IDENTIFYING AND ASSESSING THE RISKS OF MATERIAL MISSTATEM

CHAPTER 10 : 

CHAPTER 10 IDENTIFYING AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENTS THROUGH UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

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Our discussion will focus on the process of obtaining understanding of the entity and its environment including internal control and assessing the risks of material misstatements in a financial statement audit. The discussion also will relate PSA 315 IDENTIFYING AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENTS THROUGH UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

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Overview of the requirements presented by the standards: Risk assessment procedures and sources of information about the entity and its environment, including its internal control. Understanding the entity and its environment, including its internal control. Identifying and assessing of the risks of material misstatements. Material weakness in internal conrol Documentation.

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Obtaining an understanding of the entity and its environment is an essential aspect of performing an audit in accordance with PSAs because that understanding establishes a frame of reference within which the auditor plans the audit and exercises professional judgment about assessing risks of material misstatement of the financial statements and responding to those risks throughout the audit. Examples: When establishing materiality and evaluating whether the judgment about materiality remains appropriate as the audit progresses; When considering the appropriateness of the selection and application of accounting policies, and the adequacy of financial statement disclosures;

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When identifying areas where special audit consideration may be necessary, for example, related party transactions, the appropriateness of management’s use of the going concern assumption, or considering the business purpose of transactions; When developing expectations for use when performing analytical procedures; When designing and performing further audit procedures to reduce audit risk to an acceptably low level; and When evaluating the sufficiency and appropriateness of audit evidence obtained, such as the appropriateness of assumptions and of management’s oral and written representations.

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The auditor uses professional judgment to determine the extent of the understanding required of the entity and its environment, including its internal control. The auditor’s primary consideration is whether the understanding that has been obtained is sufficient to assess the risks of material misstatement of the financial statements and to design and perform further audit procedures. The depth of the overall understanding that is required by the auditor in performing the audit is less than that possessed by management in managing the entity.

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I. Risk Assessment Procedures and Sources of Information About the Entity and Its Environment, Including Its Internal Control Obtaining an understanding of the entity and its environment, including its internal control, is a continuous, dynamic process of gathering, updating and analyzing information throughout the audit. As described in PSA 500, audit procedures to obtain an understanding are referred to as “risk assessment procedures” because some of the information obtained by performing such procedures may be used by the auditor as audit evidence to support assessments of the risks of material misstatement.

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In addition, in performing risk assessment procedures, the auditor may obtain audit evidence about classes of transactions, account balances, or disclosures and related assertions and about the operating effectiveness of controls, even though such audit procedures were not specifically planned as substantive procedures or as tests of controls. The auditor also may choose to perform substantive procedures or tests of controls concurrently with risk assessment procedures because it is efficient to do so.

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RISK ASSESSMENT PROCEDURES The auditor should perform the following risk assessment procedures to obtain an understanding of the entity and its environment, including its internal control: (a) Inquiries of management and others within the entity; (b) Analytical procedures; and (c) Observation and inspection. Note: The auditor is not required to perform all the risk assessment procedures described above for each aspect of the understanding. However, all the risk assessment procedures are performed by the auditor in the course of obtaining the required understanding.

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a.) Inquiries The auditor may consider making inquiries of the entity’s external legal counsel or of valuation experts that the entity has used. Reviewing information obtained from external sources such as reports by analysts, banks, or rating agencies; trade and economic journals; or regulatory or financial publications may also be useful in obtaining information about the entity.

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Although much of the information the auditor obtains by inquiries can be obtained from management and those responsible for financial reporting, inquiries of others within the entity, such as production and internal audit personnel, and other employees with different levels of authority, may be useful in providing the auditor with a different perspective in identifying risks of material misstatement. In determining others within the entity to whom inquiries may be directed, and the extent of those inquiries, the auditor considers what information may be obtained that helps the auditor in identifying risks of material misstatement.

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Sample of Inquiries: Inquiries directed towards those charged with governance may help the auditor understand the environment in which the financial statements are prepared. Inquiries directed toward internal audit personnel may relate to their activities concerning the design and effectiveness of the entity’s internal control and whether management has satisfactorily responded to any findings from these activities. Inquiries of employees involved in initiating, processing or recording complex or unusual transactions may help the auditor in evaluating the appropriateness of the selection and application of certain accounting policies.

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Inquiries directed toward in-house legal counsel may relate to such matters as litigation, compliance with laws and regulations, knowledge of fraud or suspected fraud affecting the entity, warranties, post-sales obligations, arrangements (such as joint ventures) with business partners and the meaning of contract terms. Inquiries directed towards marketing or sales personnel may relate to changes in the entity’s marketing strategies, sales trends, or contractual arrangements with its customers.

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b.) Analytical Procedures: Analytical procedures may be helpful in identifying the existence of unusual transactions or events, and amounts, ratios, and trends that might indicate matters that have financial statement and audit implications. In performing analytical procedures as risk assessment procedures, the auditor develops expectations about plausible relationships that are reasonably expected to exist. When comparison of those expectations with recorded amounts or ratios developed from recorded amounts yields unusual or unexpected relationships, the auditor considers those results in identifying risks of material misstatement.

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c.) Observation and inspection Observation and inspection may support inquiries of management and others, and also provide information about the entity and its environment. Such audit procedures ordinarily include the following: 1. Observation of entity activities and operations. Inspection of documents (such as business plans and strategies), records, and internal control manuals. Reading reports prepared by management (such as quarterly management reports and interim financial statements) and those charged with governance (such as minutes of board of directors’ meetings). Visits to the entity’s premises and plant facilities. Tracing transactions through the information system relevant to financial reporting (walk- throughs ).

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When the auditor intends to use information about the entity and its environment obtained in prior periods, the auditor should determine whether changes have occurred that may affect the relevance of such information in the current audit. For continuing engagements, the auditor’s previous experience with the entity contributes to the understanding of the entity. Audit procedures performed in previous audits ordinarily provide audit evidence about the entity’s organizational structure, business and controls, as well as information about past misstatements and whether or not they were corrected on a timely basis, which assists the auditor in assessing risks of material misstatement in the current audit.

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However, when such analytical procedures use data aggregated at a high level (which is often the situation), the results of those analytical procedures only provide a broad initial indication about whether a material misstatement may exist. Accordingly, the auditor considers the results of such analytical procedures along with other information gathered in identifying the risks of material misstatement. When relevant to the audit, the auditor also considers other information such as that obtained from the auditor’s client acceptance or continuance process or, where practicable, experience gained on other engagements performed for the entity, for example, engagements to review interim financial information.

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DISCUSSION AMONG THE ENGAGEMENT TEAM The members of the engagement team should discuss the susceptibility of the entity’s financial statements to material misstatements. The objective of this discussion is for members of the engagement team to gain a better understanding of the potential for material misstatements of the financial statements resulting from fraud or error in the specific areas assigned to them, and to understand how the results of the audit procedures that they perform may affect other aspects of the audit including the decisions about the nature, timing, and extent of further audit procedures.

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The discussion provides an opportunity for more experienced engagement team members, including the engagement partner, to share their insights based on their knowledge of the entity, and for the team members to exchange information about the business risks1 to which the entity is subject and about how and where the financial statements might be susceptible to material misstatement. As required by PSA 240, particular emphasis is given to the susceptibility of the entity’s financial statements to material misstatement due to fraud. The discussion also addresses application of the applicable financial reporting framework to the entity’s facts and circumstances.

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Professional judgment is used to determine which members of the engagement team are included in the discussion, how and when it occurs, and the extent of the discussion. The key members of the engagement team are ordinarily involved in the discussion; however, it is not necessary for all team members to have a comprehensive knowledge of all aspects of the audit. The extent of the discussion is influenced by the roles, experience, and information needs of the engagement team members. Another factor to consider in planning the discussions is whether to include experts assigned to the engagement team.

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Depending on the circumstances of the audit, there may be further discussions in order to facilitate the ongoing exchange of information between engagement team members regarding the susceptibility of the entity’s financial statements to material misstatements. The purpose is for engagement team members to communicate and share information obtained throughout the audit that may affect the assessment of the risks of material misstatement due to fraud or error or the audit procedures performed to address the risks.

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II. Understanding the Entity and Its Environment, Including Its Internal Control 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. (b) Nature of the entity, including the entity’s selection and application of accounting policies. (c) Objectives and strategies and the related business risks that may result in a material misstatement of the financial statements. (d) Measurement and review of the entity’s financial performance. (e) Internal control.

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A. INDUSTRY, REGULATORY AND OTHER EXTERNAL FACTORS, INCLUDING THE APPLICABLE FINANCIAL REPORTING FRAMEWORK The auditor should obtain an understanding of relevant industry, regulatory, and other external factors including the applicable financial reporting framework. 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.

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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. Industry conditions: The market and competition, including demand, capacity, and price competition Cyclical or seasonal activity Product technology relating to the entity’s products Energy supply and cost

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Legislative and regulatory requirements often determine the applicable financial reporting framework to be used by management in preparing the entity’s financial statements. 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.

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Regulatory environment Accounting principles and industry specific practices Regulatory framework for a regulated industry Legislation and regulation that significantly affect the entity’s operations 4. Regulatory requirements 5. Direct supervisory activities Taxation (corporate and other) Government policies currently affecting the conduct of the entity’s business 8. Monetary, including foreign exchange controls 9. Fiscal 10. Financial incentives (for example, government aid programs) 11. Tariffs, trade restrictions Environmental requirements affecting the industry and the entity’s business Other external factors currently affecting the entity’s business 1. General level of economic activity (for example, recession, growth) 2 . Interest rates and availability of financing 3. Inflation, currency revaluation

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B. NATURE OF THE ENTITY 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 statements. The auditors’ understanding of the nature of the client will include the client’s accounting policies and procedures, ownership, capital structure, and product lines. Then the auditors turn their attention to the client’s critical business processes and obtain an understanding of how these processes create value for the client’s customers.

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

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Examples of matters an auditor may consider include the following: Business Operations Nature of revenue sources (for example, manufacturer, wholesaler, banking, insurance or other financial services, import/export trading, utility, transportation, and technology products and services) Products or services and markets (for example, major customers and contracts, terms of payment, profit margins, market share, competitors, exports, pricing policies, reputation of products, warranties, order book, trends, marketing strategy and objectives, manufacturing processes)

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Geographic dispersion and industry segmentation Location of production facilities, warehouses, and offices Key customers Important suppliers of goods and services (for example, long- term contracts, stability of supply, terms of payment, imports, methods of delivery such as “just-in-time”) Employment (for example, by location, supply, wage levels, union contracts, pension and other post employment benefits, stock option or incentive bonus arrangements, and government regulation related to employment matters) Research and development activities and expenditures 6. Transactions with related parties

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Investments Acquisitions, mergers or disposals of business activities (planned or recently executed) Investments and dispositions of securities and loans Capital investment activities, including investments in plant and equipment and technology, and any recent or planned changes Investments in non-consolidated entities, including partnerships, joint ventures and special-purpose entities

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Financing Group structure – major subsidiaries and associated entities, including consolidated and non consolidated structures Debt structure, including covenants, restrictions, guarantees, and off-balance sheet financing arrangements Leasing of property, plant or equipment for use in the business Beneficial owners (local, foreign, business reputation and experience) Related parties Use of derivative financial instruments

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Financial Reporting Accounting principles and industry specific practices Revenue recognition practices Accounting for fair values Inventories (for example , locations, quantities ) Foreign currency assets, liabilities and transactions

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Industry-specific significant categories (for example, loans and investments for banks, accounts receivable and inventory for manufacturers, research and development for pharmaceuticals) Accounting for unusual or complex transactions including those in controversial or emerging areas (for example, accounting for stock-based compensation) 9. Financial statement presentation and disclosure

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C. OBJECTIVES AND STRATEGIES AND RELATED BUSINESS RISKS The auditor should obtain an understanding of the entity’s objectives and strategies, and the related business risks that may result in material misstatement of the financial statements. Business risk – A risk resulting from significant conditions, events, circumstances , actions or inactions that could adversely affect an entity’s ability to achieve its objectives and execute its strategies, or from the setting of inappropriate objectives and strategies. Significant risk – An identified and assessed risk of material misstatement that , in the auditor’s judgment, requires special audit consideration.

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Examples of matters an auditor may consider include the following: Existence of objectives (i.e., how the entity addresses industry, regulatory and other external factors) relating to, for example, the following: Industry developments ( a potential related business risk might be, for example, that the entity does not have the personnel or expertise to deal with the changes in the industry) New products and services ( a potential related business risk might be, for example, that there is increased product liability) Expansion of the business ( a potential related business risk might be, for example, that the demand has not been accurately estimated) New accounting requirements ( a potential related business risk might be, for example, incomplete or improper implementation, or increased costs.)

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Regulatory requirements (a potential related business risk might be, for example, that there is increased legal exposure) Current and prospective financing requirements (a potential related business risk might be, for example, the loss of financing due to the entity’s inability to meet requirements) Use of IT (a potential related business risk might be, for example, that systems and processes are incompatible) Effects of implementing a strategy, particularly any effects that will lead to new accounting requirements ( a potential related business risk might be, for example, incomplete or improer implementation)

D. MEASUREMENT AND REVIEW OF THE ENTITY’S FINANCIAL PERFORMANCE: 

D. MEASUREMENT AND REVIEW OF THE ENTITY’S FINANCIAL PERFORMANCE A uditor should obtain an understanding of the measurement and review of the entity’s financial performance. Performance measures and their review indicate to the auditor aspects of the entity’s performance that 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 statements. The methods of measuring and reviewing performance are important to the auditors in determining the incentives of management and other employees because their compensation is often tied to the measures. In addition the auditors may use these measures in designing analytical procedures to provide evidence about the fairness of the financial statements.

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Management’s measurement and review of the entity’s financial performance is to be distinguished from the monitoring of controls, 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 management (or third parties), but in some cases performance indicators also provide information that enables management to identify deficiencies in internal control. 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 of incorrect conclusions about performance.

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Smaller entities ordinarily do not have formal processes to measure and review the entity’s financial performance. Examples of matters an auditor may consider include the following: Key ratios and operating statistics Key performance indicators Employee performance measures and incentive compensation policies Trends Use of forecasts, budgets and variance analysis Analyst reports and credit rating reports Competitor analysis Period-on-period financial performance (revenue growth, profitability, leverage)

E. UNDERSTANDING THE CLIENT’S INTERNAL CONTROL: 

E. UNDERSTANDING THE CLIENT’S INTERNAL CONTROL Internal control is designed to provide reasonable assurance of achieving objectives related to reliable financial reporting, efficiency and effectiveness of operations, and compliance with applicable laws and regulations. The nature and extent of the audit work to be performed on a particular engagement depend largely upon the effectiveness of the client’s internal control in preventing or detecting material misstatements in the financial statements. Before auditors can evaluate the effectiveness of internal control, they need a knowledge and understanding of how it works; what controls exist and who performs them, how various types of transactions are processed and recoded, and what accounting records and supporting documentation exists. The auditor must have a sufficient understanding of the design and implementation of internal control to plan the audit.

III. Identifying and Assessing the Risk of Material Misstatement: 

III. Identifying and Assessing the Risk of Material Misstatement The auditor should identify and assess the risks of material misstatement at the financial statement level, and at the assertion level for classes of transactions, account balances, and disclosures. For this purpose, the auditor: 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 statements; 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 material misstatement of the financial statements; and Considers the likelihood that the risks could result in a material misstatement of the financial statements.

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As part of the risk assessment as described in paragraph 100, the auditor should determine which of the risks identified are, in the auditor’s judgment, risks that require special audit consideration (such risks are defined as “significant risks“) In considering the nature of the risks, the auditor 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, requires 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.

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Whether the risk involves significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual. Significant risks often relate to significant non-routing transactions and judgmental matters. Non-routine transactions are transactions that are unusual, either due to size or nature and that therefore occur infrequently. Risks of material misstatement may be greater for risks relating to non-routine transactions arising from matters such as follows: 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.

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Risks of material misstatement may be greater for risks relating to significant judgmental 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 judgment may be subjective, complex or require assumptions about the effects of future events, for example, judgment about fair value. The following are examples of conditions and events that may indicate the existence of risks of material misstatement. The examples provided cover a broad range of conditions and events; however, not all conditions and events are relevant to every audit engagement and the list of examples is not necessarily complete. Operations in regions that are economically unstable Operations exposed to volatile markets

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High degree of complex regulation Going concern and liquidity issues including loss of significant customers. Constraints on the availability of capital and credit Changes in the industry in which the entity operates Changes in the supply chain Developing or offering new products or services, or moving into new lines of business Expanding into new locations. Changes in the entity such as large acquisitions or reorganizations or other unusual events Entities or business segments likely to be sold Complex alliances and joint ventures Use of off-balance-sheet finance, special-purpose entities, and other complex financing arrangements Significant transactions with related parties

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Lack of personnel with appropriate accounting and financial reporting skills Changes in key personnel including departure of key executives Weaknesses in internal control, especially those not addressed by management. Inconsistencies between the entity’s IT strategy and its business strategies. Changes in the IT environment. Installation of significant new IT systems related to financial reporting Inquiries into the entity’s operations or financial results by regulatory or government bodies. Past misstatements, history of errors or a significant amount of adjustments at period end. Significant amount of non-routine or non-systematic transactions including intercompany transactions and large revenue transactions at period end

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Transactions that are recorded based on management’s intent, for example, debt refinancing, assets to be sold and classification of marketable securities. Application of new accounting pronouncements. Accounting measurements that involve complex processes. Events or transactions that involve significant measurement uncertainty, including accounting estimates. Pending litigation and contingent liabilities, for example, sales warranties, financial guarantees and environmental remediation.

IV. Material Weakness in Internal Control: 

IV. Material Weakness in Internal Control The auditor shall communicate material weaknesses in internal control identifies during the audit on a timely basis to management at an appropriate level of responsibility, and, as required by PSA 260 (revised), “Communication with Those Charged with Governance,” with those charged with governance (unless all of those charged with governance are involved in managing the entity). The types of material weaknesses in internal control: Risks of material misstatement that the auditor identifies and which the entity has not controlled, or for which the relevant control is inadequate. A weakness in the entity’s risk assessment process that the auditor identifies as material, or the absence of a risk assessment process in those cases where it would be appropriate for one to have been established.

V. Documentation: 

V. Documentation The auditor should document: The discussion among the engagement team regarding the susceptibility of the entity’s financial statements to material misstatement due to error or fraud, and the significant decisions reached; Key elements of the understanding obtained regarding each of the aspects of the entity and its environment identified in paragraph 11, including each of the internal control components identified in paragraph 14-23 of PSA 315 (redrafted), to assess the risks of material misstatement of the financial statements; the sources of information from which the understanding was obtained; and the risk assessment procedures;

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The identified and assessed risks of material misstatement at the financial statement level and at the assertion level as required by paragraph 24 of PSA 315 (redrafted); and The risks identified and related controls evaluated as a result of the requirements in paragraphs 26-29 of PSA 315 (redrafted) The form and extent of the documentation is influenced by the nature , size and complexity of the entity and its internal control, availability of information from the entity and the audit methodology and technology used in the course of the audit. The more complex the entity and the more extensive the audit procedures performed by the auditor, the more extensive the auditor’s documentation will be. PSA 230 “Audit Documentation” provides guidance regarding documentation in the context of the audit of financial statements.

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