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

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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

10. 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

11. 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.

12. 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.

13. 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

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

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

16. 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