The Required Understanding of the Entity and its Environment, Including the
Entity’s Internal Control
The Entity and Its Environment
11. The auditor shall obtain an understanding of the following:
(a) Relevant industry, regulatory, and other external factors including the
applicable financial reporting framework. (Ref: Para. A15-A20)
Industry Factors
A15. Relevant industry factors include industry conditions such as the
competitive environment, supplier and customer relationships, and
technological developments.
There are approximately 20 hat manufacturers in the industry and only five of them
are in the western-style market. In the western market, Lone Star is the smallest
manufacturer, but it pulls in about 10 percent of the market. It generates its sales
from orders placed at fashion shows and buyers’ conventions and by direct contact
with retail outlets in major marketing areas by the company’s five sales
representatives. Together with Wiggins’ past experiences and acquaintance with the
buyers and industry in general, Lone Star has its designer to thank for this success
as he is considered one of the best in the industry. The designer generally sketches
ideas for new styles and creates models for Wiggins and the board of directors to
review. The company currently has five standard designs in the product line but
annually; modifications are made to give a “new twist” to the product line.
In the retail market, Lone Star sells its hats for prices between $60 and $80 each,
and the normal retail markup is 100 percent of cost. The company has been most
successful in establishing itself in the higher priced market, with approximately 90
percent of its sales in the $75 to $80 retail price range. The demand for western-
style hats has been strong for the past five years. Nevertheless, Wiggins believes that
demand will stabilize in the next two to three years.
Regulatory Factors
A17. Relevant regulatory factors include the regulatory environment. The
regulatory environment encompasses, among other matters, the applicable
financial reporting framework and the legal and political environment.
 Accounting principles and industry specific practices
Lone Star’s cost accounting records are maintained on a job order basis. They
maintain a moving average cost for the basic raw material input – fur fibers. They
also use average costs for finishing materials, which are purchased from suppliers.
In addition, a standard rate for charging overhead has been calculated and is applied
to the jobs during the year. Lone Star is considering adopting a standard cost
system, however Wiles has not had an opportunity to begin such a study. Also, she
states that the company closes the plant for the last week of the fiscal year for
Commented [MM1]: A comparison is made between the
client and its close competitors nationally and
internationally. When an auditor has a number of clients that
operate in the one industry, this stage of the audit is more
straightforward than if the client operates in an industry that
the auditor is not already familiar with. The level of
competition in the client’s industry is assessed. The more
competitive the client’s industry, the more pressure placed
on the client’s profits. In an economic downturn, the weakest
companies in highly competitive industries face financial
hardship and possible liquidation. A key issue for an auditor
is their client’s position among its competitors and its ability
to withstand downturns in the economy. An auditor also
considers their client’s reputation relative to other
companies in the same industry. If the client has a poor
reputation, customers and suppliers may shift their business
to a competing firm, threatening their client’s profits. The
auditor can assess their client’s reputation by reading articles
in the press and industry publications.
Commented [MM2]: The level of demand for the goods
sold or services provided by companies in the client’s
industry is considered. If a client’s products or services are
seasonal, this will affect revenue flow. If a client is an ice-
cream producer, sales would be expected to increase in
summer. However, if the weather is unseasonal, profits may
suffer. If a client sells swimsuits, sales will fall in a cool
summer. If a client sells ski equipment, sales will fall if the
winter brings little snow. If a client operates in an industry
subject to changing trends, such as fashion, the client risks
inventory obsolescence if it does not keep up and move
quickly with changing styles
vacation and annual maintenance of the machinery. Thus, there is no work in
process inventory at year-end.

In addressing the issue of the direct charge-off method of accounting for bad debts,
Wiles states that the company adopted from buyers’ conventions, and in the past
there have been negligible charge-offs. Some companies in the industry do use the
allowance method, but she prefers the direct charge-off method, given the
company's past credit experiences. However, the management may reevaluate the
continued use of the method in 19X2. Revenues are not recognized until shipment
occurs, and monthly financial statements and related reports are generated
internally from a trial balance of the general ledger. Lease commitments were also
discussed, and Wiles states that the previous auditor agreed that the leases on the
building and computer should be treated as operating leases.

(b) The nature of the entity, including:

Nature of the Entity (Ref: Para.11(b))

A21. An understanding of the nature of an entity enables the auditor to
understand such matters as:
• Whether the entity has a complex structure, for example with subsidiaries or
other components in multiple locations. Complex structures often introduce
issues that may give rise to risks of material misstatement. Such issues may
include whether goodwill, joint ventures, investments, or special-purpose
entities are accounted for appropriately.

Negotiations were held for the acquisition of the Western Hat Co. from A.J.
Studebaker, and an agreement reached during the latter part of 19W7. Wiggins
believes the purchase terms were very favorable. He noted that there was no
goodwill entered on the books in recording the acquisition. Wiggins was able to
attract some top management from Western Boot to join the venture and, for the
most part, the labor force of Western Hat was retained.

(i) Its operations;

○ Nature of revenue sources, products or services, and markets, including
involvement in electronic commerce such as Internet sales and marketing
activities.
Lone Star was incorporated and commenced operations in January, 19W8. The
company presently has executive offices and manufacturing operations located in a
leased 300,000 square feet facility at 3810 Longhorn Drive, Blg City. The company
has 110 employees involved in manufacturing operations and 35 in the executive
offices. At the present time Lone Star purchases raw materials and converts the
materials into western-type felt hats. The company had facilities to produce hats in a
wide variety of styles and sizes. Although operations are currently limited to a single
product line, the board of directors anticipates that as business continues to expand,
other items, such as boots and belts, will be added to the product line. The company
distributes its hats to retail chain and western apparel shops throughout the
country. The company’s sales representatives attend buyers’ conventions and
fashion shows nationwide. In addition, company representatives contact buyers
directly concerning the company’s products in certain high-volume regions.
○ Conduct of operations (for example, stages and methods of production, or
activities exposed to environmental risks).

Wiggins describes the hat manufacturing business, stating that mass production of
hats involves three stages: designing, manufacturing, and selling.

Designing: Lone Star employs a designer who reports directly to McCartin (VP-
marketing). The designer generally sketches ideas for new styles and creates models
for Wiggins and the board of directors to review. Although the company has several
standard designs, modifications are generally made each year to give a “new twist”
to the product line. Presently there are five styles of hats included in the line.
Samples of new styles are displayed at various fashion shows and buyers’
conventions, which are attended by the designer and sales representatives. After
orders are received, they are processed, and shipment is made directly to the retail
customer.

Manufacturing: Lone Star currently manufactures felt hats which are made from
fur fibers purchased from suppliers. The fiber, normally rabbit, is weighted into
quantities of about three ounces, enough for one hat. The pieces of fur are formed
around a cone and placed in hot water where they shrink and mesh together to form
a piece of felt. At this time color dyes are added. The felt is shaped in the rough form
of a hat on a stretching machine and then placed on a pattern head block, which
shapes the crown and brim of the hat to the desired size. At this point the hat is
stiffened with a chemical, and after drying, a smooth finish is obtained by sanding
the hat on a pouncing (sanding) machine. The brim is trimmed on a cutting machine
and then rolled and dressed. The hat is completed when sweatbands, inner linings,
and decorative bands and sewn into the hat in the finishing area.

Selling: Wiggins notes that 55 percent of the company's sales are generated from
orders placed at fashion shows and buyers' conventions. The remaining 15 percent
of the company's annual sales volume is generated by direct contact with retail
outlets in major marketing areas by the company's five sales representatives.

○ Location of production facilities, warehouses, and offices, and location

and quantities of inventories.
The company presently has executive offices and manufacturing operations located
in a leased 300,000 square feet facility at 3810 Longhorn Drive, Big City.

○ Key customers and important suppliers of goods and services, employment

arrangements (including the existence of union contracts, pension and other
post employment benefits, stock option or incentive bonus arrangements, and
government regulation related to employment matters)

Ross Crothers stated that there are 110 employees in the plant. Lone Star is not
presently unionized and, according to Crothers, wages are competitive with union
shops in order to reduce the potential for employee unionization.

(ii) Its ownership and governance structures;

The ownership, and relations between owners and other people or entities.
This understanding assists in determining whether related party transactions
have been identified and accounted for appropriately. PSA 550, “Related
Parties,” establishes requirements and provides guidance on the auditor’s
considerations relevant to related parties.

Wiggins owns 65 percent of the outstanding stock of Lone Star. Three individuals
who are also officers of the corporation hold the remaining 35 percent. Catherine
Meyer, vice president and secretary-treasurer, 15 percent ownership; Ross
Crothers, vice president – manufacturing, 10 percent ownership; and Claire
McCartin, vice president – marketing, 10 percent ownership. The attorney for Lone
Star is Warren Ramsay, Wiggins’ brother in law. Neither Ramsey nor Wiles, the
controller, has any ownership interest in Lone Star at the present time.

(iii) The types of investments that the entity is making and plans to make; and

Investments and investment activities – such as:

○ Planned or recently executed acquisitions or divestitures.

Lone Star’s operations are currently limited to a single product line; the board of
directors anticipates that as business continues to expand, other items, such as
boots and belts, will be added to the product line. In addition to long range plans for
expansion into other items of western apparel, the company has considered
acquiring western apparel retail outlets in selection major cities in the region; the
first would be located in Big City. Wiggins was previously associated with a large
manufacturer of western boots, and he believes this experience will prove valuable
in implementing Lone Star’s plans for expansion.
(iv) The way that the entity is structured and how it is financed, to enable the
auditor to understand the classes of transactions, account balances, and
disclosures to be expected in the financial statements. (Ref: Para. A21-
A23)
Discussion with Catherine Meyer (VP and secretary-treasurer) concerns the
company's banking arrangements and future needs for capital. Meyer notes that
prudently all the company's banking is handled through the First National Bank of
Big City where the company maintains a checking account, time deposit account,
and a separate payroll account.
To date, the company has been able to finance expansion through internally
generated funds; however, the board recently decided to consider borrowing from
the bank to raise future capital. This is especially important in the event that future
expansion plans materialize since there will be an initial drain on the financial
resources of the company. In order to begin planning these needs, preliminary
discussions have been held with the bank regarding possible lines of credit and
long-term borrowing arrangements.

(c) The entity’s selection and application of accounting policies, including the
reasons for changes thereto. The auditor shall evaluate whether the entity’s
accounting policies are appropriate for its business and consistent with the
applicable financial reporting framework and accounting policies used in the
relevant industry. (Ref: Para. A24)

Wiles relates that the company's cost accounting records are maintained on a job
order basis. The company maintains a moving average cost for the basic raw
material input, fur fibers. They also use average costs for finishing materials (bands,
etc.), which are purchased from suppliers. In addition, a standard rate for charging
overhead has been calculated and is applied to the jobs during the year. Wiles
mentions that Lone Star is considering adopting a standard cost system; however
she has not had an opportunity to begin such a study. Also, she states that the
company closes the plant for the last week of the fiscal year for vacation and annual
maintenance of the machinery. Thus, there is no work in process inventory at
yearend.
Discussion with Wiles centers on the notes to last year's financial statements. The
issue of the direct charge-of method of accounting for bad debts was addressed, and
Wiles states that the company adopted form buyers' conventions, and in the past
there have been negligible charge-offs. She admits that some companies in the
industry do use the allowance method, but she prefers the direct charge-off method,
given the company's past credit experiences. However, management may reevaluate
the continued use of the method in 19X2.
Wiles also said that revenues are not recognized until shipment occurs, and monthly
financial statements and related reports are generated internally from a trial
balance of the general ledger. The lease commitments were also discussed, and
Wiles states that the previous auditor agreed that the leases on the building and
computer should be treated as operating leases.
(d) The entity’s objectives and strategies, and those related business risks that
may result in risks of material misstatement.

A25. The entity conducts its business in the context of industry, regulatory and
other internal and external factors. To respond to these factors, the entity’s
management or those charged with governance define objectives, which are
the overall plans for the entity. Strategies are the approaches by which
management intends to achieve its objectives. The entity’s objectives and
strategies may change over time.

(e) The measurement and review of the entity’s financial performance. (Ref:
Para. A32-A37)
A34. Examples of internally generated information used by management for
measuring and reviewing financial performance, and which the auditor may
consider, include:
• Key performance indicators (financial and non-financial) and key ratios,
trends and operating statistics
• Period-on-period financial performance analyses
• Budgets, forecasts, variance analyses, segment information and divisional,
departmental or other level performance reports
• Employee performance measures and incentive compensation policies
• Comparisons of an entity’s performance with that of competitors

The firm computes the fourteen "Key Business Ratios" of Dun & Bradstreet for all
clients in the planning phase of an engagement. A summary of these ratios and how
they are computed follows:
Current Asset to Current Debt: current assets are divided to the current debt.
Current assets are the sum of cash, notes and accounts receivable (less allowances
for bad debts), advances on merchandise, inventories, and marketable securities
(not in excess of market value). Current debt is the total of all liabilities falling due
within the year. This is one test of solvency.
Net Profits on Net Sales: Obtained by dividing net earnings of the business, after
taxes, by net sales (the dollar volume less returns, allowances, and cash discounts).
This important measure of profitability should be related to the ratio which follows.
Net Profits on Tangible Net worth: Tangible Net Worth is the equity of
stockholders in the business, obtained by subtracting total liabilities from total
assets and then deducting intangibles. The ratio is obtained by dividing net profits
after taxes by tangible net worth. There is a growing tendency to view this ratio as a
final criterion of profitability. Generally, a relationship of at least 10 percent is
regarded as a deductible objective for providing dividends plus funds for future
growth.
Net Profits on Net working Capital: Net working capital represents the excess of
current assets over current debt. This margin represents the cushion available to
the business, for carrying inventories and receivables and for financing day-to-day
operations. The ratio is obtained by dividing net profits, after taxes, by net working
capital.
Net Sales to Tangible Net Worth: Net Sales are divided by tangible net worth.
This gives a measure of relative turnover of invested capital.
Net Sales to Net Working Capital: net sales are divided by net working capital.
This provides a guide as to the extent the company is turning its working capital and
the margin of operating funds.
Collection period: annual net credit sales are divided by 365 days to obtain
average daily credit sales, and then the average daily credit sales are divided into
notes and accounts receivables. Many feel the collection period should not exceed
the net maturity indicated by selling terms by more than 10 to 15 days. When
comparing the collection period of one concern with that of another, allowances
should be made for possible variations in selling terms.
Net Sales to Inventory: obtained by dividing annual net sales by inventory as
carried on the balance sheet. This quotient does not yield an actual physical
turnover. It provides a yardstick for comparing stock-to-sales ratios of one concern
with another or with those for the industry.
Fixed Assets to Tangible Net Worth: Fixed Assets are divided by tangible net
worth. Fixed assets represent depreciated book values of buildings, leasehold
improvements, machinery, furniture, tools, and other physical equipment, plus land,
if any, and valued at cost or appraised market value. Ordinarily, this relationship
should not exceed 100 percent for a manufacturer and 75 percent for a wholesaler
or retailer.
Current Debt to Tangible Net Worth: derived by dividing current debt by
tangible net worth. Current debt exceeding 80% of tangible net worth is generally
considered an indication of potential problems.
Total Debt to tangible Net worth: obtained by dividing total current and long-
term debts by tangible net worth. When this relationship exceeds 100 percent. The
equity of creditors in the assets of the business exceeds that of owners.
Inventory to Net Working Capital: inventory is divided by net working capital.
This is an additional measure of inventory balance. Ordinarily, the relationship
should not exceed 80 percent.
Current debt to Inventory: dividing the current debt by inventory yields yet
another indication of the extent to which the business relies on funds from disposal
of unsold inventories to meet its debts.
Funded Debts to Net Working Capital: Funded debts are long-term obligations,
as represented by mortgages, bonds, debentures, term loans, serial notes, and other
types of liabilities maturing more than one year form statement date. This ratio is
obtained by dividing funded debts by net working capital.
Analysts tend to compare funded debts with net working capital in determining
whether or not long-term debts are in proper proportion.
Ordinarily, this relationship should not exceed 100 percent.