FUNDAMENTALS OF AUDITING ACC311 Lec 11
Lesson 11
UNDERSTANDING THE ENTITY
AND ITS ENVIRONMENT
AND ITS ENVIRONMENT
AND ASSESSING THE RISKS
OF MATERIAL MISSTATEMENT
OF MATERIAL MISSTATEMENT
Introduction
The standard requires
that auditor should obtain an understanding of the entity and its environment,
that auditor should obtain an understanding of the entity and its environment,
including its internal
control, sufficient to identify and assess the risks of material misstatement
of the
control, sufficient to identify and assess the risks of material misstatement
of the
financial statements
whether due to fraud or error, and sufficient to design and perform other audit
whether due to fraud or error, and sufficient to design and perform other audit
procedures.
The standard provides
guidance on the following:
guidance on the following:
1. Risk assessment
procedures and sources of information about the entity and its
procedures and sources of information about the entity and its
environment including
its internal control.
its internal control.
2. Understanding the
entity and its environment, including its internal control.
entity and its environment, including its internal control.
3. Assessing the risk of
material misstatement.
material misstatement.
4. Communicating with
those charged with governance and management.
those charged with governance and management.
5. Documentation.
1. Risk Assessment
Procedures and Sources of Information about the Entity and Its
Environment
Procedures and Sources of Information about the Entity and Its
Environment
Including Its Internal
Control
Control
Risk Assessment
Procedures & Sources of Information
Procedures & Sources of Information
The auditor should perform
the following risk assessment procedures to obtain an understanding of the
the following risk assessment procedures to obtain an understanding of the
entity and its
environment, including its internal controls.
environment, including its internal controls.
a) Inquiries of
management and others within the entity;
management and others within the entity;
b) Analytical
procedures; and
procedures; and
c) Observation and
inspection.
inspection.
The auditor is not
required to apply all the risk assessment procedures for each aspect of the
understanding
required to apply all the risk assessment procedures for each aspect of the
understanding
required. However, all
the above risk assessment procedures are applied in the course of obtaining the
the above risk assessment procedures are applied in the course of obtaining the
required understanding.
In addition to the above
procedures, the auditor may obtain information by making inquiries of the
entity’s
procedures, the auditor may obtain information by making inquiries of the
entity’s
legal counsel or of
valuation experts that the entity has used. Reviewing information obtained from
external
valuation experts that the entity has used. Reviewing information obtained from
external
sources such as reports
by analysts, banks, or rating agencies, trade and economic journals or
regulatory or
by analysts, banks, or rating agencies, trade and economic journals or
regulatory or
financial publications
may also be useful in obtaining information about the entity.
may also be useful in obtaining information about the entity.
a) Inquiries
The auditor obtains
information from management and those responsible for financial reporting.
However,
information from management and those responsible for financial reporting.
However,
useful information can
be obtained from others within the entity like production staff, internal audit
be obtained from others within the entity like production staff, internal audit
personnel and other
employees. Inquiries from others may provide an auditor with the following
employees. Inquiries from others may provide an auditor with the following
information:
• Inquiries directed
towards those charged with governance may help the auditor understand
towards those charged with governance may help the auditor understand
the environment in which
the financial statements are prepared. (such persons include the
the financial statements are prepared. (such persons include the
representatives of board
of directors, Chief finance officers who are responsible of
of directors, Chief finance officers who are responsible of
designing internal
control)
control)
• Inquiries directed
towards internal audit personnel may relate to their activities concerning
towards internal audit personnel may relate to their activities concerning
the monitoring and
effectiveness of the entity’s internal control and whether management
effectiveness of the entity’s internal control and whether management
has satisfactorily
responded to any findings from these activities.
responded to any findings from these activities.
• Inquiries of employees
involved in initiating, processing or recording complex or unusual
involved in initiating, processing or recording complex or unusual
transactions (like;
accounts managers etc.) may help the auditor in evaluating the
accounts managers etc.) may help the auditor in evaluating the
appropriateness of the
selection and application of certain accounting policies.
selection and application of certain accounting policies.
• Inquiries directed
towards in-house legal counsel (like; company secretary, legal advisor
towards in-house legal counsel (like; company secretary, legal advisor
etc.) may relate to such
matters as litigation, compliance with laws and regulations,
matters as litigation, compliance with laws and regulations,
knowledge of fraud or
suspected fraud affecting the entity, warranties, post-sales
suspected fraud affecting the entity, warranties, post-sales
obligations,
arrangements (such as joint ventures) with business partners and the meaning
arrangements (such as joint ventures) with business partners and the meaning
of contract terms.
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• Inquiries directed
towards marketing or sales personnel may relate to changes in the
towards marketing or sales personnel may relate to changes in the
entity’s marketing
strategies, sales trends, or contractual arrangements with its customers.
strategies, sales trends, or contractual arrangements with its customers.
b) Analytical
procedures
procedures
These include ratio
analysis, trend analysis, and common size analysis of financial as well as non
analysis, trend analysis, and common size analysis of financial as well as non
financial information
pertaining to the entity.
pertaining to the entity.
These procedures enable
auditor to identify situation where significant fluctuations exist,
auditor to identify situation where significant fluctuations exist,
relationships are not
present as per expectations or unexpected relationships exist.
present as per expectations or unexpected relationships exist.
c) Observation and
Inspection (walk through procedures)
Inspection (walk through procedures)
It may support inquiries
of management and others and also provide information about the entity
of management and others and also provide information about the entity
and its environment.
Such audit procedures ordinarily include the following:
Such audit procedures ordinarily include the following:
• Observation of entity
activities and operations
activities and operations
• Inspection of
documents (such as business plans and strategies), records and internal
documents (such as business plans and strategies), records and internal
control manuals.
• Reading reports
prepared by management (such as quarterly management reports and
prepared by management (such as quarterly management reports and
interim financial
statements) and those charged with governance (such as minutes of board
statements) and those charged with governance (such as minutes of board
of directors’
meetings).
meetings).
• Visits to the entity’s
premises and plant facilities.
premises and plant facilities.
• Tracing transactions
through the information system relevant to financial reporting (walk-
through the information system relevant to financial reporting (walk-
through).
Discussion among
the Audit Team
the Audit Team
The members of the
engagement team should discuss the susceptibility of the entity’s financial
engagement team should discuss the susceptibility of the entity’s financial
statements to materials
misstatements. Such discussion would foster sharing of knowledge and
misstatements. Such discussion would foster sharing of knowledge and
exchange of information
