FUNDAMENTALS OF AUDITING ACC311 Lec 12
Lesson 12
UNDERSTANDING THE ENTITY
AND ITS ENVIRONMENT
AND ASSESSING THE RISKS
OF MATERIAL MISSTATEMENT
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
aspects:
(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
Fiscal
Financial
incentives (for example, government aid
programs)
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.
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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
processes).
• 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.
Investments
• 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.
Financing
• 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).
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• 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
pharmaceuticals).
• 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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