UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT
AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
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
(a) Industry, regulatory, and other external factors, including
the applicable financial reporting
framework (like; insurance companies, leasing companies, banking
(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
(e) Internal control.
a) Industry, regulatory and other External Factors, including
the Applicable Financial
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
• Industry conditions
The market and
competition, including demand, capacity, and price competition.
Cyclical or seasonal
relating to the entity’s products
Energy supply and cost
• Regulatory environment
and industry specific practices
for a regulated industry (like; baking sector)
regulation that significantly affect the entity’s operations
(like; labor laws, minimum wage rate)
activities (like; NAB, Excise & taxation Dept)
Taxation (corporate and
currently affecting the conduct of the
foreign exchange controls
(for example, government aid
requirements affecting the industry and the
• Other external factors
currently affecting the entity’s business.
General level of
economic activity (for example, recession, growth)
Interest rates and
availability of financing
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.
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
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
• Nature of Business (for
example, manufacturer, wholesaler, banking, insurance or other
financial services, import/export trading, utility,
transportation and technology products
• 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
• 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
• Employment (for example,
by location, supply, wage levels, union contracts, pension and
other post employment benefits, stock option or incentive bonus
government regulation related to employment matters).
• Research and development
activities and expenditures.
• Transactions with
• 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
• Group structure – major
subsidiaries and associated entities, including consolidated and
• Debt structure,
including covenants, restrictions, guarantees, and off-balance-sheet
• Leasing of property,
plant or equipment for use in the business.
• Beneficial owners
(local, foreign, business reputation and experience)
• Related parties
• Use of derivative
• Accounting principles
and industry specific practices.
• Revenue recognition
• Accounting for fair
• Inventories (for
example, locations, quantities).
• Foreign currency assets,
liabilities and transactions.
significant categories (for example, loans and investments for banks,
accounts receivable and inventory for manufacturers, research
and development for
• Accounting for unusual
or complex transactions including those in controversial or
emerging areas (for example, accounting for stock-based
• Financial statement
presentation and disclosure.