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The first phase of audit is obtain the understanding of the entity, as an auditor in auditing financial statements I will obtain an understanding of the entity and its environment (including internal control). It is very important to obtain understanding of the entity background in auditing because it can be assess the business risks normally faced by the entity and based on my understanding about the audit of the entity's business risks, I can assess the risk of material misstatement. Under ISA 315 the entire auditor need to obtain the understanding of the entity and its environment, efficiently to assess the risk of material misstatement of the financial statements and to efficiently design the nature, timing, and extent of further audit procedures.
There are various aspects to understanding the entity and its environment:
First aspect, the industry, regulatory, and other external factor, includes the applicable financial reporting framework. As an auditor, I will understand the industry conditions and daily operation which will cause the risks of material misstatement, such as:
Industry structure, the market, segmentation and the competition in the industry
The business risks and the problem normally will face by the industry
Competitive environment with same industry company
seasonal activity of the industry
Energy supply by the industry to produce their goods/service and the cost to be charge
Technology factors that will affect the entity ability to produce their goods at fair price
Second aspect, regulatory environment, as an auditor, I need to understand the legal and regulatory environment, any entity not compliance with the regulatory requirements they will get the penalties and reportable irregularities, as well as material misstatements in the financial statement. The legal and regulatory aspects I need to understand are:
Legal and the regulation framework for the entity and the entity industry
The financial reporting framework: the entity must follow the regulatory of the financial reporting requirement
Tax law: taxation law applicable to the entity, such as the employee tax, company tax
Government policies: affect the entity business
-Monetary, eg: foreign exchange control
-Tariffs and trade restrictions
Third aspect, external influences, there are various other external factors which cannot handle by the management and the external factor will consequently affect the business risk. The external factors I need to understand are:
The general level of the economic activities, weather the economic is growth gradually or under recession
The rate of interest and the availability of financing
The occur of the inflation and the rate of currency revaluation
Fourth aspect, nature of the entity, I need to know and observe the client's daily operations, its ownership, and the investment of the entity, the structure of the entity company and its financing method. By understanding the nature of the entity, I can come out much more better idea in the financial statement. I need to better understanding in nature of an entity; this is because I can deep understand the classes of transactions, account balances, and disclosures in the financial statements. Other than that, I should obtain an understanding in the accounting policies selected by the entity. It includes understanding the methods used of the account and wrong transactions that may affect the accounting policies and changes in accounting policies. Besides, I also need to assess suitable accounting policies are selected, that is consistency with financial reporting framework and industry practice.
Fifth aspect, I should obtain an understanding of the entity's objectives and strategies that related
business risks and it may result in material misstatement of the financial statements. Example matters as an auditor I need to consider:
The growth of the business
Adopt new products and service
The new accounting regulation
Meet the regulatory requirement
Use of new technology
The strategy implemented will have any effects on new accounting requirements
Growth of industry
As an auditor, I should always remember that business risk is bigger than the risk of material misstatement and the business risks sometimes affect the going concern only and do not affect material misstatement in the financial statements
The sixth aspect is I should obtain an understanding of the measurement and review of the entity's financial performance. This is because the performance measurement and the financial performance sometimes will effect on the entity and motivate management to misstate the financial statements. Other than that, the internally generated information can provide very useful information to me to understand the entity's position, the entity competitors. In addition, the reports form credit rating agencies and analysts may provide information to me to understanding the entity and its environments.
The last aspect is to understand the Internal Control, it is to identify types of material
misstatements, to reflect on factors that will affect to the risks of material misstatements and design the further audit procedures of nature, timing and extent. Based on my understanding in the internal control, I can identify business risks that affect the entity achievement in their company objectives. There are the components of internal control, there are included, control of environment, entity risk assessment process, control activities, monitor the control and relate the business process to financial reporting and communication.
ASSESS RISKS AND ESTABLISH MATERIALITY
The second phase of audit is assessing risks and establishes materiality. As an auditor, I should identify the business risk, business risks is the risk of materially misstated in the financial statements. The business risk can either in long run or immediately effect on the financial statement. I should identify and understand the business risk that may result in material misstatement and consequently affect on audit and detection risk. Besides, same risks will also affect on long term implications to the entity company overall health if the economic is under recession. For this case, I should consider the client will not remain financially viable and the going concern assumption whether is still appropriate or not.
Other than that, the business risks faced by the entity may also affect on their operation, financial reporting, and compliance with the law and regulations. To control the business risks, I should use the risk assessment process to reflect the entity ability to identify and respond to the business risks and changing in the environment condition. Complexity or changes in the environment may affect the business risks. There are some example of condition may indicate as business risks:
Change in the entity such as large acquisition, reorganizations, or other unusual events
Change in the industry operation
New product or new lines of business
Change in information technology environment
By understanding the business risks, I can easily identify the risk of material misstatement. However, according to the standard of audit, as an auditor, I not responsible to identify or assess all the business risks. If the business risk are result in material misstatement in the financial statements are identified, I should evaluate the entity response on the risks and the evidence of response have been implemented. If the entity response is not adequate to the business risks, as an auditor, I should develop the procedure to determine the misstatements are present in the account balance or class of transaction.
Based on the understanding of the entity and its environment, I should assess the risk of material misstatement at the assertion level and determine the audit procedures that are necessary based on the risk assessment. To assess the risk, as an auditor, I should identifies the risks by understand the entity and its environment, it including control to the risks are related, relate the risks to the transaction and account balance in the financial statement and judge that the risks will cause material misstatement in the financial statements
Other than that, I will uses the information gathered by performing risk assessment procedure to obtain an understanding of the entity and its environment, including evaluating the design of controls and determine whether they have been implemented, and to support the risk assessment.
When the risk assessment is based on the expectation of the control is operate affectively, I required to perform the test of the control to obtain evidence that control are operate effectively.
As an auditor, I should design and implement overall responses to address the assessed risks of material misstatement as follows:
Making appropriate assignments of significant engagement responsibilities. The knowledge, skill, and ability of engagement team members with significant engagement responsibilities should be commensurate with the assessed risks of material misstatement.
Providing the extent of supervision that is appropriate for the circumstances, including, in particular, the assessed risks of material misstatement. (ISA 10)
Evaluating the company's selection and application of significant accounting principles. I should evaluate whether the company's selection and application of significant accounting principles, particularly those related to subjective measurements and complex transactions, are indicative of bias that could lead to material misstatement of the financial statements.
I also should determine whether it is necessary to make pervasive changes to the nature, timing, or extent of audit procedures to adequately address the assessed risks of material misstatement. Such pervasive changes include modifying the audit strategy to increase the substantive testing of the valuation of numerous significant accounts at year end because of significantly deteriorating market conditions, and obtain more persuasive audit evidence from substantive procedures due to the identification of pervasive weaknesses in the company's control environment.
As an auditor, I should design and perform audit procedures in a manner that addresses the assessed risks of material misstatement for each relevant assertion of each significant account and disclosure. In designing the audit procedures to be performed, I should obtain more persuasive audit evidence the higher the auditor's assessment of risk, take into account the types of potential misstatements that could result from the identified risks and the likelihood and magnitude of potential misstatement and design the testing of controls to accomplish the objectives of both audits simultaneously.