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Lesson#11
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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT
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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT
AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
Introduction
The standard requires 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
financial statements whether due to fraud or error, and
sufficient to design and perform other audit
procedures.
The standard provides guidance on the following:
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 and Sources of Information about
the Entity and Its Environment
Including Its Internal Control
Risk Assessment Procedures & Sources of Information
The auditor should perform the following risk assessment
procedures to obtain an understanding of the
entity and its environment, including its internal controls.
a) Inquiries of management and others within the entity;
b) Analytical procedures; and
c) Observation and inspection.
The auditor is not 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
required understanding.
In addition to the above 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
sources such as reports 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.
a) Inquiries
The auditor obtains 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
personnel and other employees. Inquiries from others may provide
an auditor with the following
information:
• Inquiries directed
towards those charged with governance may help the auditor understand
the environment in which the financial statements are prepared.
(such persons include the
representatives of board of directors, Chief finance officers
who are responsible of
designing internal control)
• Inquiries directed
towards internal audit personnel may relate to their activities concerning
the monitoring and effectiveness of the entity’s internal
control and whether management
has satisfactorily responded to any findings from these
activities.
• Inquiries of employees
involved in initiating, processing or recording complex or unusual
transactions (like; accounts managers etc.) may help the auditor
in evaluating the
appropriateness of the selection and application of certain
accounting policies.
• Inquiries directed
towards in-house legal counsel (like; company secretary, legal advisor
etc.) may relate to such matters as litigation, compliance with
laws and regulations,
knowledge of fraud or suspected fraud affecting the entity,
warranties, post-sales
obligations, arrangements (such as joint ventures) with business
partners and the meaning
of contract terms.
page
43
• Inquiries directed
towards marketing or sales personnel may relate to changes in the
entity’s marketing strategies, sales trends, or contractual
arrangements with its customers.
b) Analytical
procedures
These include ratio analysis, trend analysis, and common size
analysis of financial as well as non
financial information pertaining to the entity.
These procedures enable auditor to identify situation where
significant fluctuations exist,
relationships are not present as per expectations or unexpected
relationships exist.
c) Observation and
Inspection (walk through
procedures)
It may support inquiries of management and others and also
provide information about the entity
and its environment. Such audit procedures ordinarily include
the following:
• Observation of entity
activities and operations
• Inspection of documents
(such as business plans and strategies), records and internal
control manuals.
• Reading reports prepared
by management (such as quarterly management reports and
interim financial statements) and those charged with governance
(such as minutes of board
of directors’ meetings).
• Visits to the entity’s
premises and plant facilities.
• Tracing transactions
through the information system relevant to financial reporting (walkthrough).
Discussion among the Audit Team
The members of the engagement team should discuss the
susceptibility of the entity’s financial
statements to materials misstatements. Such discussion would
foster sharing of knowledge and
exchange of information.
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