5. Cutoff: Transactions and events have been recorded in the appropriate period.
  6. Accuracy: Amounts and disclosures are accurate, complete and comply with IFRS.
  7. Classification: Transactions and balances have been appropriately classified and disclosed in the financial statements.
  8. Rights and Obligations: The subsidiary has rights and obligations in accordance with its contracts and agreements.
  9. Reliability of Information: Financial information is reliable and appropriate for the purposes for which it is used.
  10. Underlying Accounting Records: The subsidiary’s accounting records and systems of internal control provide a reasonable basis for preparation of the financial statements.

The auditor must consider these assertions and perform audit procedures to obtain sufficient evidence to support the assertions and to provide a reasonable basis for the auditor’s opinion.

Walkthrough testing

Walkthrough testing is a key component of the audit process for investments in subsidiaries. It is a process of evaluating a company’s internal control system by tracing transactions from source documents to recorded entries in the accounting system.

The objective of the walkthrough is to determine whether the client’s control system is sufficient to prevent or detect material misstatements in the financial statements.

The walkthrough testing process typically includes the following steps:

  1. Identify significant transactions or business processes: The auditor should start by identifying significant transactions or business processes related to the investment in the subsidiary.
  2. Evaluate the client’s internal control system: The auditor should evaluate the internal control system of the client and the subsidiary to identify any areas of weakness or control deficiencies.
  3. Trace transactions from source documents to recorded entries: The auditor should trace transactions from source documents to recorded entries in the accounting system to ensure that transactions are recorded accurately and in accordance with IFRS.
  4. Evaluate the completeness of recorded transactions: The auditor should evaluate the completeness of recorded transactions to ensure that all transactions have been recorded and that the financial statements are free from material misstatements.
  5. Test the accuracy of recorded transactions: The auditor should test the accuracy of recorded transactions by comparing them to source documents and by performing substantive analytical procedures.
  6. Evaluate the client’s control environment: The auditor should evaluate the client’s control environment to determine whether the company has established a culture of control and accountability.
  7. Document findings: The auditor should document all findings, including control deficiencies and areas of weakness, in order to provide evidence of the walkthrough testing process and to support the audit opinion.
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Overall, walkthrough testing is an important part of the audit process for investments in subsidiaries. By evaluating the internal control system and tracing transactions from source documents to recorded entries, the auditor can provide assurance that the financial statements are accurate and free from material misstatements.

Test of Control

Test of Control is an important aspect of auditing and is a procedure that auditors use to evaluate the effectiveness of an entity’s internal control over financial reporting.

The objective of the test of control is to provide the auditor with sufficient evidence to support a conclusion on the effectiveness of the entity’s internal control over financial reporting as of the balance sheet date.

The steps involved in the test of control procedure include:

  1. Identification of controls: The auditor should first identify the key controls that are in place to mitigate the risks related to the financial reporting process.
  2. Assessment of design: The auditor should assess the design of the controls to determine if they are appropriate to mitigate the identified risks.
  3. Performance testing: The auditor should perform tests to determine if the controls are being performed as designed and are operating effectively.
  4. Evaluating deficiencies: The auditor should evaluate any deficiencies in the internal control over financial reporting and determine if the deficiency is material.
  5. Documentation: The auditor should document all findings and conclusions, including the results of the test of control, in the audit work papers.
  6. Substantive testing: Based on the results of the test of control, the auditor should determine the extent of substantive testing required to support the financial statements.
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The test of control provides the auditor with a higher level of assurance over the financial statements than substantive testing alone. It also provides the auditor with a basis for reducing the level of substantive testing required.

However, it is important to note that a control that is effective in one period may not necessarily be effective in the next period, so the auditor should perform a test of control on a regular basis.

Substantive audit procedures

Substantive audit procedures are the procedures that auditors perform to obtain evidence and evaluate the financial information presented in the financial statements to obtain reasonable assurance that the financial statements are free from material misstatement.

The objective of substantive audit procedures is to provide auditors with the evidence they need to support their opinion on the financial statements. The following are the 10 substantive audit procedures for investment in subsidiary:

  1. Understanding the subsidiary: Auditors must understand the subsidiary’s business operations, internal control systems, and the nature of its investment in the subsidiary.
  2. Review of Intercompany Transactions: The auditor should review all transactions between the parent company and the subsidiary to ensure that they are properly recorded and that they comply with IFRS accounting standards.
  3. Assessment of Impairment: The auditor should assess the carrying amount of the investment and perform any necessary impairment tests as required by IFRS.
  4. Review of Financial Statements: The auditor should review the financial statements of the subsidiary to ensure that they comply with IFRS and that they are free from material misstatement.
  5. Valuation of Investments: The auditor should perform a detailed analysis of the investments in the subsidiary, including an assessment of their fair value and the method used to determine that fair value.
  6. Subsidiary’s Control Environment: The auditor should evaluate the subsidiary’s internal control environment, including its system of authorization, approval and monitoring.
  7. Review of Consolidated Financial Statements: The auditor should review the consolidated financial statements of the parent company and subsidiary to ensure that they comply with IFRS and that they are free from material misstatement.
  8. Subsidiary’s Accounting Policies: The auditor should review the accounting policies used by the subsidiary and compare them to those used by the parent company to ensure consistency and compliance with IFRS.
  9. Subsidiary’s Compliance with Laws and Regulations: The auditor should review the subsidiary’s compliance with laws and regulations, including its compliance with tax laws and regulations.
  10. Analytical Procedures: The auditor should perform analytical procedures on the subsidiary’s financial information to identify any significant fluctuations or unusual transactions that may indicate material misstatements in the financial statements.
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