Pipara & Co LLP

Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment

Introduction

Scope of this SA

This Standard on Auditing (SA) deals with the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements, through understanding the entity and its environment, including the entity’s internal control.

Effective Date
This SA is effective for audits of financial statements for periods beginning on or after April 1, 2008.
Objective
  1. The objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement. This will help the auditor to reduce the risk of material misstatement to an acceptably low level.
Definition
  1. For purposes of the SAs, the following terms have the meanings attributed below:
    1. Assertions – Representations by management, explicit or otherwise, that are embodied in the financial statements, as used by the auditor to consider the different types of potential misstatements that may occur.
    2. Business risk – A risk resulting from significant conditions, events, circumstances, actions or inactions that could adversely affect an entity’s ability to achieve its objectives and execute its strategies, or from the setting of inappropriate objectives and strategies.
    3. Internal control – The process designed, implemented and maintained by those charged with governance, management and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, safeguarding of assets, and compliance with applicable laws and regulations. The term “controls” refers to any aspects of one or more of the components of internal control.
    4. Risk assessment procedures – The audit procedures performed to obtain

an understanding of the entity and its environment, including the entity’s internal control, to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels.

Significant risk – An identified and assessed risk of material misstatement that, in the auditor’s judgment, requires special audit consideration.

Requirements
Risk Assessment Procedures and Related Activities
  1. The auditor shall perform risk assessment procedures to provide a basis for the identification and assessment of risks of material misstatement at the financial statement and assertion levels. Risk assessment procedures by themselves, however, do not provide sufficient appropriate audit evidence on which to base the audit opinion. (Ref: Para. A1-A5)
  2. The risk assessment procedures shall include the following:
    1. Inquiries of management, of appropriate individuals within the internal audit function (if the function exists), and of others within the entity who in the auditor’s judgment may have information that is likely to assist in identifying risks of material misstatement due to fraud or error. (Ref: Para. A6-A12)
    2. Analytical procedures. (Ref: Para. A13-A16)
    3. Observation and inspection. (Ref: Para. A17)
  3. The auditor shall consider whether information obtained from the auditor’s client acceptance or continuance process is relevant to identifying risks of material misstatement.
  4. Where the engagement partner has performed other engagements for the entity, the engagement partner shall consider whether information obtained is relevant to identifying risks of material misstatement.
  5. When the auditor intends to use information obtained from the auditor’s previous experience with the entity and from audit procedures performed in previous audits, the auditor shall determine whether changes have occurred since the previous audit that may affect its relevance to the current audit. (Ref: Para. A18-A19)
  6. The engagement partner and other key engagement team members shall discuss the susceptibility of the entity’s financial statements to material misstatement, and the application of the applicable financial reporting framework to the entity’s facts and circumstances. The engagement partner shall determine which matters are to be communicated to engagement team members not involved in the discussion. (Ref: Para. A20-A22)
The Required Understanding of the Entity and its Environment, Including the Entity’s Internal Control
The Entity and Its Environment
  1. The auditor shall obtain an understanding of the following:
    1. Relevant industry, regulatory, and other external factors including the applicable financial reporting framework. (Ref: Para. A23-A28)
    2. The nature of the entity, including:
      1. its operations;
      2. its ownership and governance structures;
      3. the types of investments that the entity is making and plans to make, including investments in special-purpose entities; and
      4. 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. A29-A33)
  1. 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. A34)
  2. The entity’s objectives and strategies, and those related business risks that may result in risks of material misstatement. (Ref: Para. A35-A41)
  3. The measurement and review of the entity’s financial performance. (Ref: Para. A42-A47)
The Entity’s Internal Control
  1. The auditor shall obtain an understanding of internal control relevant to the audit. Although most controls relevant to the audit are likely to relate to financial reporting, not all controls that relate to financial reporting are relevant to the audit. It is a matter of the auditor’s professional judgment whether a control, individually or in combination with others, is relevant to the audit. (Ref: Para. A48-A71)
Nature and Extent of the Understanding of Relevant Controls
  1. When obtaining an understanding of controls that are relevant to the audit, the auditor shall evaluate the design of those controls and determine whether they have been implemented, by performing procedures in addition to inquiry of the entity’s personnel. (Ref: Para. A72-A74)
Components of Internal Control

Control environment

  1. The auditor shall obtain an understanding of the control environment. As part of obtaining this understanding, the auditor shall evaluate whether:
    1. Management, with the oversight of those charged with governance, has created and maintained a culture of honesty and ethical behavior; and
    2. The strengths in the control environment elements collectively provide an appropriate foundation for the other components of internal control, and whether those other components are not undermined by deficiencies in the control environment. (Ref: Para. A75-A85)

The entity’s risk assessment process

  1. The auditor shall obtain an understanding of whether the entity has a process for:
    1. Identifying business risks relevant to financial reporting objectives;
    2. Estimating the significance of the risks;
    3. Assessing the likelihood of their occurrence; and
    4. Deciding about actions to address those risks. (Ref: Para. A86)
  2. If the entity has established such a process (referred to hereafter as the ‘entity’s risk assessment process’), the auditor shall obtain an understanding of it, and the results thereof. Where the auditor identifies risks of material misstatement that management failed to identify, the auditor shall evaluate whether there was an underlying risk of a kind that the auditor expects would have been identified by the entity’s risk assessment process. If there is such a risk, the auditor shall obtain an understanding of why that process failed to identify it, and evaluate whether the process is appropriate to its circumstances or determine if there is a significant deficiency in internal control with regard to the entity’s risk assessment process.
  3. If the entity has not established such a process or has an ad hoc process, the auditor shall discuss with management whether business risks relevant to financial reporting objectives have been identified and how they have been addressed. The auditor shall evaluate whether the absence of a documented risk assessment process is appropriate in the circumstances, or determine whether it represents a significant deficiency in internal control. (Ref: Para. A87)

The information system, including the related business processes, relevant to financial reporting, and communication

  1. The auditor shall obtain an understanding of the information system, including the related business processes, relevant to financial reporting, including the following areas:
    1. The classes of transactions in the entity’s operations that are significant to the financial statements;
    2. The procedures, within both information technology (IT) and manual systems, by which those transactions are initiated, recorded, processed, corrected as necessary, transferred to the general ledger and reported in the financial statements;
    3. The related accounting records, supporting information and specific accounts in the financial statements that are used to initiate, record, process and report transactions; this includes the correction of incorrect information and how information is transferred to the general ledger. The records may be in either manual or electronic form;
    4. How the information system captures events and conditions, other than transactions, that are significant to the financial statements;
    5. The financial reporting process used to prepare the entity’s financial statements, including significant accounting estimates and disclosures;
    6. Controls surrounding journal entries, including non-standard journal entries used to record non-recurring, unusual transactions or adjustments. (Ref: Para. A88-A92)
  2. The auditor shall obtain an understanding of how the entity communicates financial reporting roles and responsibilities and significant matters relating to financial reporting, including:
    1. Communications between management and those charged with governance; and
    2. External communications, such as those with regulatory authorities. (Ref: Para. A93-A94)

Control activities relevant to the audit

  1. The auditor shall obtain an understanding of control activities relevant to the audit, being those the auditor judges it necessary to understand in order to assess the risks of material misstatement at the assertion level and design further audit procedures responsive to assessed risks. An audit requires an understanding of only those control activities related to significant class of transactions, account balance, and disclosure in the financial statements and the

assertions which the auditor finds relevant in his risk assessment process. (Ref: Para. A95-A101)

  1. In understanding the entity’s control activities, the auditor shall obtain an understanding of how the entity has responded to risks arising from IT. (Ref: Para. A102-A104)

Monitoring of controls

  1. The auditor shall obtain an understanding of the major activities that the entity uses to monitor internal control over financial reporting, including those related to those control activities relevant to the audit, and how the entity initiates remedial actions to deficiencies in its controls. (Ref: Para. A105-A107)
  2. If the entity has an internal audit function,1 the auditor shall obtain an understanding of the nature of the internal audit function’s responsibilities, its organisational status, and the activities performed, or to be performed. (Ref: Para. A108-A115)
  3. The auditor shall obtain an understanding of the sources of the information used in the entity’s monitoring activities, and the basis upon which management considers the information to be sufficiently reliable for the purpose. (Ref: Para. A116)
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