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Lesson#13
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UNDERSTANDING THE ENTITY AND ITS
ENVIRONMENT-2
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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
b) Analytical procedures
• 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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48
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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