Lesson 12


2. Understanding the Entity and Its Environment, including Its Internal Control
The auditor’s understanding of the entity and its environment consists of an understanding of the following
(a) Industry, regulatory, and other external factors, including the applicable financial reporting
framework (like; insurance companies, leasing companies, banking companies, textile
industry etc.). 
(b) Nature of the entity, including the entity’s selection and application of accounting policies
(like; sugar, textile, hotel, tourism, services, etc.). 
(c) Objectives and strategies and the related business risks that may result in a material
misstatement of the financial statements (like; growth maximization, cost effectiveness,
quality leadership, downsizing, etc.). 
(d) Measurement and review of the entity’s financial performance.
(e) Internal control. 

a) Industry, regulatory and other External Factors, including the Applicable Financial
 Reporting Framework
The auditor should obtain information about these. Such knowledge includes information about
competitors, suppliers, customers, technological developments, the regulatory environment, legal and
political environment and the environmental requirements affecting the industry and the entity. The auditor
should also consider general economic conditions.
 Examples of matters an auditor may consider include the following: 
• Industry conditions 
 The market and competition, including demand, capacity, and price competition. 
 Cyclical or seasonal activity  
 Product technology relating to the entity’s products  
 Energy supply and cost 
• Regulatory environment  
 Accounting principles and industry specific practices 
 Regulatory framework, for a regulated industry (like; baking sector) 
 Legislation and regulation that significantly affect the entity’s operations
 Regulatory requirements (like; labor laws, minimum wage rate)
 Direct supervisory activities (like; NAB, Excise & taxation Dept) 
 Taxation (corporate and other) 
 Government policies currently affecting the conduct of the
entity’s business. 
 Monetary, including foreign exchange controls
 Financial incentives (for example, government aid 
 Tariffs, trade restrictions 
 Environmental requirements affecting the industry and the
entity’s business. 
• Other external factors currently affecting the entity’s business. 
 General level of economic activity (for example, recession, growth) 
 Interest rates and availability of financing 
 Inflation currency revaluation.

b) Nature of the Entity
The nature of an entity refers to the entity’s operations, its ownership and governance, the types of
investments that it is making and plans to make, the way that the entity is structured and how it is financed. 

An understanding of the nature of an entity enables the auditor to understand the classes of transactions,
account balances, and disclosures to be expected in the financial statements.
The auditor should obtain an understanding of the accounting policies selected and their application. It
includes understanding the methods to account for significant and unusual transactions, the effect of
significant accounting policies in controversial areas and changes in accounting policies. The auditor should
assess appropriateness, of accounting policies selected and their consistency with financial reporting
framework and industry practice.
Examples of matters an auditor may consider include the following:

Business Operations 
• Nature of Business (for example, manufacturer, wholesaler, banking, insurance or other
financial services, import/export trading, utility, transportation and technology products
and services. 
• Products or services and markets (for example, major customers and contracts, terms of
payment, profit margins, market share, competitors, exports, pricing policies, reputation of
products, warranties, order book, trends, marketing strategy and objectives, manufacturing
• Conduct of operations (for example, stages and methods of production, business
segments, delivery of products and services, details of declining or expanding operations). 
• Alliances, joint ventures and outsourcing activities
• Involvement in electronic commerce, including internet sales and marketing activities.
• Geographic dispersion and industry segmentation.
• Location of production facilities, warehouses, and offices.
• Key customers.
• Important supplies of goods and services (for example, long-term contracts, stability of 
supply, terms of payment, imports, methods of delivery such as “just-in-time”).
• Employment (for example, by location, supply, wage levels, union contracts, pension and 
other post employment benefits, stock option or incentive bonus arrangements, and
government regulation related to employment matters). 
• Research and development activities and expenditures.
• Transactions with related parties. 
• Acquisitions, mergers or disposals of business activities (planned or recently executed).
• Investments and dispositions of securities and loans.
• Capital investment activities, including investments in plant and equipment and 
technology, and any recent or planned changes.
• Investments in non-consolidated entities, including partnerships, joint ventures and 
special-purpose entities. 
• Group structure – major subsidiaries and associated entities, including consolidated and 
non-consolidated structures.
• Debt structure, including covenants, restrictions, guarantees, and off-balance-sheet 
financing arrangements.
• Leasing of property, plant or equipment for use in the business.
• Beneficial owners (local, foreign, business reputation and experience)
• Related parties
• Use of derivative financial instruments. 
Financial Reporting 
• Accounting principles and industry specific practices.
Revenue recognition practices.
• Accounting for fair values.
• Inventories (for example, locations, quantities). 

• Foreign currency assets, liabilities and transactions.
• Industry-specific significant categories (for example, loans and investments for banks, 
accounts receivable and inventory for manufacturers, research and development for
• Accounting for unusual or complex transactions including those in controversial or
emerging areas (for example, accounting for stock-based compensation). 
• Financial statement presentation and disclosure

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