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Fundamentals of Auditing

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Fundamentals of Auditing ­ACC 311
VU
Lesson 13
UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT
AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
RECAP
Sources of Obtaining Understanding
Auditor obtains an understanding of the entity and environment, including its internal control through:
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 & Sources of Information
Risk assessment procedures to obtain an understanding
a) Inquiries directed towards:
 Those charged with governance
 Internal audit personnel
 Middle management (employees)
 Legal counsel
 Marketing or sales personnel
b) Analytical procedures
 Financial
 Non financial
c) Observation and inspection of:
 Observations of Activities and operations
 Inspection of Documents and records
 Reading Management reports
 Visit to premises and plant facilities
2.
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
aspects:
a) External Factors:
 Industry conditions
 Regulatory environment
 Macro economic level factors
b) Nature of the entity:
 Business operations
 Investments
 Financing
 Financial reporting
c) Objectives and strategies and the related business risks
 Potential related business risk at existence of objective:
a) Industry developments
b) New products and services
c) Expansion of the business
d) New accounting requirements
e) Regulatory requirements
f)  Current and prospective financing requirements
g) Use of IT
 Potential related business risk at implementing a strategies:
a) Effects leading to new accounting requirements
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Fundamentals of Auditing ­ACC 311
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d) Measurement and review of the entity's financial performance.
e) Internal control.
2.
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 aspects:
(a)
Industry, regulatory, and other external factors, including the applicable financial reporting
framework (like; insurance companies, leasing companies, banking companies, textile
industry etc.).
(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 performance.
(e)
Internal control.
c)
Objectives and Strategies and Related Business Risks
The auditor should obtain an understanding of the entity's objectives and strategies and the related
business risks that may result in material misstatement of the financial statements.
Business Risk is the risk that objectives and strategies would not be met
Examples of matters an auditor may consider include the following:
 Existence of objectives with reference to:
Industry developments (a potential related business risk might be, for example,
that the entity does not have the personnel or expertise to deal with the changes
like technological changes in the industry).
New products and services (a potential related business risk might be, for example,
that there is increased product liability).
Expansion of the business (a potential related business risk might be, for example,
that the demand has not been accurately estimated).
New accounting requirements (a potential related business risk might be, for
example, incomplete or improper implementation, or increased costs).
Regulatory requirements (a potential related business risk might be, for example
that there is increased legal exposure).
Current and prospective financing requirements (a potential related business risk
might be, for example, the loss of financing due to the entity's inability to meet
requirements).
Use of IT (a potential related business risk might be, for example, that systems and
processes are incompatible).
 Effects of implementing a strategy, particularly any effects that will lead to new accounting
requirements (a potential related business risk might be, for example, incomplete or
improper implementation)
The auditor should keep in mind that business risk is broader than the risk of material misstatement.
Business risks, at times, do not cause any misstatement in the financial statements but affect the going
concern.
Conditions and events that may indicate risks of material misstatements are as follows:
The following are examples of conditions and events that may indicate the existence of risks of material
misstatement. The examples provided cover a broad range of conditions and events; however, not all
conditions and events are relevant to every audit engagement and the list of examples is not necessarily
complete.
 Operations in regions that are economically unstable, for example, countries with significant
currency devaluation or highly inflationary economies.
 Operations exposed to volatile markets, for example, futures trading.
 High degree of complex regulation.
 Going concern and liquidity issues including loss of significant customers.
 Constraints on the availability of capital and credit.
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Fundamentals of Auditing ­ACC 311
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Changes in the industry in which the entity operates.
Changes in the supply chain.
Developing or offering new products or services, or moving into new lines of business.
Expanding into new locations.
Changes in the entity such as large acquisitions or reorganizations or other unusual events.
Entities or business segments likely to be sold.
Complex alliances and joint ventures.
Use of off-balance-sheet finance, special-purpose entities, and other complex financing
arrangements.
Significant transactions with related parties.
Lack of personnel with appropriate accounting and financial reporting skills.
Changes in key personnel including departure of key executive.
Weaknesses in internal control, especially those not addressed by management.
Inconsistencies between the entity's IT strategy and its business strategies.
Changes in the IT environment.
Installation of significant new IT systems related to financial reporting.
Inquiries into the entity's operations or financial results by regulatory or government bodies.
Past misstatements, history of errors or a significant amount of adjustments at period end.
Significant amount of non-routine or non-systematic transactions including inter-company
transactions and large revenue transactions at period end.
Transactions that are recorded based on management's intent, for example, debt refinancing, assets
to be sold and classification of marketable securities.
Application of new accounting pronouncements.
Accounting measurements that involve complex processes.
Events or transactions that involve significant measurement uncertainty, including accounting
estimates.
Pending litigation and contingent liabilities for example, sales warranties, financial guarantees and
environmental remediation.
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Table of Contents:
  1. AN INTRODUCTION
  2. AUDITORSí REPORT
  3. Advantages and Disadvantages of Auditing
  4. OBJECTIVE AND GENERAL PRINCIPLES GOVERNING AN AUDIT OF FINANCIAL STATEMENTS
  5. What is Reasonable Assurance
  6. LEGAL CONSIDERATION REGARDING AUDITING
  7. Appointment, Duties, Rights and Liabilities of Auditor
  8. LIABILITIES OF AN AUDITOR
  9. BOOKS OF ACCOUNT & FINANCIAL STATEMENTS
  10. Contents of Balance Sheet
  11. ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
  12. Business Operations
  13. Risk Assessment Procedures & Sources of Information
  14. Measurement and Review of the Entityís Financial Performance
  15. Definition & Components of Internal Control
  16. Auditing ASSIGNMENT
  17. Benefits of Internal Control to the entity
  18. Flow Charts and Internal Control Questionnaires
  19. Construction of an ICQ
  20. Audit evidence through Audit Procedures
  21. SUBSTANTIVE PROCEDURES
  22. Concept of Audit Evidence
  23. SUFFICIENT APPROPRIATE AUDIT EVIDENCE AND TESTING THE SALES SYSTEM
  24. Control Procedures over Sales and Debtors
  25. Control Procedures over Purchases and Payables
  26. TESTING THE PURCHASES SYSTEM
  27. TESTING THE PAYROLL SYSTEM
  28. TESTING THE CASH SYSTEM
  29. Controls over Banking of Receipts
  30. Control Procedures over Inventory
  31. TESTING THE NON-CURRENT ASSETS
  32. VERIFICATION APPROACH OF AUDIT
  33. VERIFICATION OF ASSETS
  34. LETTER OF REPRESENTATION VERIFICATION OF LIABILITIES
  35. VERIFICATION OF EQUITY
  36. VERIFICATION OF BANK BALANCES
  37. VERIFICATION OF STOCK-IN-TRADE AND STORE & SPARES
  38. AUDIT SAMPLING
  39. STATISTICAL SAMPLING
  40. CONSIDERING THE WORK OF INTERNAL AUDITING
  41. AUDIT PLANNING
  42. PLANNING AN AUDIT OF FINANCIAL STATEMENTS
  43. Audits of Small Entities
  44. AUDITORíS REPORT ON A COMPLETE SET OF GENERAL PURPOSE FINANCIALSTATEMENTS
  45. MODIFIED AUDITORíS REPORT