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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