UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT Topic 5

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT 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. The standard provides guidance on the following: Risk assessment procedures and sources of information about the entity and its environment including its internal control. Assessing the risk of material misstatement. Communicating with governance and management. Documentation.

Risk Assessment Procedures and 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. Inquiries of management and others within the entity; Analytical procedures Observation and inspection.

Cont.… The auditor is not required to apply all the risk assessment procedures for each aspect of the understanding required. The auditor may obtain information by making inquiries of the entity’s legal direction 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.

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 with governance may help the auditor understand the environment in which the financial statements are prepared. Inquiries directed towards internal audit personnel may relate to their activities concerning the monitoring of the entity’s internal control. Inquiries of employees involved in initiating, processing or recording complex or unusual transactions. Inquiries directed towards in-house legal counsel. Inquiries directed towards marketing or sales personnel.

Analytical Procedures These include ratio analysis, trend analysis, and common size analysis of financial as well as non financial information. These procedures enable auditor to identify situation where significant fluctuations exist. Observation and Inspection Observation of entity activities and operations Inspection of documents Reading reports Visits to the entity’s plant facilities.

Discussion among the Audit Team The members of the engagement team should discuss the weakness of the entity’s financial statements to materials misstatements. Such discussion would sharing of knowledge and exchange of information.

Understanding the Entity and Its Environment Industry, regulatory, and other external factors, including the applicable financial reporting framework Nature of the entity, including the entity’s selection and application of accounting policies. Objectives and strategies and the related business risks. Measurement and review of the entity’s financial performance. Internal control.

Examples of matters Industry conditions The market and competition, including demand, capacity, and price competition. Cyclical or seasonal activity Product technology relating to the entity’s products Energy supply and cost

Regulatory environment Accounting principles and industry specific practices Regulatory framework, for a regulated industry (like; baking sector) regulation that significantly affect the entity’s operations

Other external factors currently affecting the entity’s business. General level of economic activity (for example, recession, growth) Interest rates and availability of financing Inflation currency revaluation.

Nature of the Entity 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. It enables the auditor to understand the classes of transactions, account balances, and disclosures to be expected in the financial statements.

Examples of matters Business Operations Nature of Business Products or services and markets Conduct of operations joint ventures and outsourcing activities Key customers. Employment Research and development Transactions

Investments Acquisitions, mergers Investments and dispositions of securities and loans. Capital investment activities

Financing Group structure Debt structure Leasing of property, plant or equipment Beneficial owners Related parties Use of derivative financial instruments.

Financial Reporting Accounting principles and industry specific practices. Revenue recognition practices. Accounting for fair values. Inventories Foreign currency assets, liabilities and transactions Industry-specific significant categories Financial statement presentation