ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT

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Fundamentals of Auditing ACC 311

Lesson 11

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.

Fundamentals of Auditing ACC 311

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.

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.

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 (walk-

through).

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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