FUNDAMENTALS OF AUDITING ACC311 Lec 13
Lesson 13
UNDERSTANDING THE ENTITY
AND ITS ENVIRONMENT
AND ASSESSING THE RISKS
OF MATERIAL MISSTATEMENT
RECAP
Sources of Obtaining
Understanding
Auditor obtains an
understanding of the entity and environment, including its internal control
through:
1. Risk assessment
procedures and sources of information about the entity and its environment
including its internal
control.
2. Understanding the
entity and its environment, including its internal control.
3. Assessing the risk of
material misstatement.
4. Communicating with
those charged with governance and management.
5.
Documentation
1. Risk Assessment
Procedures & Sources of Information
Risk assessment
procedures to obtain an understanding
a) Inquiries directed
towards:
• Those charged with
governance
• Internal audit
personnel
• Middle management
(employees)
• Legal counsel
• Marketing or sales
personnel
• Financial
• Non financial
c) Observation and
inspection of:
• Observations of
Activities and operations
• Inspection of
Documents and records
• Reading Management
reports
• Visit to premises and
plant facilities
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) External Factors:
• Industry conditions
• Regulatory environment
• Macro economic level
factors
b) Nature of the
entity:
• Business operations
• Investments
• Financing
• Financial
reporting
c) Objectives and
strategies and the related business risks
• Potential related
business risk at existence of objective:
a) Industry developments
b) New products and
services
c) Expansion of the
business
d) New accounting
requirements
e) Regulatory requirements
f) Current and
prospective financing requirements
g) Use of IT
• Potential related
business risk at implementing a strategies:
a) Effects leading to
new accounting requirements
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d) Measurement and
review of the entity’s financial performance.
e) Internal
control.
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.
c) Objectives and
Strategies and Related Business Risks
The auditor should
obtain an understanding of the entity’s objectives and strategies and the
related
business risks that may
result in material misstatement of the financial statements.
Business Risk is
the risk that objectives and strategies would not be met
Examples of
matters an auditor may consider include the following:
• Existence of
objectives with reference to:
Industry
developments (a potential related business risk might be, for example,
that the entity does not
have the personnel or expertise to deal with the changes
like technological
changes in the industry).
New products and
services (a potential related business risk might be, for example,
that there is increased
product liability).
Expansion of the
business (a potential related business risk might be, for example,
that the demand has not
been accurately estimated).
New accounting
requirements (a potential related business risk might be, for
example, incomplete or
improper implementation, or increased costs).
Regulatory
requirements (a potential related business risk might be, for example
that there is increased
legal exposure).
Current and
prospective financing requirements (a potential related business risk
might be, for example,
the loss of financing due to the entity’s inability to meet
requirements).
Use of IT (a
potential related business risk might be, for example, that systems and
processes are
incompatible).
• Effects of
implementing a strategy, particularly any effects that will lead to new
accounting
requirements (a
potential related business risk might be, for example, incomplete or
improper implementation)
The auditor should keep
in mind that business risk is broader than the risk of material misstatement.
Business risks, at
times, do not cause any misstatement in the financial statements but affect the
going
concern.
Conditions and
events that may indicate risks of material misstatements are as follows:
The following are
examples of conditions and events that may indicate the existence of risks of
material
misstatement. The
examples provided cover a broad range of conditions and events; however, not
all
conditions and events
are relevant to every audit engagement and the list of examples is not
necessarily
complete.
• Operations in regions
that are economically unstable, for example, countries with significant
currency devaluation or
highly inflationary economies.
• Operations exposed to
volatile markets, for example, futures trading.
• High degree of complex
regulation.
• Going concern and
liquidity issues including loss of significant customers.
• Constraints on the
availability of capital and credit.
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• Changes in the
industry in which the entity operates.
• Changes in the supply
chain.
• Developing or offering
new products or services, or moving into new lines of business.
• Expanding into new
locations.
• Changes in the entity
such as large acquisitions or reorganizations or other unusual events.
• Entities or business
segments likely to be sold.
• Complex alliances and
joint ventures.
• Use of
off-balance-sheet finance, special-purpose entities, and other complex
financing
arrangements.
• Significant
transactions with related parties.
• Lack of personnel with
appropriate accounting and financial reporting skills.
• Changes in key
personnel including departure of key executive.
• Weaknesses in internal
control, especially those not addressed by management.
• Inconsistencies
between the entity’s IT strategy and its business strategies.
• Changes in the IT
environment.
• Installation of
significant new IT systems related to financial reporting.
• Inquiries into the
entity’s operations or financial results by regulatory or government bodies.
• Past misstatements,
history of errors or a significant amount of adjustments at period end.
• Significant amount of
non-routine or non-systematic transactions including inter-company
transactions and large
revenue transactions at period end.
• Transactions that are
recorded based on management’s intent, for example, debt refinancing,
assets
to be sold and
classification of marketable securities.
• Application of new
accounting pronouncements.
• Accounting
measurements that involve complex processes.
• Events or transactions
that involve significant measurement uncertainty, including accounting
estimates.
• Pending litigation and
contingent liabilities for example, sales warranties, financial guarantees
and
environmental remediation
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