ACCTG 33 – AUDITING AND ASSURANCE PRINCIPLES MARK FRANCIS G.

NG, CPA, MBA

MODULE

7 UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

LEARNING OUTCOMES

After studying this module, the learners are expected to:

1. Explain the importance of understanding the audit client and the industry in which it operates.
2. Enumerate how the auditor may obtain an understanding of the client’s accounting and internal control systems.
3. Identify various sources of business risks and other significant risks that may affect an audit of financial
statements.

CORE DISCUSSIONS

OBTAINING AN UNDERSTANDING OF THE CLIENT AND ITS ENVIRONMENT

§ The second standard of fieldwork states that “the auditor must obtain a sufficient understanding of
the entity and its environment, including its internal control, to assess the risk of material
misstatement of the financial statements whether due to error or fraud, and to design the nature,
timing, and extent of further audit procedures”.
§ The required understanding of the client is used by the auditor to help plan the audit and to assess the risks
of material misstatement at the financial statement and relevant assertion levels.

RISK ASSESSMENT PROCEDURES

§ To obtain the understanding of the entity and its environment, the auditor performs risk assessment
procedures, which include:
ü Inquiries of management and others within the entity
ü Analytical procedures
ü Observation and inspection relating to client activities, operations, documents, reports, and premises
ü Other procedures, such as inquiries of others outside of the company (legal counsel, valuation experts)
and reviewing information from external sources (analysts, banks, rating organizations, and business
and industry journals).
§ These risk assessment procedures are supplemented by further audit procedures in the form of tests of
controls and substantive procedures to obtain sufficient audit evidence to express an opinion on the financial
statements.
§ As provided by PSA 315, the auditor’s understanding of the entity and its environment consists of an
understanding of the following aspects:
a) Relevant industry, regulatory, and other external factors including the applicable financial reporting
framework.
b) The nature of the entity, including;
ü Its operations;
ü Its ownership and governance structures;
ü The types of investments that the entity is making and plans to make; and
ü 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.
c) The entity’s selection and application of accounting policies, including the reasons for the 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 polices used in
the relevant industry.
d) The entity’s objectives and strategies, and those related business risks that may result in risks of material
misstatement.
e) The measurement and review of the entity’s financial performance.

INDUSTRY, REGULATORY, AND OTHER EXTERNAL FACTORS

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 § The factors envisioned here include industry conditions, such as the competitive environment, supplier and
customer relationships, and technological developments.
§ They also include the regulatory, legal, and political environment and general economic conditions.
§ Concerning the overall attractiveness of the industry

THE 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.
§ 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.

OBJECTIVES AND STRATEGIES AND RELATED BUSINESS RISKS

§ Business risks result from significant conditions, events, circumstances, actions, or inactions that could
adversely affect the entity’s ability to achieve its objectives and execute its strategies, or through the setting
of inappropriate objectives and strategies. Just as the external environment changes, the conduct of the
entity’s business is also dynamic and the entity’s strategies and objectives change over time.
§ Business risk is broader than the risk of material misstatement, though it includes the latter.
§ An understanding of business risks increases the likelihood of identifying risks of material misstatement.
§ However, the auditor does not have a responsibility to identify or assess all business risks.
§ The auditor obtains an understanding of the client’s operating and financing strategies and attempt to identify
significant business risks faced by the client.
§ Many of these business risks may create risks of material misstatement of the financial statements.

INTERNAL CONTROL
§ Internal control is designed to provide reasonable assurance of achieving objectives related to reliable
financial reporting, efficiency and effectiveness of operations, and compliance with applicable laws and
regulations.
§ The nature and extent of the audit work to be performed on a particular engagement depend largely upon
the effectiveness of the client’s internal control in preventing or detecting material misstatements in the
financial statements.
§ Before auditors can evaluate the effectiveness of internal control, they need a knowledge and understanding
of how it works: what controls exist and who performs them, how various types of transactions are processed
and recorded, and what accounting records and supporting documentation exist.
§ The auditor must have a sufficient understanding of the design and implementation of internal control to
plan the audit.

SOURCES OF INFORMATION
Much information about the nature of the client may be obtained through inquiries of management and other
personnel. For example, the auditor may use inquiry to determine the major types of sales transactions and the
nature of the client’s customers. The auditor may combine inquiry and inspection to determine the content of sales
contracts and the accounting policies used for recognizing revenues under the contracts. They also make inquiries
of other personnel within the organization. As an example, production personnel can provide the auditor with a more
detailed understanding of production processes. In addition, informal discussions between the auditors and key
officers of the client can provide information about the history, size, operations, accounting records, and internal
control of the enterprise. Finally, the auditor may make numerous inquiries to identify and assess fraud risks. Many
other sources of information on clients are available to the auditor. Electronic research are also available to allow the
auditor to efficiently obtain information for use in the audit.

TOUR OF PLANT OFFICES

Another useful preliminary step for the auditors is to arrange an inspection tour of the plant and offices of a
prospective client. This tour will give the auditor some understanding of the plant layout, manufacturing process,
principal products, and physical safeguards surrounding inventories. During the tour, the auditor should be alert for
signs of potential problems. Rust on equipment may indicate that plant assets have been idle; excessive dust on raw
materials or finished goods may indicate a problem of obsolescence. A knowledge of the physical facilities will assist
the auditors in planning how many audit staff members will be needed to participate in observing the physical
inventory.

The tour affords the auditor an opportunity to observe firsthand what types of information technology and internal
documentation are used to record such activities as receiving raw materials, transferring materials into production,
and shipping finished goods to customers. An understanding of these computer applications and documentation is
essential to the auditor’s consideration of internal control. Inquiries of personnel in various departments may provide

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the auditor with critical information about the client’s operations and may serve to confirm information obtained from
financial management.

In visiting the offices, the auditor will learn the location of various computer terminals and accounting records. The
auditor ca ascertain the practical extent of segregation of duties within the client organization by observing the
number of office employees. In addition, the tour will afford an opportunity to meet the key personnel whose names
appear on the organizational chart. The auditor will record the background information about the client in a
permanent file available for reference in future engagements.

ANALYTICAL PROCEDURES
Analytical procedures involve comparisons of financial statement balances and ratios for the period under audit with
auditor expectations developed from sources such as the client’s prior years’ financial statements, published industry
statistics, and budgets. When used for planning purposes, analytical procedures assist the auditor in planning the
nature, timing, and extent of audit procedures that will be used for the specific accounts. The approach used us of
obtaining an understanding of the client’s business transactions and identifying areas that may represent higher
risks. The auditor will then plan a more thorough investigation of these potential problem areas.

REVIEW QUESTIONS:

1. Why is there a need for the auditor to obtain a preliminary understanding of the client and its environment?
How does this process impact the client engagement process of an audit?
2. What information is the auditor seeking when obtaining a preliminary understanding of the client?
3. What risk assessment procedures may be used by the auditor in obtaining a preliminary understanding of
the client?
4. How do industry, regulatory, and external factors affect the environment of the audit client and the auditor’s
understanding of the client?
5. What is meant by nature of an entity?
6. Discuss the concept of business risk and its importance to an audit of financial statements.
7. How does an understanding of internal control help the auditor in obtaining an understanding of the client?
8. What are some sources of information that can help the auditor in obtaining an understanding of the client?
9. What are analytical procedures?
10. What should the auditor do after having obtained a preliminary understanding of the prospective audit client?

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