ASA 315 - Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement - April 2006

26 The auditor’s understanding of the entity and its environment consists of an understanding of the following aspects:

• 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 that may result in a material misstatement of the financial report.
• Measurement and review of the entity’s financial performance.
• Internal control.

Appendix 1 contains examples of matters that the auditor may consider in obtaining an understanding of the entity and its environment relating to the above categories. Appendix 2 contains a detailed explanation of the internal control components.

27 The nature, timing, and extent of the risk assessment procedures performed depend on the circumstances of the engagement such as the size and complexity of the entity and the auditor’s experience with it. In addition, identifying significant changes in any of the above aspects of the entity from prior periods is particularly important in gaining a sufficient understanding of the entity to identify and assess risks of material misstatement.

Industry, Regulatory and Other External Industry, Regulatory and Other External Factors, Including the Applicable Financial Reporting Framework

Industry, Regulatory and Other External Factors, Including the Applicable Financial Reporting Framework

28 The auditor shall obtain an understanding of relevant industry, regulatory, and other external factors including the applicable financial reporting framework.

29 These factors include industry conditions such as the competitive environment, supplier and customer relationships, and technological developments; the regulatory environment encompassing, among other matters, the applicable financial reporting framework, the legal and political environment, and environmental requirements affecting the industry and the entity; and other external factors such as general economic conditions. See ASA 250 Consideration of Laws and Regulations in an Audit of a Financial Report, for additional mandatory requirements related to the legal and regulatory framework applicable to the entity and the industry.

30 The industry in which the entity operates may give rise to specific risks of material misstatement arising from the nature of the business or the degree of regulation. For example, long-term contracts may involve significant estimates of revenues and costs that give rise to risks of material misstatement. In such cases, under ASA 220 Quality Control for Audits of Historical Financial Information, the auditor needs to consider whether the engagement team includes members with sufficient relevant knowledge and experience.

31 Legislative and regulatory requirements often determine the applicable financial reporting framework to be used by management in preparing the entity’s financial report. In most cases, the applicable financial reporting framework will be that of the jurisdiction in which the entity is registered or operates and the auditor is based, and the auditor and the entity will have a common understanding of that framework. In some cases there may be no local financial reporting framework, in which case the entity’s choice will be governed by local practice, industry practice, user needs, or other factors. For example, the entity’s competitors may apply International Financial Reporting Standards (IFRS) and the entity may determine that IFRS are also appropriate for its financial reporting requirements. Under paragraph 28 of this Auditing Standard, the auditor needs to consider whether local regulations specify certain financial reporting requirements for the industry in which the entity operates, since the financial report may be materially misstated in the context of the applicable financial reporting framework if management fails to prepare the financial report in accordance with such regulations.

Nature of the Entity Nature of the Entity

Nature of the Entity

32 The auditor shall obtain an understanding of the nature of the entity.

33 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 report.

34 The entity may have a complex structure with subsidiaries or other components in multiple locations. In addition to the difficulties of consolidation in such cases, other issues with complex structures that may give rise to risks of material misstatement include: the allocation of goodwill to business segments, and its impairment; whether investments are joint ventures, subsidiaries, or investments accounted for using the equity method; and whether special-purpose entities are accounted for appropriately.

35 An understanding of the ownership and relations between owners and other people or entities is also important in determining whether related party transactions have been identified and accounted for appropriately. ASA 550 Related Parties, provides additional explanatory guidance on the auditor’s considerations relevant to related parties.

36 The auditor shall obtain an understanding of the entity’s selection and application of accounting policies and consider whether they are appropriate for its business and consistent with the applicable financial reporting framework and accounting policies used in the relevant industry.

37 The understanding encompasses the methods the entity uses to account for significant and unusual transactions; the effect of significant accounting policies in controversial or emerging areas for which there is a lack of authoritative guidance or consensus; and changes in the entity’s accounting policies. Ordinarily, the auditor:

(a) identifies financial reporting standards and regulations that are new to the entity and considers when and how the entity will adopt such requirements; and

(b) considers the reasons for the change and whether it is appropriate and consistent with the requirements of the applicable financial reporting framework, where the entity has changed its selection of or method of applying a significant accounting policy.

38 The presentation of a financial report in conformity with the applicable financial reporting framework includes adequate disclosure of material matters. These matters relate to the form, arrangement, and content of the financial report and its appended notes, including, for example, the terminology used, the amount of detail given, the classification of items in the report, and the basis of amounts set forth. Ordinarily, the auditor considers whether the entity has disclosed a particular matter appropriately in light of the circumstances and facts of which the auditor is aware at the time.

Objectives and Strategies and Related Bu Objectives and Strategies and Related Business Risks

Objectives and Strategies and Related Business Risks

39 The auditor shall obtain an understanding of the entity’s objectives and strategies, and the related business risks that may result in material misstatement of the financial report.

40 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 and those charged with governance define objectives, which are the overall plans for the entity. Strategies are the operational approaches by which management intends to achieve its objectives. 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.

41 Business risk is broader than the risk of material misstatement of the financial report, though it includes the latter. Business risk particularly may arise from change or complexity, though a failure to recognise the need for change may also give rise to risk. Change may arise, for example, from the development of new products that may fail; from an inadequate market, even if successfully developed; or from flaws that may result in liabilities and reputational risk. 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.

42 Most business risks will eventually have financial consequences and, therefore, an effect on the financial report. However, not all business risks give rise to risks of material misstatement. A business risk may have an immediate consequence for the risk of misstatement for classes of transactions, account balances, and disclosures at the assertion level or the financial report as a whole. For example, the business risk arising from a contracting customer base due to industry consolidation may increase the risk of misstatement associated with the valuation of receivables. However, the same risk, particularly in combination with a contracting economy, may also have a longer-term consequence, which under ASA 570 Going Concern, the auditor needs to consider when assessing the appropriateness of the going concern assumption. The auditor’s consideration of whether a business risk may result in material misstatement is, therefore, made in light of the entity’s circumstances. Examples of conditions and events that may indicate risks of material misstatement are given in Appendix 3.

43 Usually those charged with governance and management identify business risks and develop approaches to address them. Such a risk assessment process is part of internal control and is discussed in paragraphs 89 to 93.

44 Smaller entities often do not set their objectives and strategies, or manage the related business risks, through formal plans or processes. In many cases there may be no documentation of such matters. In such entities, the auditor’s understanding is ordinarily obtained through enquiries of those charged with governance and management and observation of how the entity responds to such matters.

Measurement and Review of the Entity’s F Measurement and Review of the Entity’s Financial Performance

Measurement and Review of the Entity’s Financial Performance

45 The auditor shall obtain an understanding of the measurement and review of the entity’s financial performance.

46 Performance measures and their review indicate to the auditor aspects of the entity’s performance that those charged with governance, management and others consider to be of importance. Performance measures, whether external or internal, create pressures on the entity that, in turn, may motivate management to take action to improve the business performance or to misstate the financial report. Obtaining an understanding of the entity’s performance measures assists the auditor in considering whether such pressures result in management actions that may have increased the risks of material misstatement.

47 Management’s measurement and review of the entity’s financial performance is to be distinguished from the monitoring of controls (discussed as a component of internal control in paragraphs 113-116), though their purposes may overlap. Monitoring of controls, however, is specifically concerned with the effective operation of internal control through consideration of information about the control. The measurement and review of performance is directed at whether business performance is meeting the objectives set by those charged with governance and management (or third parties), but in some cases performance indicators also provide information that enables management to identify deficiencies in internal control.

48 Internally-generated information used by management for this purpose may include key performance indicators (financial and non-financial), budgets, variance analysis, segment information and divisional, departmental or other level performance reports, and comparisons of an entity’s performance with that of competitors. External parties may also measure and review the entity’s financial performance. For example, external information such as analysts’ reports and credit rating agency reports may provide information useful to the auditor’s understanding of the entity and its environment. Such reports often are obtained from the entity being audited.

49 Internal measures may highlight unexpected results or trends requiring management’s enquiry of others in order to determine their cause and take corrective action (including, in some cases, the detection and correction of misstatements on a timely basis). Performance measures may also indicate to the auditor a risk of misstatement of related financial report information. For example, performance measures may indicate that the entity has unusually rapid growth or profitability when compared to that of other entities in the same industry. Such information, particularly if combined with other factors such as performance-based bonus or incentive remuneration, may indicate the potential risk of management bias in the preparation of the financial report.

50 Much of the information used in performance measurement may be produced by the entity’s information system. If management assumes that data used for reviewing the entity’s performance are accurate without having a basis for that assumption, errors may exist in the information, potentially leading management to incorrect conclusions about performance. When the auditor intends to make use of the performance measures for the purpose of the audit (for example, for analytical procedures), under paragraph 45 of this Auditing Standard, the auditor needs to consider whether:

(a) the information related to management’s review of the entity’s performance provides a reliable basis and is sufficiently precise for such a purpose; and

(b) they are precise enough to detect material misstatements.

51 Smaller entities ordinarily do not have formal processes to measure and review the entity’s financial performance. Management nevertheless often relies on certain key indicators which knowledge and experience of the business suggest are reliable bases for evaluating financial performance and taking appropriate action.

Internal Control Internal Control

Internal Control

52 The auditor shall obtain an understanding of internal control relevant to the audit.

53 Under paragraph 5 of this Auditing Standard, the auditor needs to use the understanding of internal control to identify types of potential misstatements, consider factors that affect the risks of material misstatement, and design the nature, timing, and extent of further audit procedures. Internal control relevant to the audit is discussed in explanatory paragraphs 59-65 below. In addition, the depth of the understanding is discussed in explanatory paragraphs 66-68 below.

54 Internal control is the process designed and effected by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of the entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations. It follows that internal control is designed and implemented to address identified business risks that threaten the achievement of any of these objectives.

55 Internal control, as discussed in this Auditing Standard, consists of the following components:

(a) the control environment;

(b) the entity’s risk assessment process;

(c) the information system, including the related business processes, relevant to financial reporting, and communication;

(d) control activities; and

(e) monitoring of controls.

Appendix 2 contains a detailed discussion of the internal control components.

56 The division of internal control into the five components provides a useful framework for auditors to consider how different aspects of an entity’s internal control may affect the audit. The division does not necessarily reflect how an entity considers and implements internal control. Also, the auditor’s primary consideration is whether, and how, a specific control prevents, or detects and corrects, material misstatements in classes of transactions, account balances, or disclosures, and their related assertions, rather than its classification into any particular component. Accordingly, auditors may use different terminology or frameworks to describe the various aspects of internal control, and their effect on the audit than those used in this Auditing Standard, provided all the components described in this Auditing Standard are addressed.

57 The way in which internal control is designed and implemented varies with an entity’s size and complexity. Specifically, smaller entities may use less formal means and simpler processes and procedures to achieve their objectives. For example, smaller entities with active management involvement in the financial reporting process may not have extensive descriptions of accounting procedures or detailed written policies. For some entities, in particular very small entities, the owner-manager[3] may perform functions which in a larger entity would be regarded as belonging to several of the components of internal control. Therefore, the components of internal control may not be clearly distinguished within smaller entities, but their underlying purposes are equally valid.

58 For the purposes of this Auditing Standard, the term “internal control” encompasses all five components of internal control stated above. In addition, the term “controls” refers to one or more of the components, or any aspect thereof.

Controls Relevant to the Audit

59 There is a direct relationship between an entity’s objectives and the controls it implements to provide reasonable assurance about their achievement. The entity’s objectives, and therefore controls, relate to financial reporting, operations and compliance; however, not all of these objectives and controls are relevant to the auditor’s risk assessment.

60 Ordinarily, controls that are relevant to an audit pertain to the entity’s objective of preparing a financial report for external purposes that gives a true and fair view (or is presented fairly, in all material respects) in accordance with the applicable financial reporting framework and the management of risk that may give rise to a material misstatement in that financial report. It is a matter of the auditor’s professional judgement, subject to the mandatory requirements of this Auditing Standard, whether a control, individually or in combination with others, is relevant to the auditor’s considerations in assessing the risks of material misstatement and designing and performing further procedures in response to assessed risks. In exercising that judgement, the auditor considers the circumstances, the applicable component and factors such as the following:

• The auditor’s judgement about materiality.
• The size of the entity.
• The nature of the entity’s business, including its organisation and ownership characteristics.
• The diversity and complexity of the entity’s operations.
• Applicable legal and regulatory requirements.
• The nature and complexity of the systems that are part of the entity’s internal control, including the use of service organisations.

61 Controls over the completeness and accuracy of information produced by the entity may also be relevant to the audit if the auditor intends to make use of the information in designing and performing further procedures. The auditor’s previous experience with the entity and information obtained in understanding the entity and its environment and throughout the audit assists the auditor in identifying controls relevant to the audit. Further, although internal control applies to the entire entity or to any of its operating units or business processes, an understanding of internal control relating to each of the entity’s operating units and business processes may not be relevant to the audit.

62 Controls relating to operations and compliance objectives may, however, be relevant to an audit if they pertain to data the auditor evaluates or uses in applying audit procedures. For example, controls pertaining to non-financial data that the auditor uses in analytical procedures, such as production statistics, or controls pertaining to detecting non-compliance with laws and regulations that may have a direct and material effect on the financial report, such as controls over compliance with income tax laws and regulations used to determine the income tax provision, may be relevant to an audit.

63 An entity generally has controls relating to objectives that are not relevant to an audit and therefore need not be considered. For example, an entity may rely on a sophisticated system of automated controls to provide efficient and effective operations (such as a commercial airline’s system of automated controls to maintain flight schedules), but these controls ordinarily would not be relevant to the audit.

64 Internal control over safeguarding of assets against unauthorised acquisition, use, or disposition may include controls relating to financial reporting and operations objectives. In obtaining an understanding of each of the components of internal control, the auditor’s consideration of safeguarding controls is generally limited to those relevant to the reliability of financial reporting. For example, use of access controls, such as passwords, that limit access to the data and programs that process cash disbursements may be relevant to a financial report audit. Conversely, controls to prevent the excessive use of materials in production generally are not relevant to a financial report audit.

65 Controls relevant to the audit may exist in any of the components of internal control and a further discussion of controls relevant to the audit is included under the heading of each internal control component below. In addition, under paragraphs 132 and 135 there are certain risks for which the auditor needs to evaluate the design of the entity’s controls over such risks and determine whether they have been implemented.

Depth of Understanding of Internal Control

66 Obtaining an understanding of internal control involves evaluating the design of a control and determining whether it has been implemented. Evaluating the design of a control involves considering whether the control, individually or in combination with other controls, is capable of effectively preventing, or detecting and correcting, material misstatements. Further explanation is contained in the discussion of each internal control component below. Implementation of a control means that the control exists and that the entity is using it. Under paragraph 135 of this Auditing Standard, the auditor needs to consider the design of a control in determining whether to consider its implementation. An improperly designed control may represent a material weakness[4] in the entity’s internal control and under paragraph 141 of this Auditing Standard the auditor needs to consider whether to communicate this to those charged with governance and management.

67 Risk assessment procedures to obtain audit evidence about the design and implementation of relevant controls may include enquiring of entity personnel, observing the application of specific controls, inspecting documents and reports, and tracing transactions through the information system relevant to financial reporting. Enquiry alone is not sufficient to evaluate the design of a control relevant to an audit and to determine whether it has been implemented.

68 Obtaining an understanding of an entity’s controls is not sufficient to serve as testing the operating effectiveness of controls, unless there is some automation that provides for the consistent application of the operation of the control (manual and automated elements of internal control relevant to the audit are further described below). For example, obtaining audit evidence about the implementation of a manually operated control at a point in time does not provide audit evidence about the operating effectiveness of the control at other times during the period under audit. However, IT enables an entity to process large volumes of data consistently and enhances the entity’s ability to monitor the performance of control activities and to achieve effective segregation of duties by implementing security controls in applications, databases, and operating systems. Therefore, because of the inherent consistency of IT processing, performing audit procedures to determine whether an automated control has been implemented may serve as a test of that control’s operating effectiveness, depending on the auditor’s assessment and testing of controls such as those over program changes. Tests of the operating effectiveness of controls are further described in ASA 330.

Characteristics of Manual and Automated Elements of Internal Control Relevant to the Auditor’s Risk Assessment

69 Most entities make use of IT systems for financial reporting and operational purposes. However, even when IT is extensively used, there will be manual elements to the systems. The balance between manual and automated elements varies. In certain cases, particularly smaller, less complex entities, the systems may be primarily manual. In other cases, the extent of automation may vary with some systems substantially automated with few related manual elements and others, even within the same entity, predominantly manual. As a result, an entity’s system of internal control is likely to contain manual and automated elements, the characteristics of which are relevant to the auditor’s risk assessment and further audit procedures based thereon.

70 The use of manual or automated elements in internal control also affects the manner in which transactions are initiated, recorded, processed, and reported.[5] Controls in a manual system may include such procedures as approvals and reviews of activities, and reconciliations and follow-up of reconciling items. Alternatively, an entity may use automated procedures to initiate, record, process, and report transactions, in which case records in electronic format replace such paper documents as purchase orders, invoices, shipping documents, and related accounting records. Controls in IT systems consist of a combination of automated controls (for example, controls embedded in computer programs) and manual controls. Further, manual controls may be independent of IT, may use information produced by IT, or may be limited to monitoring the effective functioning of IT and of automated controls, and to handling exceptions. When IT is used to initiate, record, process or report transactions, or other financial data for inclusion in the financial report, the systems and programs may include controls related to the corresponding assertions for material accounts or may be critical to the effective functioning of manual controls that depend on IT. An entity’s mix of manual and automated controls varies with the nature and complexity of the entity’s use of IT.

71 Generally, IT provides potential benefits of effectiveness and efficiency for an entity’s internal control because it enables an entity to:

• Consistently apply predefined business rules and perform complex calculations in processing large volumes of transactions or data.
• Enhance the timeliness, availability, and accuracy of information.
• Facilitate the additional analysis of information.
• Enhance the ability to monitor the performance of the entity’s activities and its policies and procedures.
• Reduce the risk that controls will be circumvented.
• Enhance the ability to achieve effective segregation of duties by implementing security controls in applications, databases, and operating systems.

72 IT also poses specific risks to an entity’s internal control, including the following:

• Reliance on systems or programs that are inaccurately processing data, processing inaccurate data, or both.
• Unauthorised access to data that may result in destruction of data or improper changes to data, including the recording of unauthorised or non-existent transactions, or inaccurate recording of transactions. Particular risks may arise where multiple users access a common database.
• The possibility of IT personnel gaining access privileges beyond those necessary to perform their assigned duties thereby breaking down segregation of duties.
• Unauthorised changes to data in master files.
• Unauthorised changes to systems or programs.
• Failure to make necessary changes to systems or programs.
• Inappropriate manual intervention.
• Potential loss of data or inability to access data as required.

73 Manual aspects of systems may be more suitable where judgement and discretion are required such as for the following circumstances:

• Large, unusual or non-recurring transactions.
• Circumstances where errors are difficult to define, anticipate or predict.
• In changing circumstances that require a control response outside the scope of an existing automated control.
• In monitoring the effectiveness of automated controls.

74 Manual controls are performed by people, and therefore pose specific risks to the entity’s internal control. Manual controls may be less reliable than automated controls because they can be more easily bypassed, ignored, or overridden and they are also more prone to simple errors and mistakes. Consistency of application of a manual control element cannot therefore be assumed. Manual systems may be less suitable for the following:

• High volume or recurring transactions, or in situations where errors that can be anticipated or predicted can be prevented or detected by control parameters that are automated.
• Control activities where the specific ways to perform the control can be adequately designed and automated.

75 The extent and nature of the risks to internal control vary depending on the nature and characteristics of the entity’s information system. Therefore in understanding internal control under paragraphs 52 and 109 of this Auditing Standard, the auditor needs to consider whether the entity has responded adequately to the risks arising from the use of IT or manual systems by establishing effective controls.

Limitations of Internal Control

76 Internal control, no matter how well designed and operated, can provide an entity with only reasonable assurance about achieving the entity’s financial reporting objectives. The likelihood of achievement is affected by limitations inherent to internal control. These include the realities that human judgement in decision-making can be faulty and that breakdowns in internal control can occur because of human failures, such as simple errors or mistakes. For example, if an entity’s information system personnel do not completely understand how an order entry system processes sales transactions, they may erroneously design changes to the system to process sales for a new line of products. On the other hand, such changes may be correctly designed but misunderstood by individuals who translate the design into program code. Errors also may occur in the use of information produced by IT. For example, automated controls may be designed to report transactions over a specified amount for management review, but individuals responsible for conducting the review may not understand the purpose of such reports and, accordingly, may fail to review them or investigate unusual items.

77 Additionally, controls can be circumvented by the collusion of two or more people or inappropriate management override of internal control. For example, management may enter into side agreements with customers that alter the terms and conditions of the entity’s standard sales contracts, which may result in improper revenue recognition. Also, edit checks in a software program that are designed to identify and report transactions that exceed specified credit limits may be overridden or disabled.

78 Smaller entities often have fewer employees which may limit the extent to which segregation of duties is practicable. However, for key areas, even in a very small entity, it can be practicable to implement some degree of segregation of duties or other form of unsophisticated but effective controls. The potential for override of controls by the owner-manager depends to a great extent on the control environment and in particular, the owner-manager’s attitudes about the importance of internal control.

Control Environment

79 The auditor shall obtain an understanding of the control environment.

80 The control environment includes the governance and management functions and the attitudes, awareness, and actions of those charged with governance and management concerning the entity’s internal control and its importance in the entity. The control environment sets the tone of an organisation, influencing the control consciousness of its people. It is the foundation for effective internal control, providing discipline and structure.

81 The primary responsibility for the prevention and detection of fraud and error rests with both those charged with governance and management of an entity. In evaluating the design of the control environment and determining whether it has been implemented, ordinarily the auditor understands how management, with the oversight of those charged with governance, has created and maintained a culture of honesty and ethical behaviour, and established appropriate controls to prevent and detect fraud and error within the entity.

82 In evaluating the design of the entity’s control environment, the auditor ordinarily considers the following elements and how they have been incorporated into the entity’s processes:

• Communication and enforcement of integrity and ethical values — essential elements which influence the effectiveness of the design, administration and monitoring of controls.
• Commitment to competence — management’s consideration of the competence levels for particular jobs and how those levels translate into requisite skills and knowledge.
• Participation by those charged with governance — independence from management, their experience and stature, the extent of their involvement and scrutiny of activities, the information they receive, the degree to which difficult questions are raised and pursued with management and their interaction with internal and external auditors.
• Management’s philosophy and operating style — management’s approach to taking and managing business risks, and management’s attitudes and actions toward financial reporting, information processing and accounting functions and personnel.
• Organisational structure — the framework within which an entity’s activities for achieving its objectives are planned, executed, controlled and reviewed.
• Assignment of authority and responsibility — how authority and responsibility for operating activities are assigned and how reporting relationships and authorisation hierarchies are established.
• Human resource policies and practices — recruitment, orientation, training, evaluating, counselling, promoting, compensating and remedial actions.

83 In understanding the control environment, under paragraph 79 of this Auditing Standard, the auditor needs to consider whether controls have been implemented. Ordinarily, the auditor obtains relevant audit evidence through a combination of enquiries and other risk assessment procedures, for example, corroborating enquiries through observation or inspection of documents. For example, through enquiries of management and employees, the auditor may obtain an understanding of how management communicates to employees its views on business practices and ethical behaviour. Ordinarily, the auditor determines whether controls have been implemented by considering, for example, whether management has established a formal code of conduct and whether it acts in a manner that supports the code or condones violations of, or authorises exceptions to the code.

84 Audit evidence for elements of the control environment may not be available in documentary form, in particular for smaller entities where communication between management and other personnel may be informal, yet effective. For example, management’s commitment to ethical values and competence are often implemented through the behaviour and attitude they demonstrate in managing the entity’s business instead of in a written code of conduct. Consequently, management’s attitudes, awareness and actions are of particular importance in the design of a smaller entity’s control environment. In addition, the role of those charged with governance is often undertaken by the owner-manager where there are no other owners.

85 The overall responsibilities of those charged with governance are recognised in codes of practice and other regulations or guidance produced for the benefit of those charged with governance. It is one, but not the only, role of those charged with governance to counterbalance pressures on management in relation to financial reporting. For example, the basis for management remuneration may place stress on management arising from the conflicting demands of fair reporting and the perceived benefits of improved results. In understanding the design of the control environment, ordinarily the auditor considers:

(a) such matters as the independence of the directors and those charged with governance, and their ability to evaluate the actions of management; and

(b) whether there is an audit committee that understands the entity’s business transactions and evaluates whether the financial report gives a true and fair view (or is presented fairly, in all material respects) in accordance with the applicable financial reporting framework.

86 The nature of an entity’s control environment is such that it has a pervasive effect on assessing the risks of material misstatement. For example, owner-manager controls may mitigate a lack of segregation of duties in a small business, or an active and independent board of directors may influence the philosophy and operating style of senior management in larger entities. The auditor’s evaluation of the design of the entity’s control environment ordinarily includes considering whether the strengths in the control environment elements collectively provide an appropriate foundation for the other components of internal control, and are not undermined by control environment weaknesses. For example, human resource policies and practices directed toward hiring competent financial, accounting, and IT personnel may not mitigate a strong bias by senior management to overstate earnings. Changes in the control environment may affect the relevance of information obtained in prior audits. For example, management’s decision to commit additional resources for training and awareness of financial reporting activities may reduce the risk of errors in processing financial information. Alternatively, management’s failure to commit sufficient resources to address security risks presented by IT may adversely affect internal control by allowing improper changes to be made to computer programs or to data, or by allowing unauthorised transactions to be processed.

87 The existence of a satisfactory control environment can be a positive factor when the auditor assesses the risks of material misstatement and as explained in ASA 330, influences the nature, timing, and extent of the auditor’s further audit procedures. In particular, it may help reduce the risk of fraud, although a satisfactory control environment is not an absolute deterrent to fraud. Conversely, weaknesses in the control environment may undermine the effectiveness of controls and therefore be negative factors in the auditor’s assessment of the risks of material misstatement, in particular in relation to fraud.

88 The control environment in itself does not prevent, or detect and correct, a material misstatement in classes of transactions, account balances, and disclosures and related assertions. The auditor, therefore, ordinarily considers the effect of other components along with the control environment when assessing the risks of material misstatement; for example, the monitoring of controls and the operation of specific control activities.

The Entity’s Risk Assessment Process

89 The auditor shall obtain an understanding of the entity’s process for identifying business risks relevant to financial reporting objectives and deciding about actions to address those risks, and the results thereof.

90 The process is described as the “entity’s risk assessment process” and forms the basis for how management determines the risks to be managed.

91 In evaluating the design and implementation of the entity’s risk assessment process, the auditor ordinarily determines how management identifies business risks relevant to financial reporting, estimates the significance of the risks, assesses the likelihood of their occurrence, and decides upon actions to manage them. If the entity’s risk assessment process is appropriate to the circumstances, it assists the auditor in identifying risks of material misstatement.

92 Ordinarily, the auditor enquires about business risks that management has identified and considers whether they may result in material misstatement. During the audit, the auditor may identify risks of material misstatement that management failed to identify. In such cases, the auditor ordinarily considers whether there was an underlying risk of a kind that ought to have been identified by the entity’s risk assessment process, and if so, why that process failed to do so and whether the process is appropriate to its circumstances. If, as a result, the auditor judges that there is a material weakness in the entity’s risk assessment process, under paragraph 141 of this Auditing Standard, the auditor needs to communicate to those charged with governance.

93 In a smaller entity, management may not have a formal risk assessment process as described in paragraph 89. For such entities, under paragraph 89 of this Auditing Standard, the auditor needs to discuss with management how risks to the business are identified by management and how they are addressed.

Information System, Including the Related Business Processes, Relevant to Financial Reporting, and Communication

94 The information system relevant to financial reporting objectives, which includes the accounting system, consists of the procedures and records established to initiate, record, process, and report entity transactions (as well as events and conditions) and to maintain accountability for the related assets, liabilities, and equity.

95 The auditor shall obtain an understanding of the information system, including the related business processes, relevant to financial reporting, including the following areas:

(a) The classes of transactions in the entity’s operations that are significant to the financial report.

(b) The procedures, within both IT and manual systems, by which those transactions are initiated, recorded, processed and reported in the financial report.

(c) The related accounting records, whether electronic or manual, supporting information, and specific accounts in the financial report, in respect of initiating, recording, processing and reporting transactions.

(d) How the information system captures events and conditions, other than classes of transactions, that are significant to the financial report.

(e) The financial reporting process used to prepare the entity’s financial report, including significant accounting estimates and disclosures.

96 In obtaining this understanding, the auditor ordinarily:

(a) considers the procedures used to transfer information from transaction processing systems to the general ledger or financial reporting systems; and

(b) understands the entity’s procedures to capture information relevant to financial reporting for events and conditions other than transactions, such as the depreciation and amortisation of assets and changes in the recoverability of accounts receivable.

97 An entity’s information system typically includes the use of standard journal entries that are required on a recurring basis to record transactions such as sales, purchases, and cash disbursements in the general ledger, or to record accounting estimates that are periodically made by management, such as changes in the estimate of uncollectible accounts receivable.

98 An entity’s financial reporting process also includes the use of non-standard journal entries to record non-recurring, unusual transactions or adjustments. Examples of such entries include consolidating adjustments and entries for a business combination or disposal or non-recurring estimates such as an asset impairment. In manual, paper-based general ledger systems, non-standard journal entries may be identified through inspection of ledgers, journals, and supporting documentation. However, when automated procedures are used to maintain the general ledger and prepare a financial report, such entries may exist only in electronic form and may be more easily identified through the use of computer-assisted audit techniques.

99 Preparation of the entity’s financial report includes procedures that are designed to ensure information required to be disclosed by the applicable financial reporting framework is accumulated, recorded, processed, summarised and appropriately reported in the financial report.

100 In obtaining an understanding, the auditor ordinarily considers risks of material misstatement associated with inappropriate override of controls over journal entries and the controls surrounding non-standard journal entries. For example, automated processes and controls may reduce the risk of inadvertent error but do not overcome the risk that individuals may inappropriately override such automated processes, for example, by changing the amounts being automatically passed to the general ledger or financial reporting system. Furthermore, the auditor ordinarily maintains an awareness that when IT is used to transfer information automatically, there may be little or no visible evidence of such intervention in the information systems.

101 Ordinarily, the auditor understands how the incorrect processing of transactions is resolved, for example, whether there is an automated suspense file and how it is used by the entity to ensure that suspense items are cleared out on a timely basis, and how system overrides or bypasses to controls are processed and accounted for.

102 Under paragraph 95 of this Auditing Standard, the auditor needs to obtain an understanding of the entity’s information system relevant to financial reporting in a manner that is appropriate to the entity’s circumstances. This includes obtaining an understanding of how transactions originate within the entity’s business processes. An entity’s business processes are the activities designed to develop, purchase, produce, sell and distribute an entity’s products and services; ensure compliance with laws and regulations; and record information, including accounting and financial reporting information.

103 The auditor shall understand how the entity communicates financial reporting roles and responsibilities and significant matters relating to financial reporting.

104 Communication involves providing an understanding of individual roles and responsibilities pertaining to internal control over financial reporting and may take such forms as policy manuals and financial reporting manuals. It includes the extent to which personnel understand how their activities in the financial reporting information system relate to the work of others and the means of reporting exceptions to an appropriate higher level within the entity. Open communication channels help ensure that exceptions are reported and acted on. The auditor’s understanding of communication pertaining to financial reporting matters ordinarily includes communications between management and those charged with governance, particularly the audit committee, as well as external communications such as those with regulatory authorities.

Control Activities

105 The auditor shall obtain a sufficient understanding of control activities to assess the risks of material misstatement at the assertion level and to design further audit procedures responsive to assessed risks.

106 Control activities are the policies and procedures that help ensure that management directives are carried out; for example, that necessary actions are taken to address risks that threaten the achievement of the entity’s objectives. Control activities, whether within IT or manual systems, have various objectives and are applied at various organisational and functional levels. Examples of specific control activities include those relating to the following:

• Authorisation.
• Performance reviews.
• Information processing.
• Physical controls.
• Segregation of duties.

107 In obtaining an understanding of control activities, the auditor’s primary consideration is whether, and how, a specific control activity, individually or in combination with others, prevents, or detects and corrects, material misstatements in classes of transactions, account balances, or disclosures. Control activities relevant to the audit are those for which the auditor considers it necessary to obtain an understanding in order to assess risks of material misstatement at the assertion level and to design and perform further audit procedures responsive to the assessed risks. An audit does not require an understanding of all the control activities related to each significant class of transactions, account balance, and disclosure in the financial report or to every assertion relevant to them. Ordinarily, the auditor’s emphasis is on identifying and obtaining an understanding of control activities that address the areas where the auditor considers that material misstatements are more likely to occur. When multiple control activities achieve the same objective, it is unnecessary to obtain an understanding of each of the control activities related to such objective.

108 Ordinarily, the auditor considers the knowledge about the presence or absence of control activities obtained from the understanding of the other components of internal control in determining whether it is necessary to devote additional attention to obtaining an understanding of control activities. In considering whether control activities are relevant to the audit, the auditor ordinarily considers the risks the auditor has identified that may give rise to material misstatement. Also, control activities are relevant to the audit if the auditor needs to evaluate them under paragraphs 132 and 135.

109 The auditor shall obtain an understanding of how the entity has responded to risks arising from IT.

110 The use of IT affects the way that control activities are implemented. Ordinarily, the auditor considers whether the entity has responded adequately to the risks arising from IT by establishing effective general IT-controls and application controls. From the auditor’s perspective, controls over IT systems are effective when they maintain the integrity of information and the security of the data such systems process.

111 General IT-controls are policies and procedures that relate to many applications and support the effective functioning of application controls by helping to ensure the continued proper operation of information systems. General IT-controls that maintain the integrity of information and security of data commonly include controls over the following:

• Data centre and network operations.
• System software acquisition, change and maintenance.
• Access security.
• Application system acquisition, development, and maintenance.

They are generally implemented to deal with the risks referred to in paragraph 72 above.

112 Application controls are manual or automated procedures that typically operate at a business process level. Application controls can be preventative or detective in nature and are designed to ensure the integrity of the accounting records. Accordingly, application controls relate to procedures used to initiate, record, process and report transactions or other financial data. These controls help ensure that transactions occurred, are authorised, and are completely and accurately recorded and processed. Examples include edit checks of input data, and numerical sequence checks with manual follow-up of exception reports or correction at the point of data entry.

Monitoring of Controls

113 The auditor shall obtain an understanding of the major types of 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 corrective actions to its controls.

114 Monitoring of controls is a process to assess the effectiveness of internal control performance over time. It involves assessing the design and operation of controls on a timely basis and taking necessary corrective actions modified for changes in conditions. Those charged with governance and management accomplish monitoring of controls through ongoing activities, separate evaluations, or a combination of the two. Ongoing monitoring activities are often built into the normal recurring activities of an entity and include regular management and supervisory activities.

115 In many entities, internal auditors or personnel performing similar functions contribute to the monitoring of an entity’s activities. See ASA 610 Considering the Work of Internal Audit, for additional explanatory guidance. Management’s monitoring activities may also include using information from communications from external parties such as customer complaints and regulator comments that may indicate problems or highlight areas in need of improvement.

116 Much of the information used in monitoring may be produced by the entity’s information system. If management assumes that data used for monitoring are accurate without having a basis for that assumption, errors may exist in the information, potentially leading management to incorrect conclusions from its monitoring activities. Ordinarily, the auditor obtains an understanding of the sources of the information related to the entity’s monitoring activities, and the basis upon which management considers the information to be sufficiently reliable for the purpose. When the auditor intends to make use of the entity’s information produced for monitoring activities, such as internal auditor’s reports, under ASA 500, the auditor needs to consider whether the information provides a reliable basis and is sufficiently detailed for the auditor’s purpose.

Assessing the Risks of Material Misstate Assessing the Risks of Material Misstatement

Assessing the Risks of Material Misstatement

117 The auditor shall identify and assess the risks of material misstatement at the financial report level, and at the assertion level for classes of transactions, account balances, and disclosures.

118 For this purpose, the auditor ordinarily:

• Identifies risks throughout the process of obtaining an understanding of the entity and its environment, including relevant controls that relate to the risks, and by considering the classes of transactions, account balances, and disclosures in the financial report.
• Relates the identified risks to what can go wrong at the assertion level.
• Considers whether the risks are of a magnitude that could result in a material misstatement of the financial report.
• Considers the likelihood that the risks could result in a material misstatement of the financial report.

119 The auditor uses information gathered by performing risk assessment procedures, including the audit evidence obtained in evaluating the design of controls and determining whether they have been implemented, as audit evidence to support the risk assessment. Under ASA 330, the auditor needs to use the risk assessment to determine the nature, timing, and extent of further audit procedures to be performed.

120 Under paragraph 117 of this Auditing Standard, the auditor needs to determine whether the identified risks of material misstatement relate to specific classes of transactions, account balances, and disclosures and related assertions, or whether they relate more pervasively to the financial report as a whole and potentially affect many assertions. The latter risks (risks at the financial report level) may derive in particular from a weak control environment.

121 The nature of the risks arising from a weak control environment is such that they are not likely to be confined to specific individual risks of material misstatement in particular classes of transactions, account balances, and disclosures. Rather, weaknesses such as management’s lack of competence may have a more pervasive effect on the financial report and may require an overall response by the auditor.

122 In making risk assessments, the auditor may identify the controls that are likely to prevent, or detect and correct, material misstatement in specific assertions. Generally, the auditor gains an understanding of controls and relates them to assertions in the context of processes and systems in which they exist. Doing so is useful because individual control activities often do not in themselves address a risk. Often only multiple control activities, together with other elements of internal control, will be sufficient to address a risk.

123 Conversely, some control activities may have a specific effect on an individual assertion embodied in a particular class of transactions or account balance. For example, the control activities that an entity established to ensure that its personnel are properly counting and recording the annual physical inventory relate directly to the existence and completeness assertions for the inventory account balance.

124 Controls can be either directly or indirectly related to an assertion. The more indirect the relationship, the less effective that control may be in preventing, or detecting and correcting, misstatements in that assertion. For example, a sales manager’s review of a summary of sales activity for specific stores by region ordinarily is only indirectly related to the completeness assertion for sales revenue. Accordingly, it may be less effective in reducing risk for that assertion than controls more directly related to that assertion, such as matching shipping documents with billing documents.

125 The auditor’s understanding of internal control may raise doubts about the auditability of an entity’s financial report. Concerns about the integrity of the entity’s management may be so serious as to cause the auditor to conclude that the risk of management misrepresentation in the financial report is such that an audit cannot be conducted. Also, concerns about the condition and reliability of an entity’s records may cause the auditor to conclude that it is unlikely that sufficient appropriate audit evidence will be available to support an unqualified opinion on the financial report. In such circumstances, under ASA 701 Modifications to the Auditor’s Report, the auditor needs to consider a “qualified” or “disclaimer of opinion”, but in some cases the auditor’s only recourse may be to withdraw from the engagement.

Significant Risks that Require Special A Significant Risks that Require Special Audit Consideration

Significant Risks that Require Special Audit Consideration

126 As part of the risk assessment as described in paragraph 117, the auditor shall determine which of the risks identified are, in the auditor’s judgement, risks that require special audit consideration (such risks are defined as “significant risks”).

127 In addition, ASA 330 describes the consequences for further audit procedures of identifying a risk as significant.

128 The determination of significant risks, which arise on most audits, is a matter for the auditor’s professional judgement. In exercising this judgement, the auditor excludes the effect of identified controls related to the risk to determine whether the nature of the risk, the likely magnitude of the potential misstatement including the possibility that the risk may give rise to multiple misstatements, and the likelihood of the risk occurring are such that they require special audit consideration. Routine, non-complex transactions that are subject to systematic processing are less likely to give rise to significant risks because they have lower inherent risks. On the other hand, significant risks are often derived from business risks that may result in a material misstatement. In considering the nature of the risks, the auditor ordinarily considers a number of matters, including the following:

• Whether the risk is a risk of fraud.
• Whether the risk is related to recent significant economic, accounting or other developments and, therefore, warrants specific attention.
• The complexity of transactions.
• Whether the risk involves significant transactions with related parties.
• The degree of subjectivity in the measurement of financial information related to the risk especially those involving a wide range of measurement uncertainty.
• Whether the risk involves significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual.

129 Significant risks often relate to significant non-routine transactions and judgemental matters. Non-routine transactions are transactions that are unusual, either due to size or nature, and that therefore occur infrequently. Judgemental matters may include the development of accounting estimates for which there is significant measurement uncertainty.

130 Risks of material misstatement may be greater for risks relating to significant non-routine transactions arising from matters such as the following:

• Greater management intervention to specify the accounting treatment.
• Greater manual intervention for data collection and processing.
• Complex calculations or accounting principles.
• The nature of non-routine transactions, which may make it difficult for the entity to implement effective controls over the risks.

131 Risks of material misstatement may be greater for risks relating to significant judgemental matters that require the development of accounting estimates, arising from matters such as the following:

• Accounting principles for accounting estimates or revenue recognition may be subject to differing interpretation.
• Required judgement may be subjective, complex or require assumptions about the effects of future events, for example, judgement about fair value.

132 For significant risks, to the extent the auditor has not already done so, the auditor shall evaluate the design of the entity’s related controls, including relevant control activities, and determine whether they have been implemented.

133 Under paragraph 135 of this Auditing Standard, the auditor needs to have an understanding of the entity’s controls related to significant risks to provide adequate information to develop an effective audit approach. Those charged with governance and management ought to be aware of significant risks; however, risks relating to significant non-routine or judgemental matters are often less likely to be subject to routine controls. Therefore, the auditor’s understanding of whether the entity has designed and implemented controls for such significant risks ordinarily includes whether and how management responds to the risks and whether control activities such as a review of assumptions by senior management or experts, formal processes for estimations or approval by those charged with governance have been implemented to address the risks. For example, where there are one-off events such as the receipt of notice of a significant lawsuit, consideration of the entity’s response will include such matters as whether it has been referred to appropriate experts (such as internal or external legal counsel), whether an assessment has been made of the potential effect, and how it is proposed that the circumstances are to be disclosed in the financial report.

134 If management has not appropriately responded by implementing controls over significant risks and if, as a result, the auditor judges that there is a material weakness in the entity’s internal control, under paragraph 141 of this Auditing Standard, the auditor needs to communicate this matter to those charged with governance. In these circumstances, under paragraph 132 of this Auditing Standard, the auditor needs to consider the implications for the auditor’s risk assessment.

Risks for which Substantive Procedures a Risks for which Substantive Procedures alone do not provide Sufficient Appropriate Audit Evidence

Risks for which Substantive Procedures alone do not provide Sufficient Appropriate Audit Evidence

135 As part of the risk assessment as described in paragraph 117, the auditor shall evaluate the design and determine the implementation of the entity’s controls, including relevant control activities, over those risks for which, in the auditor’s judgement, it is not possible or practicable to reduce the risks of material misstatement at the assertion level to an acceptably low level with audit evidence obtained only from substantive procedures.

136 The consequences for further audit procedures of identifying such risks are described in ASA 330.

137 The understanding of the entity’s information system relevant to financial reporting enables the auditor to identify risks of material misstatement that relate directly to the recording of routine classes of transactions or account balances, and the preparation of a reliable financial report; these include risks of inaccurate or incomplete processing. Ordinarily, such risks relate to significant classes of transactions such as an entity’s revenue, purchases, and cash receipts or cash payments.

138 The characteristics of routine day-to-day business transactions often permit highly automated processing with little or no manual intervention. In such circumstances, it may not be possible to perform only substantive procedures in relation to the risk. For example, in circumstances where a significant amount of an entity’s information is initiated, recorded, processed, or reported electronically such as in an integrated system, the auditor may determine that it is not possible to design effective substantive procedures that by themselves would provide sufficient appropriate audit evidence that relevant classes of transactions or account balances, are not materially misstated. In such cases, audit evidence may be available only in electronic form, and its sufficiency and appropriateness usually depend on the effectiveness of controls over its accuracy and completeness. Furthermore, the potential for improper initiation or alteration of information to occur and not be detected may be greater if information is initiated, recorded, processed or reported only in electronic form and appropriate controls are not operating effectively.

139 Examples of situations where the auditor may find it impossible to design effective substantive procedures that by themselves provide sufficient appropriate audit evidence that certain assertions are not materially misstated include the following:

• An entity that conducts its business using IT to initiate orders for the purchase and delivery of goods based on predetermined rules of what to order and in what quantities and to pay the related accounts payable based on system-generated decisions initiated upon the confirmed receipt of goods and terms of payment. No other documentation of orders placed or goods received is produced or maintained, other than through the IT system.
• An entity that provides services to customers via electronic media (for example, an Internet service provider or a telecommunications company) and uses IT to create a log of the services provided to its customers, initiate and process its billings for the services and automatically record such amounts in electronic accounting records that are part of the system used to produce the entity’s financial report.

Revision of Risk Assessment Revision of Risk Assessment

Revision of Risk Assessment

140 The auditor’s assessment of the risks of material misstatement at the assertion level is based on available audit evidence and may change during the course of the audit as additional audit evidence is obtained. In particular, the risk assessment may be based on an expectation that controls are operating effectively to prevent, or detect and correct, a material misstatement at the assertion level. In performing tests of controls to obtain audit evidence about their operating effectiveness, the auditor may obtain audit evidence that controls are not operating effectively at relevant times during the audit. Similarly, in performing substantive procedures the auditor may detect misstatements in amounts or frequency greater than is consistent with the auditor’s risk assessments. In circumstances where the auditor obtains audit evidence from performing further audit procedures that tends to contradict the audit evidence on which the auditor originally based the assessment, under ASA 330, the auditor needs to revise the assessment and modify the further planned audit procedures accordingly. See ASA 330 for further explanatory guidance.

Communicating with Those Charged With Go Communicating with Those Charged With Governance and Management

Communicating with Those Charged With Governance and Management

141 The auditor shall make those charged with governance or management aware, as soon as practicable, and at an appropriate level of responsibility, of material weaknesses in the design or implementation of internal control which have come to the auditor’s attention.

142 If the auditor identifies risks of material misstatement which the entity has either not controlled, or for which the relevant control is inadequate, or if in the auditor’s judgement there is a material weakness in the entity’s risk assessment process, then under paragraph 141 of this Auditing Standard, the auditor needs to include such internal control weaknesses in the communication of audit matters of governance interest. See ASA 260 Communication of Audit Matters with Those Charged With Governance.

Documentation Documentation

Documentation