Chapter 8 - Understanding the entity and its environment Flashcards
What are the key stages in a risk assesment conducted by auditors at the planning stage?
- Understanding the entity and its environment
- Identify risk of material misstatements (audit risk)
Why is it important that auditors understand the entity and its environment when developing an audit strategy and plan?
ISA 315 and 330 (UK) requires the auditor to assess the risk of material misstatement through understanding the entity and its environment
It’s crucial for auditors to understand the entity and its environment because it helps assess the risks and design an effective audit strategy.
Specifically, understanding who the client is, what they do, how they do it, and any special circumstances (like laws and regulations) is necessary to evaluate risks. Additionally, understanding the integrity and competence of the client’s staff ensures proper planning.
With this knowledge, auditors can:
* Assess the skills and competence needed by the audit team.
* Plan the audit to be appropriate and efficient.
* Evaluate the client’s internal controls.
* Identify significant risks that require special attention.
* Perform effective analytical procedures.
* Ensure compliance with professional requirements.
What types of information sources can auditors use to understand the entity and its environment? (3)
- External sources
- Firm/Internal sources
- The client
What types of external information sources can auditors use to understand the entity and its environment? (5)
Auditors can use various external sources to gain insights into the entity and its environment, including:
- Credit reference agencies – Provide financial stability and creditworthiness reports.
- Industry surveys – Offer insights into market trends and economic conditions.
- Industry publications (e.g., trade journals) – Help auditors understand industry-specific risks and developments.
- HM Revenue and Customs Business Economic Notes – Provide economic data on different sectors (though they may be outdated).
- Companies House searches – Give access to financial statements, director information, and filing history of registered companies.
What types of internal information sources can auditors use to understand the entity and its environment? (4-5)
Auditors can use several internal sources within the audit firm to gain insights into the entity, including:
Reviewing key audit files:
* Last year’s file – Provides historical audit findings and identified risks.
* The permanent file – Contains essential background information on the client.
* The correspondence file – Includes important communications with the client.
* The tax file – Holds tax-related information and compliance details.
Consulting key personnel within the firm:
* The audit partner – Offers strategic insights and key risk areas.
* The audit manager – Provides planning guidance and oversight.
* The tax person – Shares tax compliance and risk information.
* Last year’s senior auditor – Can provide continuity and lessons from past audits.
* The firm’s industry specialist – Offers expertise on sector-specific risks and best practices.
What types of client-side information sources can auditors use to understand the entity and its environment? (4-5)
Auditors can gather valuable insights directly from the client by:
- Talking to key personnel – Engaging with staff responsible for the areas being audited to understand processes and controls.
- Reviewing internal documents – Examining internal correspondence, board meeting minutes, and internal audit reports for significant issues or decisions.
- Observing operations – Watching how transactions are recorded, processes are executed, and controls are implemented in practice.
- Examining public materials – Checking the company’s website, brochures, and other marketing materials to understand its business model, products, and market positioning.
What key aspects of an entity and its environment must auditors assess to comply with ISA 315?
To comply with ISA 315 (Identifying and Assessing the Risks of Material Misstatement), auditors must gain a thorough understanding of the entity and its environment. Key aspects to assess include:
- Nature of the Business – What does the client do? Understanding its products, services, operations, and business model helps assess risks.
- Industry and Regulatory Environment – What are the industry characteristics? Is the business subject to specific laws and regulations? Some industries, like finance or healthcare, have stricter compliance requirements.
- Legal and Economic Risks – Is the entity at greater risk from regulatory changes or legal disputes? Is it financially stable, or does it face potential threats such as takeover risks or lack of funding?
- Relationships with External Parties – What are the client’s relationships with shareholders, stakeholders, trading partners, and financial providers? Unusual arrangements may indicate risk areas.
- Related Party Transactions – Are there dealings with related parties? Such transactions may pose risks of fraud or misstatement if not properly disclosed.
- Management Competence and Integrity – Is management experienced and ethical? Poor management increases financial reporting risks and weakens controls.
- Internal Controls and Systems – Are suitable accounting systems and controls in place? Weak controls may lead to errors or fraud.
- Accounting Policies and Financial Reporting – What accounting policies has the entity adopted? Are they in line with IFRS, GAAP, or other relevant standards? Any aggressive or unusual accounting treatments should be scrutinized.
When understanding an entity and its environment, what must auditors consider regarding third party organisations to the entity?
Many companies outsource key processes to third-party organizations. Common outsourced activities include:
* Information Processing – e.g., payroll services.
* Accounting & Record-Keeping – e.g., bookkeeping.
* Facilities Management – e.g., cleaning services.
If an entity outsources part of its business, auditors must:
✔ Understand the Services Provided by the Third Party, including:
* The nature of the services and their impact on financial reporting.
* The materiality of transactions processed by the service provider.
* The level of interaction between the entity and the service provider.
* The contractual relationship between the entity and the provider, including key terms.
✔ Consider Access to Evidence
* Determine if sufficient audit evidence is available.
* Assess whether direct access to the service provider is necessary.
* Consider using a Service Auditor’s Report (e.g., SOC 1 report) to evaluate controls.
✔ Assess Risks Arising from Outsourcing
* Identify risks related to data security, reliability, and internal controls.
* Evaluate whether outsourcing increases the risk of material misstatements.
* Ensure the entity has proper oversight and monitoring of the service provider.
By understanding the role of third-party organizations, auditors can better assess risk and ensure reliable financial reporting.
In order to understand a third party service organisations internal controls, what evidence can auditors obtain
The user auditor, in obtaining an understanding of the service organisation’s internal controls, may obtain one of the following reports from the auditor of the service organisation:
From an audit perspective, identify the key risks associated with an entity outsourcing to a third party
- Loss of Control Over Processes - The entity may not have direct oversight of outsourced activities, leading to weaker internal controls. Management may rely too heavily on the service provider without adequate monitoring.
- Weaknesses in Third-Party Internal Controls - The service provider may not have sufficient controls to ensure accuracy, completeness, and security of financial data. If internal controls are weak, errors or fraud could go undetected.
- Data Security & Confidentiality Risks - Sensitive financial and personal data (e.g., payroll, customer records) may be exposed to unauthorized access or cyber threats. Compliance with data protection laws (e.g., GDPR, HIPAA) could be at risk.
- Inadequate Audit Evidence - Auditors may struggle to obtain sufficient and appropriate audit evidence if access to third-party records is restricted. The entity may not have visibility into how transactions are processed.
- Financial Reporting Risks - The entity may not correctly record transactions handled by the service provider, leading to potential misstatements. Timing differences or errors in processing financial data could impact accuracy.
- Compliance Risks - The third party may not comply with legal, tax, or regulatory requirements, exposing the entity to penalties. Outsourcing contracts may not align with industry-specific regulations.
- Business Continuity Risks - If the service provider fails (e.g., financial distress, operational failure), the entity may struggle to continue critical operations. Lack of contingency planning could disrupt financial reporting and operations.
