Application and Other Explanatory Material
Risk Assessment Procedures and Related Activities (Ref: Para. 5)
A1. Obtaining an understanding of the entity and its environment, including the entity’s internal control (referred to hereafter as an “understanding of the entity”), is a continuous, dynamic process of gathering, updating and analysing information throughout the audit. The understanding establishes a frame of reference within which the auditor plans the audit and exercises professional judgment throughout the audit, for example, when: Assessing risks of material misstatement of the financial statements;
Determining materiality in accordance with SA 320
2; 2 SA 320, “Materiality in Planning and Performing an Audit”.
Considering the appropriateness of the selection and application of
accounting policies, and the adequacy of financial statement disclosures; 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; Developing expectations for use when performing analytical procedures;
Responding to the assessed risks of material misstatement, including
designing and performing further audit procedures to obtain sufficient appropriate audit evidence; and Evaluating the sufficiency and appropriateness of audit evidence obtained, such as the appropriateness of assumptions and of management’s oral and written representations.
A2. Information obtained by performing risk assessment procedures and related activities may be used by the auditor as audit evidence to support assessments of the risks of material misstatement. In addition, 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 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.
A3. The auditor uses professional judgment to determine the extent of the understanding required. The auditor’s primary consideration is whether the understanding that has been obtained is sufficient to meet the objective stated in this SA. The depth of the overall understanding that is required by the auditor is less than that possessed by management in managing the entity.
A4. The risks to be assessed include both those due to error and those due to fraud, and both are covered by this SA. However, the significance of fraud is such that further requirements and guidance are included in SA 2403, in relation to risk assessment procedures and related activities to obtain information that is used to identify the risks of material misstatement due to fraud.
A5. Although the auditor is required to perform all the risk assessment procedures described in paragraph 6 in the course of obtaining the required understanding of the entity (see paragraphs 11-24), the auditor is not required to perform all of them for each aspect of that understanding. Other procedures may 3 SA 240, “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements”, paragraphs 12-24. be performed where the information to be obtained therefrom may be helpful in identifying risks of material misstatement. Examples of such procedures include:
Reviewing information obtained from external sources such as trade and
economic journals; reports by analysts, banks, or rating agencies; or regulatory or financial publications. Making inquiries of the entity’s external legal counsel or of valuation experts that the entity has used. Inquiries of Management, the Internal Audit Function and Others Within the
A6. Much of the information obtained by the auditor’s inquiries is obtained from management and those responsible for financial reporting. Information may also be obtained by the auditor through inquiries with the internal audit function, if the entity has such a function, and others within the entity.
A7. The auditor may also obtain information, or a different perspective in identifying risks of material misstatement, through inquiries of others within the entity and other employees with different levels of authority. For example:
Inquiries directed towards those charged with governance may help the
auditor understand the environment in which the financial statements are prepared.
Inquiries of employees involved in initiating, processing or recording
complex or unusual transactions may help the auditor to evaluate the appropriateness of the selection and application of certain accounting policies. Inquiries directed toward in-house legal counsel may provide information about 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 provide
information about changes in the entity’s marketing strategies, sales trends, or contractual arrangements with its customers.
Inquiries of the Internal Audit Function
A8. If an entity has an internal audit function, inquiries of the appropriate individuals within the function may provide information that is useful to the auditor in obtaining an understanding of the entity and its environment, and in identifying and assessing risks of material misstatement at the financial statement and assertion levels. In performing its work, the internal audit function is likely to have obtained insight into the entity’s operations and business risks, and may have findings based on its work, such as identified control deficiencies or risks, that may provide valuable input into the auditor’s understanding of the entity, the auditor’s risk assessments or other aspects of the audit. The auditor’s inquiries are therefore made whether or not the auditor expects to use the work of the internal audit function to modify the nature or timing, or reduce the extent, of audit procedures to be performed.4 Inquiries of particular relevance may be about matters the internal audit function has raised with those charged with governance and the outcomes of the function’s own risk assessment process.
A9. If, based on responses to the auditor’s inquiries, it appears that there are findings that may be relevant to the entity’s financial reporting and the audit, the auditor may consider it appropriate to read related reports of the internal audit function. Examples of reports of the internal audit function that may be relevant include the function’s strategy and planning documents and reports that have been prepared for management or those charged with governance describing the findings of the internal audit function’s examinations.
A10. In addition, in accordance with SA 240,5 if the internal audit function provides information to the auditor regarding any actual, suspected or alleged fraud, the auditor takes this into account in the auditor’s identification of risk of material misstatement due to fraud.
A11. Appropriate individuals within the internal audit function with whom inquiries are made are those who, in the auditor’s judgment, have the appropriate knowledge, experience and authority, such as the chief internal audit executive or, depending on the circumstances, other personnel within the function. The auditor may also consider it appropriate to have periodic meetings with these individuals.
Considerations specific to public sector entities (Ref: Para 6(a))
A12. Auditors of public sector entities often have additional responsibilities with regard to internal control and compliance with applicable laws and regulations. Inquiries of appropriate individuals in the internal audit function can assist the auditors in identifying the risk of material non-compliance with applicable laws and regulations and the risk of deficiencies in internal control over financial reporting. 4 The relevant requirements are contained in SA 610(Revised). 5 SA 240, paragraph 19.
Analytical Procedures (Ref: Para. 6(b))
A13. Analytical procedures performed as risk assessment procedures may identify aspects of the entity of which the auditor was unaware and may assist in assessing the risks of material misstatement in order to provide a basis for designing and implementing responses to the assessed risks*. Analytical procedures performed as risk assessment procedures may include both financial and non-financial information, for example, the relationship between sales and square footage of selling space or volume of goods sold.
A14. Analytical procedures may help identify the existence of unusual transactions or events, and amounts, ratios, and trends that might indicate matters that have audit implications. Unusual or unexpected relationships that are identified may assist the auditor in identifying risks of material misstatement, especially risks of material misstatement due to fraud.
A15. However, when such analytical procedures use data aggregated at a high level (which may be the situation with analytical procedures performed as risk assessment procedures), the results of those analytical procedures only provide a broad initial indication about whether a material misstatement may exist. Accordingly, in such cases, consideration of other information that has been gathered when identifying the risks of material misstatement together with the results of such analytical procedures may assist the auditor in understanding and evaluating the results of the analytical procedures.
Considerations Specific to Smaller Entities
A16. Some smaller entities may not have interim or monthly financial information that can be used for purposes of analytical procedures. In these circumstances, although the auditor may be able to perform limited analytical procedures for purposes of planning the audit or obtain some information through inquiry, the auditor may need to plan to perform analytical procedures to identify and assess the risks of material misstatement when an early draft of the entity’s financial statements is available.
Observation and Inspection (Ref: Para. 6(c))
A17. Observation and inspection may support inquiries of management and others, and may also provide information about the entity and its environment. Examples of such audit procedures include observation or inspection of the following: * SA 520, “Analytical Procedures”, paragraphs A1-A3 describe the nature of analytical procedures. The entity’s operations. Documents (such as business plans and strategies), records, and internal control manuals.
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). The entity’s premises and plant facilities.
Information Obtained in Prior Periods (Ref: Para. 9)
A18. The auditor’s previous experience with the entity and audit procedures performed in previous audits may provide the auditor with information about such matters as: Past misstatements and whether they were corrected on a timely basis. The nature of the entity and its environment, and the entity’s internal control (including deficiencies in internal control). Significant changes that the entity or its operations may have undergone since the prior financial period, which may assist the auditor in gaining a sufficient understanding of the entity to identify and assess risks of material misstatement.
A19. The auditor is required to determine whether information obtained in prior periods remains relevant, if the auditor intends to use that information for the purposes of the current audit. This is because changes in the control environment, for example, may affect the relevance of information obtained in the prior year. To determine whether changes have occurred that may affect the relevance of such information, the auditor may make inquiries and perform other appropriate audit procedures, such as walk-throughs of relevant systems.
Discussion Among the Engagement Team (Ref: Para. 10)
A20. The discussion among the engagement team about the susceptibility of the entity’s financial statements to material misstatement: Provides an opportunity for more experienced engagement team members, including the engagement partner, to share their insights based on their knowledge of the entity.
Allows the engagement team members to exchange information about the
business risks to which the entity is subject and about how and where the financial statements might be susceptible to material misstatement due to fraud or error. Assists the engagement team members to gain a better understanding of the potential for material misstatement of the financial statements 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.
Provides a basis upon which engagement team members communicate
and share new information obtained throughout the audit that may affect the assessment of risks of material misstatement or the audit procedures performed to address these risks. SA 240 provides further requirements and guidance in relation to the discussion among the engagement team about the risks of fraud.6
A21. It is not always necessary or practical for the discussion to include all members in a single discussion (as, for example, in a multi-location audit), nor is it necessary for all of the members of the engagement team to be informed of all of the decisions reached in the discussion. The engagement partner may discuss matters with key members of the engagement team including, if considered appropriate, specialists and those responsible for the audits of components, while delegating discussion with others, taking account of the extent of communication considered necessary throughout the engagement team. A communications plan, agreed by the engagement partner, may be useful.
Considerations Specific to Smaller Entities
A22. Many small audits are carried out entirely by the engagement partner (who may be a sole practitioner). In such situations, it is the engagement partner who, having personally conducted the planning of the audit, would be responsible for considering the susceptibility of the entity’s financial statements to material misstatement due to fraud or error. The Required Understanding of the Entity and its Environment,
Including the Entity’s Internal Control
The Entity and its Environment
Industry, Regulatory and Other External Factors (Ref: Para. 11(a))
A23. Relevant industry factors include industry conditions such as the competitive environment, supplier and customer relationships, and technological developments. Examples of matters the auditor may consider include: 6 SA 240, paragraph 15.
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.
A24. 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 expenses that give rise to risks of material misstatement. In such cases, it is important that the engagement team include members with sufficient relevant knowledge and experience7.
A25. Relevant regulatory factors include the regulatory environment. The regulatory environment encompasses, among other matters, the applicable financial reporting framework and the legal and political environment. Examples of matters the auditor may consider include: Accounting principles and industry specific practices. Regulatory framework for a regulated industry. Legislation and regulation that significantly affect the entity’s operations, including direct supervisory activities. Taxation (corporate and other). Government policies currently affecting the conduct of the entity’s business, such as monetary, including foreign exchange controls, fiscal, financial incentives (for example, government aid programs), and tariffs or trade restrictions policies. Environmental requirements affecting the industry and the entity’s business.
A26. SA 2508, includes some specific requirements related to the legal and regulatory framework applicable to the entity and the industry.
A27. In case of the audits of certain entities, in addition to legislation or regulations, there may be government policy requirements and resolutions of the legislature that affect the entity’s operations. Such elements are essential to consider when obtaining an understanding of the entity and its environment. 7 SA 220, “Quality Control for an Audit of Financial Statements”, paragraph 14. 8 SA 250, “Consideration of Laws and Regulations in an Audit of Financial Statements”, paragraph 10.
A28. Examples of other external factors affecting the entity that the auditor may consider include the general economic conditions, interest rates and availability of financing, and inflation or currency revaluation.
Nature of the Entity (Ref: Para.11(b))
A29. An understanding of the nature of an entity enables the auditor to understand such matters as: Whether the entity has a complex structure, for example with subsidiaries or other components in multiple locations. Complex structures often introduce issues that may give rise to risks of material misstatement. Such issues may include whether goodwill, joint ventures, investments, or special-purpose entities are accounted for appropriately. The ownership, and relations between owners and other people or entities.
This understanding assists in determining whether related party
transactions have been identified and accounted for appropriately. SA 5509, establishes requirements and provides guidance on the auditor’s considerations relevant to related parties.
A30. Examples of matters that the auditor may consider when obtaining an understanding of the nature of the entity include: Business operations – such as: Nature of revenue sources, products or services, and markets, including involvement in electronic commerce such as internet sales and marketing activities. Conduct of operations (for example, stages and methods of production, or activities exposed to environmental risks). Alliances, joint ventures, and outsourcing activities. Geographic dispersion and industry segmentation. Location of production facilities, warehouses, and offices, and location and quantities of inventories. Key customers and important suppliers of goods and services, employment arrangements (including the existence of union contracts, pension and other post employment benefits, stock option or incentive 9 SA 550, “Related Parties”. Reference may also be made to the Accounting Standard (AS) 18, “Related Party Disclosures” for definition of related party and related party transactions. bonus arrangements, and government regulation related to employment matters). Research and development activities and expenditures. Transactions with related parties. Investments and investment activities – such as: Planned or recently executed acquisitions or divestitures. Investments and dispositions of securities and loans. Capital investment activities. Investments in non-consolidated entities, including partnerships, joint ventures and special-purpose entities. Financing and financing activities – such as: Major subsidiaries and associated entities, including consolidated and non-consolidated structures. Debt structure and related terms, including off-balance-sheet financing arrangements and leasing arrangements. Beneficial owners (local, foreign, business reputation and experience) and related parties. Use of derivative financial instruments. Financial reporting – such as: Accounting principles and industry - specific practices, including industry - specific significant categories (for example, loans and investments for banks, or research and development for pharmaceuticals). Revenue recognition practices. Accounting for fair values. Foreign currency assets, liabilities and transactions. Accounting for unusual or complex transactions including those in controversial or emerging areas (for example, accounting for stock- based compensation).
A31. Significant changes in the entity from prior periods may give rise to, or change, risks of material misstatement.
Nature of Special-Purpose Entities
A32. A special-purpose entity (sometimes referred to as a special purpose vehicle) is an entity that is generally established for a narrow and well-defined purpose, such as to effect a lease or a securitisation of financial assets, or to carry out research and development activities. It may take the form of a corporation, trust, partnership or unincorporated entity. The entity on behalf of which the special-purpose entity has been created may often transfer assets to the latter (e.g., as part of a de-recognition transaction involving financial assets), obtain the right to use the latter’s assets, or perform services for the latter, while other parties may provide the funding to the latter. As SA 550 indicates, in some circumstances, a special-purpose entity may be a related party of the entity.10
A33. Financial reporting frameworks often specify detailed conditions that are deemed to amount to control, or circumstances under which the special-purpose entity should be considered for consolidation. The interpretation of the requirements of such frameworks often demands a detailed knowledge of the relevant agreements involving the special- purpose entity. The Entity’s Selection and Application of Accounting Policies (Ref: Para.11(c))
A34. An understanding of the entity’s selection and application of accounting policies may encompass such matters as: 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. Changes in the entity’s accounting policies. Financial reporting standards and laws and regulations that are new to the entity, and when and how the entity will adopt such requirements.
Objectives and Strategies and Related Business Risks (Ref. Para.11(d))
A35. 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 or those charged with governance define objectives, which are the overall plans for the entity. Strategies are the approaches by which management intends to achieve its objectives. The entity’s objectives and strategies may change over time.
A36. Business risk is broader than the risk of material misstatement of the financial statements, though it includes the latter. Business risk may arise from change or complexity. A failure to recognise the need for change may also give rise to business risk. Business risk may arise, for example, from: The development of new products or services that may fail; 10 SA 550, ‘Related Parties’, paragraph A7. A market which, even if successfully developed, is inadequate to support a product or service; or Flaws in a product or service that may result in liabilities and reputational risk.
A37. An understanding of the business risks facing the entity increases the likelihood of identifying risks of material misstatement, since most business risks will eventually have financial consequences and, therefore, an effect on the financial statements. However, the auditor does not have a responsibility to identify or assess all business risks because not all business risks give rise to risks of material misstatement.
A38. Examples of matters that the auditor may consider when obtaining an understanding of the entity’s objectives, strategies and related business risks that may result in a risk of material misstatement of the financial statements include:
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). 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). The 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 improper implementation).
A39. A business risk may have an immediate consequence for the risk of material misstatement for classes of transactions, account balances, and disclosures at the assertion level or the financial statement level. For example, the business risk arising from a contracting customer base may increase the risk of material 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 the auditor considers when assessing the appropriateness of the going concern assumption. Whether a business risk may result in a risk of material misstatement is, therefore, considered in light of the entity’s circumstances. Examples of conditions and events that may indicate risks of material misstatement are indicated in the Appendix 2.
A40. Usually, management identifies business risks and develops approaches to address them. Such a risk assessment process is part of internal control and is discussed in paragraph 15 and paragraphs A86-A87.
A41. In case of audits of certain entities, “management objectives” may be influenced by concerns regarding public accountability and may include objectives which have their source in legislation, regulations, and government directions. Measurement and Review of the Entity’s Financial Performance (Ref: Para. 11(e))
A42. Management and others will measure and review those things they regard as important. Performance measures, whether external or internal, create pressures on the entity. These pressures, in turn, may motivate management to take action to improve the business performance or to misstate the financial statements. Accordingly, an understanding of the entity’s performance measures assists the auditor in considering whether pressures to achieve performance targets may result in management actions that increase the risks of material misstatement, including those due to fraud – See SA 240 for requirements and guidance in relation to the risks of fraud.
A43. The measurement and review of financial performance is not the same as the monitoring of controls (discussed as a component of internal control in paragraphs A105-A116), though their purposes may overlap:
The measurement and review of performance is directed at whether
business performance is meeting the objectives set by management (or third parties). Monitoring of controls is specifically concerned with the effective operation of internal control. In some cases, however, performance indicators also provide information that enables management to identify deficiencies in internal control.
A44. Examples of internally-generated information used by management for measuring and reviewing financial performance, and which the auditor may consider, include: Key performance indicators (financial and non-financial) and key ratios, trends and operating statistics. Period-on-period financial performance analyses. Budgets, forecasts, variance analyses, segment information and divisional, departmental or other level performance reports. Employee performance measures and incentive compensation policies. Comparisons of an entity’s performance with that of competitors.
A45. 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 represent useful information for the auditor. Such reports can often be obtained from the entity being audited.
A46. Internal measures may highlight unexpected results or trends requiring management 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 that risks of misstatement of related financial statement information do exist. 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 statements.
Considerations specific to smaller entities
A47. Smaller entities often do not have processes to measure and review financial performance. Inquiry of management may reveal that it relies on certain key indicators for evaluating financial performance and taking appropriate action. If such inquiry indicates an absence of performance measurement or review, there may be an increased risk of misstatements not being detected and corrected.
The Entity’s Internal Control (Ref: Para. 12)
A48. An understanding of internal control assists the auditor in identifying types of potential misstatements and factors that affect the risks of material misstatement, and in designing the nature, timing, and extent of further audit procedures.
A49. The following application material on internal control is presented in four sections, as follows: General Nature and Characteristics of Internal Control. Controls Relevant to the Audit. Nature and Extent of the Understanding of Relevant Controls. Components of Internal Control.
General Nature and Characteristics of Internal Control (Ref: Para. 12)
Purpose of internal control
A50. Internal control is designed, implemented and maintained to address identified business risks that threaten the achievement of any of the entity’s objectives that concern: The reliability of the entity’s financial reporting; The effectiveness and efficiency of its operations;
Its compliance with applicable laws and regulations; and
Safeguarding of assets. The way in which internal control is designed, implemented and maintained varies with an entity’s size and complexity.
Considerations specific to smaller entities
A51. Smaller entities may use less structured means and simpler processes and procedures to achieve their objectives.
Limitations of internal control
A52. Internal control, no matter how effective, can provide an entity with only reasonable assurance about achieving the entity’s financial reporting objectives. The likelihood of their achievement is affected by inherent limitations of internal control. These include the realities that human judgment in decision-making can be faulty and that breakdowns in internal control can occur because of human error. For example, there may be an error in the design of, or in the change to, a control. Equally, the operation of a control may not be effective, such as where information produced for the purposes of internal control (for example, an exception report) is not effectively used because the individual responsible for reviewing the information does not understand its purpose or fails to take appropriate action.
A53. 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.
A54. Further, in designing and implementing controls, management may make judgments on the nature and extent of the controls it chooses to implement, and the nature and extent of the risks it chooses to assume.
Considerations specific to smaller entities
A55. Smaller entities often have fewer employees which may limit the extent to which segregation of duties is practicable. However, in a small owner-managed entity, the owner-manager11 may be able to exercise more effective oversight than in a larger entity. This oversight may compensate for the generally more limited opportunities for segregation of duties.
A56. On the other hand, the owner-manager may be more able to override controls because the system of internal control is less structured. This is taken into account by the auditor when identifying the risks of material misstatement due to fraud.
Division of internal control into components
A57. The division of internal control into the following five components, for purposes of the SAs, provides a useful framework for auditors to consider how different aspects of an entity’s internal control may affect the audit:
