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LECTURE NOTES
Importance of Understanding the Entity and its information, or a different perspective in identifying risks
Environment including Internal Control of material misstatement, through inquiries of others
within the entity. Inquiries directed towards with others
The auditor’s understanding of the entity and its
within the entity are summarized below:
environment, including internal control (this will be
discussed next topic, ‘AT.1510B-Understanding the Entity’s Those May help the auditor understand the
Internal Control’), is the foundation of the conduct of an charged with environment in which the financial
effective audit. It establishes a frame of reference within governance statements are prepared.
which the auditor plans the audit and exercises Internal audit May provide information about internal
professional judgment throughout the audit, for example, personnel audit procedures performed during the
when: year relating to the design and
Assessing ROMM of the financial statements; effectiveness of the entity’s internal
Establishing materiality; control and whether management has
Considering the appropriateness of the selection and satisfactorily responded to findings from
application of accounting policies, and the adequacy of those procedures.
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financial statement disclosures; Employees May help the auditor to evaluate the
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Identifying areas where special audit consideration involved in appropriateness of the selection and
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Developing expectations for use when performing initiating, application of certain accounting policies.
analytical procedures;
Responding to the assessed ROMM and
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recording
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Evaluating the sufficiency and appropriateness of audit complex or
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evidence obtained. unusual
transactions
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The auditor uses professional judgment to determine the In-house legal May provide information about such
extent of the understanding required sufficiently enough to counsel matters as litigation, compliance with laws
be able to identify and assess risks of material and regulations, knowledge of fraud or
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misstatements, which is ordinarily less than that possessed suspected fraud affecting the entity,
by management in managing the entity. warranties, post- sales obligations,
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the following:
its customers.
a. performing risk assessment procedures;
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Risk Assessment Procedures (RAP) among both financial and non-financial data. Analytical
procedures also encompass such investigation as is
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In summary, analytical procedures are performed in the following areas of audit:
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Stage Planning and Risk Assessment Testing (Fieldwork) Completion
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Procedure Preliminary analytical Substantive analytical Concluding (Final or overall)
Objective
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procedures (As part of RAP)
To obtain understanding the
procedures
To detect material
analytical procedures
To form an overall conclusion that
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entity and its environment in misstatements, about an the financial statements are
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order to identify and assess assertion, as part of responses to consistent with the auditor’s
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Results Identification and assessment Obtain reasonable assurance Conclusion that FSs are consistent
of ROMMs about the fairness of an with the auditor’s understanding or
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unrecognized ROMM
Observation and Inspection relevance of such information, the auditor may make
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records, and internal control manuals. application of the applicable financial reporting framework
Reports prepared by management (such as quarterly to the entity’s facts and circumstances. The engagement
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management reports and interim financial statements) partner shall determine which matters are to be
and those charged with governance (such as minutes communicated to engagement team members not involved
of board of directors’ meetings). in the discussion.
The entity’s premises and plant facilities (tour).
Books, periodicals and other publications related to the Understanding The Entity and Its Environment
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The entity’s objectives and strategies, and those The effect of significant accounting policies in
related business risks that may result in risks of controversial or emerging areas for which there is a
material misstatement. lack of authoritative guidance or consensus.
The measurement and review of the entity’s financial Changes in the entity’s accounting policies.
performance Financial reporting standards and laws and regulations
that are new to the entity and when and how the
Industry, Regulatory and Other External Factors entity will adopt such requirements.
Industry Factors
Objectives and Strategies and Related Business Risks
Relevant industry factors include industry conditions such
The entity conducts its business in the context of industry,
as the competitive environment, supplier and customer
regulatory and other internal and external factors. To
relationships, and technological developments. Examples
respond to these factors, the entity’s management or
of matters the auditor may consider include:
those charged with governance define objectives, which
The market and competition, including demand,
are the overall plans for the entity. Strategies are the
capacity, and price competition.
approaches by which management intends to achieve its
Cyclical or seasonal activity.
objectives. The entity’s objectives and strategies may
Product technology relating to the entity’s products.
change over time.
Energy supply and cost.
Business risk is a risk resulting from significant conditions,
The industry in which the entity operates may give rise to
events, circumstances, actions or inactions that could
specific risks of material misstatement. Hence, it is
adversely affect an entity’s ability to achieve its objectives
important that the engagement team include members
and execute its strategies, or from the setting of
with sufficient relevant knowledge and experience.
inappropriate objectives and strategies. Business risk is
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broader than the risk of material misstatement of the
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Regulatory Factors
financial statements, though it includes the latter.
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Relevant regulatory factors include the regulatory
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environment. The regulatory environment encompasses,
among other matters, the applicable financial reporting
Business risk may arise from change or complexity. A
failure to recognize the need for change may also give rise
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framework and the legal and political environment. to business risk. Business risk may arise, for example,
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Examples of matters the auditor may consider include: from:
Accounting principles and industry specific practices. The development of new products or services that may
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Environmental requirements affecting the industry and liabilities and reputational risk.
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the auditor may consider include the general economic the financial statements. However, the auditor does not
conditions, interest rates and availability of financing, and
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The ownership, and relations between owners and risk of material misstatement of the financial statements
other people or entities. This understanding assists in include:
determining whether related party transactions have Industry developments (a potential related business
been identified and accounted for appropriately. risk might be, for example, that the entity does not
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Use of IT (a potential related business risk might be, Management and others will measure and review those
for example, that systems and processes are things they regard as important. Performance measures,
incompatible). whether external or internal, create pressures on the
The effects of implementing a strategy, particularly entity. These pressures, in turn, may motivate
any effects that will lead to new accounting management to take action to improve the business
requirements (a potential related business risk might performance or to misstate the financial statements.
be, for example, incomplete or improper Accordingly, an understanding of the entity’s performance
implementation). measures assists the auditor in considering whether
pressures to achieve performance targets may result in
A business risk may have an immediate consequence for management actions that increase the risks of material
the risk of material misstatement for classes of misstatement, including those due to fraud.
transactions, account balances, and disclosures at the
assertion level or the financial statement level. For Documentation
example, the business risk arising from a contracting
The auditor shall document:
customer base may increase the risk of material
The risk assessment procedures performed, as part of
misstatement associated with the valuation of receivables.
detailed audit plan.
However, the same risk, particularly in combination with a
The discussion among the engagement team, and the
contracting economy, may also have a longer-term
significant decisions reached (normally in a
consequence, which the auditor considers when assessing
memorandum or minutes of meeting)
the appropriateness of the going concern assumption.
Key elements of the understanding obtained regarding
Whether a business risk may result in a risk of material
each of the aspects of the entity and its environment
misstatement is, therefore, considered in light of the
including the sources of information from which the
entity’s circumstances.
understanding was obtained (normally in a
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‘understanding the business template’)
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Usually, management identifies business risks and
develops approaches to address them as an entity’s risk For recurring audits, certain documentation may be carried
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assessment process, which is part of the entity’s internal
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control. entity’s business or processes.
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Measurement and Review of the Entity’s Financial - done -
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Performance
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MULTIPLE CHOICE
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1. The main purpose of risk assessment procedures is to least likely perform while obtaining an understanding
a. Obtain an understanding of the entity and its of a client in a financial statement audit?
environment, including its internal control, to a. Coordinating the assistance of entity personnel in
assess the risks of material misstatement at the data preparation.
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financial statement and assertion levels. b. Discussing matters that may affect the audit with
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b. Test the operating effectiveness of controls in firm personnel responsible for non-audit services
preventing, or detecting and correcting, material to the entity.
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2. Which of the following is least likely to be considered a 5. Which one of the following is a valid source of
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accounting procedures.
6. Each of the following may be relevant to an auditor
3. Inquiries directed towards internal audit personnel may when obtaining knowledge about the client’s business
most likely and industry, except
a. Relate to their activities concerning the design and a. Performing a walkthrough tests
effectiveness of the entity’s internal control and b. Publications related to the industry
whether management has satisfactorily responded c. Visits the entity’s premises
to any findings from those activities d. Discussion with people within or outside the entity
a. Help the auditor in understanding the environment
in which the financial statements are prepared 7. An understanding of a client’s business and industry
b. Relate to changes in the entity’s marketing and knowledge about operations are essential for
strategies, sales trends or contractual performing an adequate audit. For a new client, most
arrangements with its customers of this information is obtained:
c. Help the auditor in evaluating the appropriateness a. from the predecessor auditor.
of the selection and application of accounting b. from the Securities and Exchange Commission.
policies c. from the permanent file.
d. at the client’s premises.
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8. To obtain an understanding of a continuing client's c. Study of the relationships of financial data with
business, an auditor most likely would relevant nonfinancial data.
a. Perform tests of details of transactions and d. Tracing transactions through the system to
balances. determine whether procedures are being applied as
b. Review prior year working papers and the prescribed.
permanent file for the client.
14. In performing an audit, which one of the following
c. Read current issues of specialized industry
procedures would be considered an analytical
journals.
procedure?
d. Reevaluate the client's internal control
a. Comparing last year’s interest expense with this
environment.
year’s interest expense.
9. Which of the following statements is correct, when b. Comparing signatures on checks with the
obtaining understanding about the client’s business? signatures of authorized check signers.
a. For continuing engagements, the auditor may no c. Reviewing initials on received documents
longer obtain knowledge about the client’s d. Reviewing procedures followed in receiving,
business. depositing, and disbursing cash.
b. The level of knowledge required of the auditor is
15. Which of the following is not an example of analytical
ordinarily more than the level of knowledge
evidence?
possessed by management.
a. Compared inventory turnover by major class with
c. Preliminary knowledge about the entity’s industry
the prior year on a monthly and quarterly basis.
must be obtained after accepting the engagement
b. Compared gross profit percentages by major
to determine whether the auditor has the
product classes with the prior year.
necessary knowledge to perform the audit.
c. Examined invoices for plant asset additions to
d. Following the acceptance of the engagement, the
determine whether the client had erroneously
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auditor should obtain detailed knowledge about the
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recorded ordinary repairs as plant assets.
client’s business preferably at the start of the
d. Examined monthly performance reports and
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engagement.
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10. The auditor’s understanding of the entity and its amounts.
environment assists the auditor in
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16. An auditor compares year-to-year account balances in
a. Assessing the risks and identifying potential
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order to perform analytical procedures. This is an
problems.
example of:
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d. Vertical analysis
when performing analytical procedures.
d. All of the above.
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differ from expected values by a significant amount. accordance with PSAs, the use of analytical procedures
a. Audit planning is required to some extent
b. Audit evidence In the As a As an overall in
c. Analytical procedures assessment of substantive the completion
is
exists. focus on
c. analytical procedures are used as tests of controls. a. Reducing the scope of tests of controls and
d. plausible relationships among data may reasonably substantive tests.
be expected to exist and continue in the absence of b. Providing assurance that potential material
known conditions to the contrary. misstatements will be identified.
c. Enhancing the auditor’s understanding of the
13. Analytical procedures enable the auditor to predict the client’ s business required to identify areas of
balance or quantity of an item under audit. heightened risk.
Information to develop this estimate can be obtained d. Assessing the adequacy of the available evidence.
from all of the following, except
a. Comparison of financial data with data for 20. The auditor notices significant fluctuations in key
comparable prior periods, anticipated results (e.g., elements of the company's financial statements. If
budgets and forecasts), and similar data for the management is unable to provide an acceptable
industry in which the entity operates. explanation, the auditor should
b. Study of the relationships of elements of financial a. Consider the matter a scope limitation.
data that would be expected to conform to a b. Perform additional audit procedures to investigate
predictable pattern based upon the entity’s the matter further.
experience. c. Intensify the examination with the expectation of
detecting management fraud.
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d. Withdraw from the engagement. III. Objectives and strategies and the related business
risks that may result in a material misstatement of
21. Which of the following statements is not correct with
the financial statements
respect to analytical procedures?
IV. Measurement and review of the entity’s financial
a. Auditing standards emphasize the need for
performance.
auditors to develop and use expectations.
V. Internal control
b. Analytical procedures must be performed
a. All of the above
throughout the audit.
b. I, II and III only
c. Analytical procedures may be performed at any
c. I and II, III and IV only
time during the audit.
d. I and III only
d. Analytical procedures use comparisons and
relationships to assess whether account balances 26. Nature of the entity refers to
appear reasonable. a. The entity’s operations, its ownership and
governance, the types of investments that it is
The Entity and Its Environment
making and plans to make, the way that the entity
22. The audit team gathers information about a new
is structured and how it is financed
client's business and industry in order to obtain:
b. The overall plans for the entity
a. an understanding of the clients internal control
c. The operational approaches by which management
system for financial reporting.
intends to achieve its objectives
b. an understanding of how economic events and
d. The result of significant conditions, events and
transactions have an effect on the company's
circumstances, actions or inactions that could
financial statements.
adversely affects the entity’s ability to achieve its
c. information about engagement risk.
objectives and execute the strategies or the setting
d. information regarding whether the company is
of inappropriate objectives and strategies
engaging in financial statement fraud.
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27. The result of significant conditions, events and
23. Which statement is incorrect regarding obtaining an
circumstances, actions or inactions that could
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understanding of the entity and its environment?
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a. Obtaining an understanding of the entity and its
objectives and execute the strategies or the setting of
environment is an essential aspect of performing
inappropriate objectives and strategies
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an audit in accordance with PSAs.
a. Audit risk c. Significant risk
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b. That understanding establishes a frame of
b. Business risk d. Sampling risk
reference within which the auditor plans the audit
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and exercises professional judgment about 28. Which statement is correct regarding business risk?
assessing risks of material misstatement of the a. The risk of material misstatement of the financial
financial statements and responding to those risks statements is broader than business risk, though it
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to assess the risks of material misstatement of the c. All business risks give rise to risks of material
financial statements and to design and perform misstatements
further audit procedures. d. A business risk may have an immediate
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d. The depth of the overall understanding that is consequence for the risk of misstatement for
required by the auditor in performing the audit is classes of transactions, account balances, and
ed d
equal to that possessed by management in disclosures in the assertion level or the financial
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b. predecessor auditors need to be consumed. expertise to deal with the changes in the industry.
c. the client's business, industry and internal control d. Loss of financing due to the entity’s inability to
are unfamiliar to the auditor and need to be meet financing requirements.
carefully studied.
d. a larger proportion of customer accounts 30. A potential business risk created by new products may
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balances or classes of transaction. 12. Which of the following is not a typical analytical review
c. As an overall review of financial information in the procedure?
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final review stage of the audit. eH w a. Study of relationships of the financial information
d. All of the above. with relevant non-financial information.
b. Comparison of the financial information with
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5. The preliminary use of analytical review procedures by
similar information regarding the industry in which
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the auditor is
the entity operates.
a. required to identify areas of heightened risk
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