Business Operations

<< ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT

Risk Assessment Procedures & Sources of Information >>

Fundamentals of Auditing ACC 311

Lesson 12

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

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.

Industry, regulatory and other External Factors, including the Applicable Financial

Reporting Framework

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 following:

· 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)

Legislation and regulation that significantly affect the entity's operations

Regulatory requirements (like; labor laws, minimum wage rate)

Direct supervisory activities (like; NAB, Excise & taxation Dept)

Taxation (corporate and other)

Government policies currently affecting the conduct of the

entity's business.

Monetary, including foreign exchange controls

Fiscal

Financial incentives (for example, government aid

programs)

Tariffs, trade restrictions

Environmental requirements affecting the industry and the

entity's business.

· 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 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.

Fundamentals of Auditing ACC 311

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 financial statements.

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 following:

Business Operations

· Nature of Business (for example, manufacturer, wholesaler, banking, insurance or other

financial services, import/export trading, utility, transportation and technology products

and services.

· 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 objectives, manufacturing

processes).

· 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 "just-in-time").

· Employment (for example, by location, supply, wage levels, union contracts, pension and

other post employment benefits, stock option or incentive bonus arrangements, and

government regulation related to employment matters).

· Research and development activities and expenditures.

· Transactions with related parties.

Investments

· 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

special-purpose entities.

Financing

· Group structure major subsidiaries and associated entities, including consolidated and

non-consolidated structures.

· Debt structure, including covenants, restrictions, guarantees, and off-balance-sheet

financing arrangements.

· Leasing of property, plant or equipment for use in the business.

· Beneficial owners (local, foreign, business reputation and experience)

· Related parties

· Use of derivative financial instruments.

Financial Reporting

· Accounting principles and industry specific practices.

· Revenue recognition practices.

· Accounting for fair values.

· Inventories (for example, locations, quantities).

Fundamentals of Auditing ACC 311

Foreign currency assets, liabilities and transactions.

Industry-specific significant categories (for example, loans and investments for banks,

accounts receivable and inventory for manufacturers, research and development for

pharmaceuticals).

Accounting for unusual or complex transactions including those in controversial or

emerging areas (for example, accounting for stock-based compensation).

Financial statement presentation and disclosure.

Table of Contents: