ASA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment October 2009 (Cth)
| Compiled Auditing Standard | ASA 315 (December 2015) |
Auditing Standard ASA 315
Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment
This compilation was prepared on 1 December 2015 taking into account amendments made by ASA 2011‑1, ASA 2013‑2 and ASA 2015‑1
Prepared by the Auditing and Assurance Standards Board
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This Auditing Standard reproduces substantial parts of the corresponding International Standard on Auditing issued by the International Auditing and Assurance Standards Board (IAASB) and published by the International Federation of Accountants (IFAC), in the manner described in the statement on Conformity with International Standards on Auditing. The AUASB acknowledges that IFAC is the owner of copyright in the International Standard on Auditing incorporated in this Auditing Standard throughout the world.
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ISSN 1833‑4393
CONTENTS
COMPILATION DETAILS
AUTHORITY STATEMENT
CONFORMITY WITH INTERNATIONAL STANDARDS ON AUDITING
Paragraphs
Application.......................................................................................................... Aus 0.1-Aus 0.2
Operative Date................................................................................................................. Aus 0.3
Introduction
Scope of this Auditing Standard................................................................................................... 1
Effective Date.............................................................................................................................. 2
Objective..................................................................................................................................... 3
Definitions................................................................................................................................... 4
Requirements
Risk Assessment Procedures and Related Activities............................................................... 5-10
The Required Understanding of the Entity and its Environment, Including the Entity’s Internal Control........................................................................................................................................... 11-24
Identifying and Assessing the Risks of Material Misstatement.............................................. 25-31
Documentation.......................................................................................................................... 32
Application and Other Explanatory Material
Risk Assessment Procedures and Related Activities.......................................................... A1-A24
The Required Understanding of the Entity and Its Environment, Including the Entity’s Internal Control................................................................................................................................... A25-A121
Identifying and Assessing the Risks of Material Misstatement.................................... A122-A151
Documentation............................................................................................................ A152-A155
Appendix 1: Internal Control Components
Appendix 2: Conditions and Events That May Indicate Risks of Material Misstatement
COMPILATION DETAILS
Auditing Standard ASA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment (as Amended)
This compilation takes into account amendments made up to and including 1 December 2015 and was prepared on 1 December 2015 by the Auditing and Assurance Standards Board (AUASB).
This compilation is not a separate Auditing Standard made by the AUASB. Instead, it is a representation of ASA 315 (October 2009) as amended by other Auditing Standards which are listed in the Table below.
Table of Standards
| Standard | Date made | Operative Date |
| ASA 315 [A] | 27 October 2009 | Financial reporting periods commencing on or after 1 January 2010 |
| ASA 2011‑1 [B] | 27 June 2011 | Financial reporting periods commencing on or after 1 July 2011 |
| ASA 2013‑2 [C] | 11 November 2013 | Financial reporting periods commencing on or after 1 January 2014 |
| ASA 2015‑1 [D] | 1 December 2015 | Financial reporting periods ending on or after 15 December 2016 |
[A] Federal Register of Legislative Instruments – registration number F2009L04079, 12 November 2009
[B] Federal Register of Legislative Instruments – registration number F2011L01379, 30 June 2011
[C] Federal Register of Legislative Instruments – registration number F2013L01939, 14 November 2013
[D] Federal Register of Legislative Instruments – registration number F2015L02032, 16 December 2015
Table of Amendments
| Paragraph affected | How affected | By … [paragraph] |
| A26 | Amended | ASA 2011-1 [28] |
| Appendix 1 Para. 3 | Amended | ASA 2011-1 [29] |
| Appendix 1 Sub-heading above Para. 5 | Amended | ASA 2011-1 [30] |
| 6(a) | Amended | ASA 2013-2 [58] |
| 22 | Amended | ASA 2013-2 [59] |
| 23 | Amended | ASA 2013-2 [60] |
| 23 and Footnote 1 | Amended | ASA 2013-2 [61] |
| Heading above paragraph A6 | Amended | ASA 2013-2 [62] |
| A6-A7 | Amended | ASA 2013-2 [63] |
| A7 and Footnote 5 | Addition | ASA 2013-2 [64] |
| A8-A13 | Additions | ASA 2013-2 [65] |
| A9 and Footnote 6 | Addition | ASA 2013-2 [66] |
| A11 and Footnote 7 | Addition | ASA 2013-2 [67] |
| Paragraph numbers | Re-numbered | ASA 2013-2 [68] [70] [76] |
| Footnote references | Re-numbered | ASA 2013-2 [68] |
| A79 | Addition | ASA 2013-2 [69] |
| Heading above paragraph A109 | Amended | ASA 2013-2 [71] |
| A109 | Amended | ASA 2013-2 [72] |
| A110-A111 | Amended | ASA 2013-2 [73] |
| A112 | Amended | ASA 2013-2 [74] |
| A113-A116 | Additions | ASA 2013-2 [75] |
| 18 | Amended | ASA 2015-1 [58] |
| 26 | Amended | ASA 2015-1 [59] |
| A1 | Amended | ASA 2015-1 [60] |
| A19 | Amended | ASA 2015-1 [61] |
| A22 | Addition | ASA 2015-1 [62-63] |
| A27 | Amended | ASA 2015-1 [65] |
| A31 | Amended | ASA 2015-1 [66] |
| Aus A31.1 | Deleted | ASA 2015-1 [64] |
| A32 | Amended | ASA 2015-1 [67] |
| A81 | Amended | ASA 2015-1 [68] |
| A91 | Addition | ASA 2015-1 [69 and 71] |
| Footnote 15 | Addition | ASA 2015-1 [70] |
| A92 | Addition | ASA 2015-1 [72-73] |
| A96 | Amended | ASA 2015-1 [74] |
| A103 | Addition | ASA 2015-1 [75-76] |
| A123 | Amended | ASA 2015-1 [77] |
| A125 (pre-existing paragraph) | Deleted | ASA 2015-1 [85] |
| A127 | Amended | ASA 2015-1 [78] |
| Heading above paragraph A128 | Addition | ASA 2015-1 [80] |
| A128 | Amended | ASA 2015-1 [81] |
| Heading above paragraph A129 | Addition | ASA 2015-1 [82] |
| A129 | Addition | ASA 2015-1 [83-84] |
| A131 | Amended | ASA 2015-1 [86] |
| Footnote 17 | Addition | ASA 2015-1 [87] |
| A132 | Amended | ASA 2015-1 [88] |
| A133 | Addition | ASA 2015-1 [89 and 91] |
| Footnote 18 | Addition | ASA 2015-1 [90] |
| Footnote 19 | Addition | ASA 2015-1 [90] |
| A134 | Addition | ASA 2015-1 [92-93] |
| Heading above paragraph A135 | Addition | ASA 2015-1 [94] |
| A135 | Addition | ASA 2015-1 [95-96] |
| Heading above paragraph A136 | Addition | ASA 2015-1 [97] |
| A136 | Addition | ASA 2015-1 [98-99] |
| Appendix 2 | Amended | ASA 2015-1 [100] |
AUTHORITY STATEMENT
Auditing Standard ASA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment (as amended to 1 December 2015) is set out in paragraphs Aus 0.1 to A155 and Appendices 1 and 2.
This Auditing Standard is to be read in conjunction with ASA 101 Preamble to Australian Auditing Standards, which sets out the intentions of the AUASB on how the Australian Auditing Standards, operative for financial reporting periods commencing on or after 1 January 2010, are to be understood, interpreted and applied. This Auditing Standard is to be read also in conjunction with ASA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Australian Auditing Standards.
Dated: 1 December 2015
Conformity with International Standards on Auditing
This Auditing Standard conforms with International Standard on Auditing ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment issued by the International Auditing and Assurance Standards Board (IAASB), an independent standard‑setting board of the International Federation of Accountants (IFAC).
Paragraphs that have been added to this Auditing Standard (and do not appear in the text of the equivalent ISA) are identified with the prefix “Aus”.
Compliance with this Auditing Standard enables compliance with ISA 315.
AUDITING STANDARD ASA 315
The Auditing and Assurance Standards Board (AUASB) made Auditing Standard ASA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment pursuant to section 227B of the Australian Securities and Investments Commission Act 2001 and section 336 of the Corporations Act 2001, on 27 October 2009.
This compiled version of ASA 315 incorporates subsequent amendments contained in other Auditing Standards made by the AUASB up to and including 1 December 2015 (see Compilation Details).
AUDITING STANDARD ASA 315
Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment
Application
Aus 0.1 This Auditing Standard applies to:
(a) an audit of a financial report for a financial year, or an audit of a financial report for a half‑year, in accordance with the Corporations Act 2001; and
(b) an audit of a financial report, or a complete set of financial statements, for any other purpose.
Aus 0.2 This Auditing Standard also applies, as appropriate, to an audit of other historical financial information.
Operative Date
Aus 0.3 This Auditing Standard is operative for financial reporting periods commencing on or after 1 January 2010. [Note: For operative dates of paragraphs changed or added by an Amending Standard, see Compilation Details.]
Introduction
Scope of this Auditing Standard
This Auditing Standard deals with the auditor’s responsibility to identify and assess the risks of material misstatement in the financial report, through understanding the entity and its environment, including the entity’s internal control.
Effective Date
[Deleted by the AUASB. Refer Aus 0.3]
Objective
The objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial report and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement.
Definitions
For the purposes of this Auditing Standard, the following terms have the meanings attributed below:
(a)Assertions means representations by management and those charged with governance, explicit or otherwise, that are embodied in the financial report, as used by the auditor to consider the different types of potential misstatements that may occur.
(b)Business risk means 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.
(c)Internal control means the process designed, implemented and maintained by those charged with governance, management and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations. The term “controls” refers to any aspects of one or more of the components of internal control.
(d)Risk assessment procedures means the audit procedures performed to obtain an understanding of the entity and its environment, including the entity’s internal control, to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial report and assertion levels.
(e)Significant risk means an identified and assessed risk of material misstatement that, in the auditor’s judgement, requires special audit consideration.
Requirements
Risk Assessment Procedures and Related Activities
The auditor shall perform risk assessment procedures to provide a basis for the identification and assessment of risks of material misstatement at the financial report and assertion levels. Risk assessment procedures by themselves, however, do not provide sufficient appropriate audit evidence on which to base the audit opinion. (Ref: Para. A1-A5)
The risk assessment procedures shall include the following:
(a)Enquiries of management, of appropriate individuals within the internal audit function (if the function exists) and of others within the entity who in the auditor’s judgement may have information that is likely to assist in identifying risks of material misstatement due to fraud or error. (Ref: Para. A6-A13)
(b)Analytical procedures. (Ref: Para. A14-A17)
(c)Observation and inspection. (Ref: Para. A18)
The auditor shall consider whether information obtained from the auditor’s client acceptance or continuance process is relevant to identifying risks of material misstatement.
If the engagement partner has performed other engagements for the entity, the engagement partner shall consider whether information obtained is relevant to identifying risks of material misstatement.
Where the auditor intends to use information obtained from the auditor’s previous experience with the entity and from audit procedures performed in previous audits, the auditor shall determine whether changes have occurred since the previous audit that may affect its relevance to the current audit. (Ref: Para. A19-A20)
The engagement partner and other key engagement team members shall discuss the susceptibility of the entity’s financial report to material misstatement, and the application of the applicable financial reporting framework to the entity’s facts and circumstances. The engagement partner shall determine which matters are to be communicated to engagement team members not involved in the discussion. (Ref: Para. A21-A24)
The Required Understanding of the Entity and its Environment, Including the Entity’s Internal Control
The Entity and Its Environment
The auditor shall obtain an understanding of the following:
(a)Relevant industry, regulatory, and other external factors and the applicable financial reporting framework. (Ref: Para. A25-A30)
(b)The nature of the entity, including:
(i)its operations;
(ii)its ownership and governance structures;
(iii)the types of investments that the entity is making and plans to make, including investments in special‑purpose entities; and
(iv)the way that the entity is structured and how it is financed
to enable the auditor to understand the classes of transactions, account balances, and disclosures to be expected in the financial report. (Ref: Para. A31-A35)
(c)The entity’s selection and application of accounting policies, including the reasons for changes thereto. The auditor shall evaluate whether the entity’s accounting policies are appropriate for its business and consistent with the applicable financial reporting framework and accounting policies used in the relevant industry. (Ref: Para. A36)
(d)The entity’s objectives and strategies, and those related business risks that may result in risks of material misstatement. (Ref: Para. A37-A43)
(e)The measurement and review of the entity’s financial performance. (Ref: Para. A44-A49)
The Entity’s Internal Control
The auditor shall obtain an understanding of internal control relevant to the audit. Although most controls relevant to the audit are likely to relate to financial reporting, not all controls that relate to financial reporting are relevant to the audit. It is a matter of the auditor’s professional judgement whether a control, individually or in combination with others, is relevant to the audit. (Ref: Para. A50-A73)
Nature and Extent of the Understanding of Relevant Controls
When obtaining an understanding of controls that are relevant to the audit, the auditor shall evaluate the design of those controls and determine whether they have been implemented, by performing procedures in addition to enquiry of the entity’s personnel. (Ref: Para. A74-A76)
Components of Internal Control
Control environment
The auditor shall obtain an understanding of the control environment. As part of obtaining this understanding, the auditor shall evaluate whether:
(a)Management, with the oversight of those charged with governance, has created and maintained a culture of honesty and ethical behaviour; and
(b)The strengths in the control environment elements collectively provide an appropriate foundation for the other components of internal control, and whether those other components are not undermined by control environment weaknesses. (Ref: Para. A77‑A87)
The entity’s risk assessment process
The auditor shall obtain an understanding of whether the entity has a process for:
(a)Identifying business risks relevant to financial reporting objectives;
(b)Estimating the significance of the risks;
(c)Assessing the likelihood of their occurrence; and
(d)Deciding about actions to address those risks. (Ref: Para. A88)
If the entity has established such a process (referred to hereafter as the “entity’s risk assessment process”), the auditor shall obtain an understanding of it, and the results thereof. If the auditor identifies risks of material misstatement that management failed to identify, the auditor shall evaluate whether there was an underlying risk of a kind that the auditor expects would have been identified by the entity’s risk assessment process. If there is such a risk, the auditor shall obtain an understanding of why that process failed to identify it, and evaluate whether the process is appropriate to its circumstances or determine if there is a significant deficiency in internal control with regard to the entity’s risk assessment process.
If the entity has not established such a process or has an ad hoc undocumented process, the auditor shall discuss with management whether business risks relevant to financial reporting objectives have been identified and how they have been addressed. The auditor shall evaluate whether the absence of a documented risk assessment process is appropriate in the circumstances, or determine whether it represents a significant deficiency in internal control. (Ref: Para. A89)
The information system, including the related business processes, relevant to financial reporting, and communication
The auditor shall obtain an understanding of the information system, including the related business processes, relevant to financial reporting, including the following areas:
(Ref: Para. A90–A92)(a)The classes of transactions in the entity’s operations that are significant to the financial report;
(b)The procedures, within both information technology (IT) and manual systems, by which those transactions are initiated, recorded, processed, corrected as necessary, transferred to the general ledger and reported in the financial report;
(c)The related accounting records, supporting information and specific accounts in the financial report that are used to initiate, record, process and report transactions; this includes the correction of incorrect information and how information is transferred to the general ledger. The records may be in either manual or electronic form;
(d)How the information system captures events and conditions, other than transactions, that are significant to the financial report;
(e)The financial reporting process used to prepare the entity’s financial report, including significant accounting estimates and disclosures; and
(f)Controls surrounding journal entries, including non‑standard journal entries used to record non‑recurring, unusual transactions or adjustments. (Ref: Para. A93-A94)
This understanding of the information system relevant to financial reporting shall include relevant aspects of that system relating to information disclosed in the financial report that is obtained from within or outside of the general and subsidiary ledgers.
The auditor shall obtain an understanding of how the entity communicates financial reporting roles and responsibilities and significant matters relating to financial reporting, including: (Ref: Para. A97-A98)
(a)Communications between management and those charged with governance; and
(b)External communications, such as those with regulatory authorities.
Control activities relevant to the audit
The auditor shall obtain an understanding of control activities relevant to the audit, being those the auditor judges it necessary to understand in order to assess the risks of material misstatement at the assertion level and design further audit procedures responsive to assessed risks. An audit does not require an understanding of all the control activities related to each significant class of transactions, account balance, and disclosure in the financial report or to every assertion relevant to them. (Ref: Para. A93-A106)
In understanding the entity’s control activities, the auditor shall obtain an understanding of how the entity has responded to risks arising from IT. (Ref: Para. A107-A109)
Monitoring of controls
The auditor shall obtain an understanding of the major activities that the entity uses to monitor internal control relevant to financial reporting, including those related to those control activities relevant to the audit, and how the entity initiates remedial actions to address deficiencies in its controls. (Ref: Para. A110-A112)
If the entity has an internal audit function,[1] the auditor shall obtain an understanding of the nature of the internal audit function’s responsibilities, its organisational status, and the activities performed, or to be performed. (Ref: Para. A113-A120)
[1] See ASA 610 Using the Work of Internal Auditors, paragraph 14(a).
The auditor shall obtain an understanding of the sources of the information used in the entity’s monitoring activities, and the basis upon which management considers the information to be sufficiently reliable for the purpose. (Ref: Para. A121)
Identifying and Assessing the Risks of Material Misstatement
The auditor shall identify and assess the risks of material misstatement at:
(a)the financial report level; and (Ref: Para. A122-A125)
(b)the assertion level for classes of transactions, account balances, and disclosures (Ref: Para. A126-A131)
to provide a basis for designing and performing further audit procedures.
For this purpose, the auditor shall:
(a)Identify 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 (including the quantitative or qualitative aspects of such disclosures) in the financial report; (Ref: Para. A132-A137)
(b)Assess the identified risks, and evaluate whether they relate more pervasively to the financial report as a whole and potentially affect many assertions;
(c)Relate the identified risks to what can go wrong at the assertion level, taking account of relevant controls that the auditor intends to test; and (Ref: Para. A138-A140)
(d)Consider the likelihood of misstatement, including the possibility of multiple misstatements, and whether the potential misstatement could result in a material misstatement. (Ref: Para. A137)
Risks that Require Special Audit Consideration
As part of the risk assessment as described in paragraph 25 of this Auditing Standard, the auditor shall determine whether any of the risks identified are, in the auditor’s judgement, a significant risk. In exercising this judgement, the auditor shall exclude the effects of identified controls related to the risk.
In exercising judgement as to which risks are significant risks, the auditor shall consider at least the following:
(a)Whether the risk is a risk of fraud;
(b)Whether the risk is related to recent significant economic, accounting or other developments and, therefore, requires specific attention;
(c)The complexity of transactions;
(d)Whether the risk involves significant transactions with related parties;
(e)The degree of subjectivity in the measurement of financial information related to the risk, especially those measurements involving a wide range of measurement uncertainty; and
(f)Whether the risk involves significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual. (Ref: Para. A141-A145)
If the auditor has determined that a significant risk exists, the auditor shall obtain an understanding of the entity’s controls, including control activities, relevant to that risk. (Ref: Para. A146-A148)
Risks for Which Substantive Procedures Alone Do Not Provide Sufficient Appropriate Audit Evidence
In respect of some risks, the auditor may judge that it is not possible or practicable to obtain sufficient appropriate audit evidence only from substantive procedures. Such risks may relate to the inaccurate or incomplete recording of routine and significant classes of transactions or account balances, the characteristics of which often permit highly automated processing with little or no manual intervention. In such cases, the entity’s controls over such risks are relevant to the audit and the auditor shall obtain an understanding of them. (Ref: Para. A149‑A151)
Revision of Risk Assessment
The auditor’s assessment of the risks of material misstatement at the assertion level may change during the course of the audit as additional audit evidence is obtained. In circumstances where the auditor obtains audit evidence from performing further audit procedures, or if new information is obtained, either of which is inconsistent with the audit evidence on which the auditor originally based the assessment, the auditor shall revise the assessment and modify the further planned audit procedures accordingly. (Ref: Para. A152)
Documentation
The auditor shall include in the audit documentation:[2]
[2] See ASA 230 Audit Documentation, paragraphs 8-11 and paragraph A6.
(a)The discussion among the engagement team where required by paragraph 10 of this Auditing Standard, and the significant decisions reached;
(b)Key elements of the understanding obtained regarding each of the aspects of the entity and its environment specified in paragraph 11 of this Auditing Standard and of each of the internal control components specified in paragraphs 14-24 of this Auditing Standard; the sources of information from which the understanding was obtained; and the risk assessment procedures performed;
(c)The identified and assessed risks of material misstatement at the financial report level and at the assertion level as required by paragraph 25 of this Auditing Standard; and
(d)The risks identified, and related controls about which the auditor has obtained an understanding, as a result of the requirements in paragraphs 27-30 of this Auditing Standard. (Ref: Para. A153-A156)
* * *
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 judgement throughout the audit, for example, when:
·Assessing risks of material misstatement of the financial report;
·Determining materiality in accordance with ASA 320;[3]
[3] See ASA 320 Materiality in Planning and Performing an Audit.
·Considering the appropriateness of the selection and application of accounting policies, and the adequacy of financial report disclosures;
·Identifying areas relating to amounts or disclosures in the financial report where special audit consideration may be necessary, for example: related party transactions, or management assessment of the entity’s ability to continue as a going concern , or when 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 judgement 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 Auditing Standard. 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 Auditing Standard. However, the significance of fraud is such that further requirements and guidance are included in ASA 240, 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.[4]
[4] See ASA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of a Financial Report, paragraphs 12-24.
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 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 enquiries of the entity’s external legal counsel or of valuation experts that the entity has used.
Enquiries of Management, the Internal Audit Function and Others within the Entity (Ref: Para. 6(a))
A6.Much of the information obtained by the auditor’s enquiries is obtained from management and those responsible for financial reporting. Information may also be obtained by the auditor through enquiries 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 enquiries of others within the entity and other employees with different levels of authority. For example:
·Enquiries directed towards those charged with governance may help the auditor understand the environment in which the financial report is prepared. ASA 260[5] identifies the importance of effective two‑way communication in assisting the auditor to obtain information from those charged with governance in this regard.
[5] See ASA 260 Communication with Those Charged with Governance, paragraph 4(b).
·Enquiries 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.
·Enquiries 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.
·Enquiries 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.
·Enquiries directed to the risk management function (or those performing such roles) may provide information about operational and regulatory risks that may affect financial reporting.
·Enquiries direct to information systems personnel may provide information about system changes, system or control failures, or other information system‑related risks.
A8.As obtaining an understanding of the entity and its environment is a continual, dynamic process, the auditor’s enquiries may occur throughout the audit engagement.
Enquiries of the Internal Audit Function
A9.If an entity has an internal audit function, enquiries 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 enquiries 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.[6] Enquiries 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.
[6] The relevant requirements are contained in ASA 610.
A10.If, based on responses to the auditor’s enquiries, 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.
A11.In addition, in accordance with ASA 240,[7] 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.
[7] See ASA 240, paragraph 19.
A12.Appropriate individuals within the internal audit function with whom enquiries are made are those who, in the auditor’s judgement, 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))
A13.Auditors of public sector entities often have additional responsibilities with regard to internal control and compliance with applicable laws and regulations. Enquiries of appropriate individuals in the internal audit function can assist the auditors in identifying the risk of material noncompliance with applicable laws and regulations and the risk of deficiencies in internal control over financial reporting.
Analytical Procedures (Ref: Para. 6(b))
A14.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.
A15.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.
A16.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
A17.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 enquiry, 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 report is available.
Observation and Inspection (Ref: Para. 6(c))
A18.Observation and inspection may support enquiries 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:
·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 reports) 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)
A19.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.
·Those particular types of transactions and other events or account balances (and related disclosures) where the auditor experienced difficulty in performing the necessary audit procedures, for example due to their complexity.
A20.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 enquiries and perform other appropriate audit procedures, such as walk‑throughs of relevant systems.
Discussion among the Engagement Team (Ref: Para. 10)
A21.The discussion among the engagement team about the susceptibility of the entity’s financial report 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 report 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 report 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.
ASA 240 provides further requirements and guidance in relation to the discussion among the engagement team about the risks of fraud.[8]
[8] See ASA 240, paragraph 15.
A22.As part of the discussion among the engagement team required by paragraph 10, consideration of the disclosure requirements of the applicable financial reporting framework assists in identifying early in the audit where there may be risks of material misstatement in relation to disclosures. Examples of matters the engagement team may discuss include:
·Changes in financial reporting requirements that may result in significant new or revised disclosures;
·Changes in the entity’s environment, financial condition or activities that may result in significant new or revised disclosures, for example, a significant business combination in the period under audit;
·Disclosures for which obtaining sufficient appropriate audit evidence may have been difficult in the past; and
·Disclosures about complex matters, including those involving significant management judgement as to what information to disclose.
A23.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
A24.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 report 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))
Industry Factors
A25.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:
·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.
A26.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 experience, as required by ASA 220.[9]
[9] See ASA 220 Quality Control for an Audit of a Financial Report and Other Historical Financial Information, paragraph 14.
Regulatory Factors
A27.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, including requirements for disclosures.
·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.
A28.ASA 250 includes some specific requirements related to the legal and regulatory framework applicable to the entity and the industry or sector in which the entity operates.[10]
[10] See ASA 250 Consideration of Laws and Regulations in the Audit of a Financial Report, paragraph 12.
Considerations specific to public sector entities
A29.For the audits of public sector entities, law, regulation or other authority may affect the entity’s operations. Such elements are essential to consider when obtaining an understanding of the entity and its environment.
Other External Factors
A30.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))
A31.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 and whether adequate disclosure of such issues in the financial report have been made.
·The ownership, and relationships between owners and other people or entities. This understanding assists in determining whether related party transactions have been appropriately identified, accounted for and adequately disclosed in the financial report. ASA 550[11] establishes requirements and provides guidance on the auditor’s considerations relevant to related parties.
[11] See ASA 550 Related Parties.
A32.Examples of matters that the auditor may consider when obtaining an understanding of the nature of the entity include:
·Business operations such as:
oNature of revenue sources, products or services, and markets, including involvement in electronic commerce such as Internet sales and marketing activities.
oConduct of operations (for example, stages and methods of production, or activities exposed to environmental risks).
oAlliances, joint ventures, and outsourcing activities.
oGeographic dispersion and industry segmentation.
oLocation of production facilities, warehouses, and offices, and location and quantities of inventories.
oKey customers and important suppliers of goods and services, employment arrangements (including the existence of union contracts, superannuation and other post-employment benefits, share option or incentive bonus arrangements, and government regulation related to employment matters).
oResearch and development activities and expenditures.
oTransactions with related parties.
·Investments and investment activities such as:
oPlanned or recently executed acquisitions or divestitures.
oInvestments and dispositions of securities and loans.
oCapital investment activities.
oInvestments in non‑consolidated entities, including partnerships, joint ventures and special‑purpose entities.
·Financing and financing activities such as:
oMajor subsidiaries and associated entities, including consolidated and non‑consolidated structures.
oDebt structure and related terms, including off‑balance‑sheet financing arrangements and leasing arrangements.
oBeneficial owners (local, foreign, business reputation and experience) and related parties.
oUse of derivative financial instruments.
·Financial reporting practices such as:
oAccounting principles and industry-specific practices, including industry‑specific significant classes of transactions, account balances and related disclosures in the financial report (for example, loans and investments for banks, or research and development for pharmaceuticals).
oRevenue recognition.
oAccounting for fair values.
oForeign currency assets, liabilities and transactions.
oAccounting for unusual or complex transactions including those in controversial or emerging areas (for example, accounting for share‑based compensation).
A33.Significant changes in the entity from prior periods may give rise to, or change, risks of material misstatement.
Nature of Special‑Purpose Entities
A34.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 (for example, as part of a de-recognition transaction involving financial assets), obtain the right to sue the latter’s assets, or perform services for the later, while other parties may provide the funding to the latter. As ASA 550 indicates, in some circumstances, a special‑purpose entity may be a related party of the entity.[12]
[12] See ASA 550, paragraph A7.
A35.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))
A36.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))
A37.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.
A38.Business risk is broader than the risk of material misstatement of the financial report, 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;
·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.
A39.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 report. 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.
A40.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 report 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).
A41.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 report 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 Appendix 2.
A42.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 A88-A89.
Considerations Specific to Public Sector Entities
A43.For the audits of public sector entities, “management objectives” may be influenced by concerns regarding public accountability and may include objectives which have their source in law, regulation, or other authority.
Measurement and Review of the Entity’s Financial Performance (Ref: Para. 11(e))
A44.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 report. 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 ASA 240 for requirements and guidance in relation to the risks of fraud.
A45.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 A110-A121), 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.
A46.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.
A47.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.
A48.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 report 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 report.
Considerations Specific to Smaller Entities
A49.Smaller entities often do not have processes to measure and review financial performance. Enquiry of management may reveal that it relies on certain key indicators for evaluating financial performance and taking appropriate action. If such enquiry 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)
A50.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.
A51.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
Purpose of Internal Control
A52.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; and
·Its compliance with applicable laws and regulations.
The way in which internal control is designed, implemented and maintained varies with an entity’s size and complexity.
Considerations specific to smaller entities
A53.Smaller entities may use less structured means and simpler processes and procedures to achieve their objectives.
Limitations of Internal Control
A54.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 the inherent limitations of internal control. These include the realities that human judgement in decision‑making can be faulty and that breakdowns in internal control can occur because of human 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.
A55.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.
A56.Further, in designing and implementing controls, management may make judgements 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
A57.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‑manager 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.
A58.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
A59.The division of internal control into the following five components, for purposes of Australian Auditing Standards, provides a useful framework for auditors to consider how different aspects of an entity’s internal control may affect the audit:
(a)The control environment;
(b)The entity’s risk assessment process;
(c)The information system, including the related business processes, relevant to financial reporting, and communication;
(d)Control activities; and
(e)Monitoring of controls.
The division does not necessarily reflect how an entity designs, implements and maintains internal control, or how it may classify any particular component. Auditors may use different terminology or frameworks to describe the various aspects of internal control, and their effect on the audit than those used in this Auditing Standard, provided all the components described in this Auditing Standard are addressed.
A60.Application material relating to the five components of internal control as they relate to a financial report audit is set out in paragraphs A77-A121 below. Appendix 1 provides further explanation of these components of internal control.
Characteristics of Manual and Automated Elements of Internal Control Relevant to the Auditor’s Risk Assessment
A61.An entity’s system of internal control contains manual elements and often contains automated elements. The characteristics of manual or automated elements are relevant to the auditor’s risk assessment and further audit procedures based thereon.
A62.The use of manual or automated elements in internal control also affects the manner in which transactions are initiated, recorded, processed, and reported:
·Controls in a manual system may include such procedures as approvals and reviews of transactions, and reconciliations and follow‑up of reconciling items. Alternatively, an entity may use automated procedures to initiate, record, process, and report transactions, in which case records in electronic format replace paper documents.
·Controls in IT systems consist of a combination of automated controls (for example, controls embedded in computer programs) and manual controls. Further, manual controls may be independent of IT, may use information produced by IT, or may be limited to monitoring the effective functioning of IT and of automated controls, and to handling exceptions. When IT is used to initiate, record, process or report transactions, or other financial data for inclusion in the financial report, the systems and programs may include controls related to the corresponding assertions for material accounts or may be critical to the effective functioning of manual controls that depend on IT.
An entity’s mix of manual and automated elements in internal control varies with the nature and complexity of the entity’s use of IT.
A63.Generally, IT benefits an entity’s internal control by enabling an entity to:
·Consistently apply predefined business rules and perform complex calculations in processing large volumes of transactions or data;
·Enhance the timeliness, availability, and accuracy of information;
·Facilitate the additional analysis of information;
·Enhance the ability to monitor the performance of the entity’s activities and its policies and procedures;
·Reduce the risk that controls will be circumvented; and
·Enhance the ability to achieve effective segregation of duties by implementing security controls in applications, databases, and operating systems.
A64.IT also poses specific risks to an entity’s internal control, including, for example:
·Reliance on systems or programs that are inaccurately processing data, processing inaccurate data, or both.
·Unauthorised access to data that may result in destruction of data or improper changes to data, including the recording of unauthorised or non‑existent transactions, or inaccurate recording of transactions. Particular risks may arise where multiple users access a common database.
·The possibility of IT personnel gaining access privileges beyond those necessary to perform their assigned duties thereby breaking down segregation of duties.
·Unauthorised changes to data in master files.
·Unauthorised changes to systems or programs.
·Failure to make necessary changes to systems or programs.
·Inappropriate manual intervention.
·Potential loss of data or inability to access data as required.
A65.Manual elements in internal control may be more suitable where judgement and discretion are required such as for the following circumstances:
·Large, unusual or non‑recurring transactions.
·Circumstances where errors are difficult to define, anticipate or predict.
·In changing circumstances that require a control response outside the scope of an existing automated control.
·In monitoring the effectiveness of automated controls.
A66.Manual elements in internal control may be less reliable than automated elements because they can be more easily bypassed, ignored, or overridden and they are also more prone to simple errors and mistakes. Consistency of application of a manual control element cannot therefore be assumed. Manual control elements may be less suitable for the following circumstances:
·High volume or recurring transactions, or in situations where errors that can be anticipated or predicted can be prevented, or detected and corrected, by control parameters that are automated.
·Control activities where the specific ways to perform the control can be adequately designed and automated.
A67.The extent and nature of the risks to internal control vary depending on the nature and characteristics of the entity’s information system. The entity responds to the risks arising from the use of IT or from use of manual elements in internal control by establishing effective controls in light of the characteristics of the entity’s information system.
Controls Relevant to the Audit
A68.There is a direct relationship between an entity’s objectives and the controls it implements to provide reasonable assurance about their achievement. The entity’s objectives, and therefore controls, relate to financial reporting, operations and compliance; however, not all of these objectives and controls are relevant to the auditor’s risk assessment.
A69.Factors relevant to the auditor’s judgement about whether a control, individually or in combination with others, is relevant to the audit may include such matters as the following:
·Materiality.
·The significance of the related risk.
·The size of the entity.
·The nature of the entity’s business, including its organisation and ownership characteristics.
·The diversity and complexity of the entity’s operations.
·Applicable legal and regulatory requirements.
·The circumstances and the applicable component of internal control.
·The nature and complexity of the systems that are part of the entity’s internal control, including the use of service organisations.
·Whether, and how, a specific control, individually or in combination with others, prevents, or detects and corrects, material misstatement.
A70.Controls over the completeness and accuracy of information produced by the entity may be relevant to the audit if the auditor intends to make use of the information in designing and performing further audit procedures. Controls relating to operations and compliance objectives may also be relevant to an audit if they relate to data the auditor evaluates or uses in applying audit procedures.
A71.Internal control over safeguarding of assets against unauthorised acquisition, use, or disposition may include controls relating to both financial reporting and operations objectives. The auditor’s consideration of such controls is generally limited to those relevant to the reliability of financial reporting.
A72.An entity generally has controls relating to objectives that are not relevant to an audit and therefore need not be considered. For example, an entity may rely on a sophisticated system of automated controls to provide efficient and effective operations (such as an airline’s system of automated controls to maintain flight schedules), but these controls ordinarily would not be relevant to the audit. Further, although internal control applies to the entire entity or to any of its operating units or business processes, an understanding of internal control relating to each of the entity’s operating units and business processes may not be relevant to the audit.
Considerations Specific to Public Sector Entities
A73.Public sector auditors often have additional responsibilities with respect to internal control, for example to report on compliance with an established Code of Practice. Public sector auditors can also have responsibilities to report on the compliance with law, regulation or other authority. As a result, their review of internal control may be broader and more detailed.
Nature and Extent of the Understanding of Relevant Controls (Ref: Para. 13)
A74.Evaluating the design of a control involves considering whether the control, individually or in combination with other controls, is capable of effectively preventing, or detecting and correcting, material misstatements. Implementation of a control means that the control exists and that the entity is using it. There is little point in assessing the implementation of a control that is not effective, and so the design of a control is considered first. An improperly designed control may represent a significant deficiency in internal control.
A75.Risk assessment procedures to obtain audit evidence about the design and implementation of relevant controls may include:
·Enquiring of entity personnel.
·Observing the application of specific controls.
·Inspecting documents and reports.
·Tracing transactions through the information system relevant to financial reporting.
·Enquiry alone, however, is not sufficient for such purposes.
A76.Obtaining an understanding of an entity’s controls is not sufficient to test their operating effectiveness, unless there is some automation that provides for the consistent operation of the controls. For example, obtaining audit evidence about the implementation of a manual control at a point in time does not provide audit evidence about the operating effectiveness of the control at other times during the period under audit. However, because of the inherent consistency of IT processing (see paragraph A63), performing audit procedures to determine whether an automated control has been implemented may serve as a test of that control’s operating effectiveness, depending on the auditor’s assessment and testing of controls such as those over program changes. Tests of the operating effectiveness of controls are further described in ASA 330.[13]
[13] See ASA 330 The Auditor’s Responses to Assessed Risks.
Components of Internal Control—Control Environment (Ref: Para. 14)
A77.The control environment includes the governance and management functions and the attitudes, awareness, and actions of those charged with governance and management concerning the entity’s internal control and its importance in the entity. The control environment sets the tone of an organisation, influencing the control consciousness of its people.
A78.Elements of the control environment that may be relevant when obtaining an understanding of the control environment include the following:
(a)Communication and enforcement of integrity and ethical values – These are essential elements that influence the effectiveness of the design, administration and monitoring of controls.
(b)Commitment to competence – Matters such as management’s consideration of the competence levels for particular jobs and how those levels translate into requisite skills and knowledge.
(c)Participation by those charged with governance – Attributes of those charged with governance such as:
·Their independence from management.
·Their experience and stature.
·The extent of their involvement and the information they receive, and the scrutiny of activities.
·The appropriateness of their actions, including the degree to which difficult questions are raised and pursued with management, and their interaction with internal and external auditors.
(d)Management’s philosophy and operating style – Characteristics such as management’s:
·Approach to taking and managing business risks.
·Attitudes and actions toward financial reporting.
·Attitudes toward information processing and accounting functions and personnel.
(e)Organisational structure – The framework within which an entity’s activities for achieving its objectives are planned, executed, controlled, and reviewed.
(f)Assignment of authority and responsibility – Matters such as how authority and responsibility for operating activities are assigned and how reporting relationships and authorisation hierarchies are established.
Significant risks relating to the risks of material misstatement due to fraud
A144.ASA 240 provides further requirements and guidance in relation to the identification and assessment of the risks of material misstatement due to fraud.[21]
[21] See ASA 240, paragraphs 25-27.
Understanding Controls Related to Significant Risks (Ref: Para. 29)
A145.Although risks relating to significant non‑routine or judgemental matters are often less likely to be subject to routine controls, management may have other responses intended to deal with such risks. Accordingly, the auditor’s understanding of whether the entity has designed and implemented controls for significant risks arising from non‑routine or judgemental matters includes whether and how management responds to the risks. Such responses might include:
·Control activities such as a review of assumptions by senior management or experts.
·Documented processes for estimations.
·Approval by those charged with governance.
A146.For example, where there are one‑off events such as the receipt of notice of a significant lawsuit, consideration of the entity’s response may include such matters as whether it has been referred to appropriate experts (such as internal or external legal counsel), whether an assessment has been made of the potential effect, and how it is proposed that the circumstances are to be disclosed in the financial report.
A147.In some cases, management may not have appropriately responded to significant risks of material misstatement by implementing controls over these significant risks. Failure by management to implement such controls is an indicator of a significant deficiency in internal control.[22]
[22] See ASA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management, paragraph A7.
Risks for Which Substantive Procedures Alone Do Not Provide Sufficient Appropriate Audit Evidence (Ref: Para. 30)
A148.Risks of material misstatement may relate directly to the recording of routine classes of transactions or account balances, and the preparation of a reliable financial report. Such risks may include risks of inaccurate or incomplete processing for routine and significant classes of transactions such as an entity’s revenue, purchases, and cash receipts or cash payments.
A149.Where such routine business transactions are subject to highly automated processing with little or no manual intervention, it may not be possible to perform only substantive procedures in relation to the risk. For example, the auditor may consider this to be the case in circumstances where a significant amount of an entity’s information is initiated, recorded, processed, or reported only in electronic form such as in an integrated system. In such cases:
·Audit evidence may be available only in electronic form, and its sufficiency and appropriateness usually depend on the effectiveness of controls over its accuracy and completeness.
·The potential for improper initiation or alteration of information to occur and not be detected may be greater if appropriate controls are not operating effectively.
A150.The consequences for further audit procedures of identifying such risks are described in ASA 330.[23]
[23] See ASA 330, paragraph 8.
Revision of Risk Assessment (Ref: Para. 31)
A151.During the audit, information may come to the auditor’s attention that differs significantly from the information on which the risk assessment was based. For example, the risk assessment may be based on an expectation that certain controls are operating effectively. In performing tests of those controls, the auditor may obtain audit evidence that they were not operating effectively at relevant times during the audit. Similarly, in performing substantive procedures the auditor may detect misstatements in amounts or frequency greater than is consistent with the auditor’s risk assessments. In such circumstances, the risk assessment may not appropriately reflect the true circumstances of the entity and the further planned audit procedures may not be effective in detecting material misstatements. See ASA 330 for further guidance.
Documentation (Ref: Para. 32)
A152.The manner in which the requirements of paragraph 32 are documented is for the auditor to determine using professional judgement. For example, in audits of small entities the documentation may be incorporated in the auditor’s documentation of the overall strategy and audit plan.[24] Similarly, for example, the results of the risk assessment may be documented separately, or may be documented as part of the auditor’s documentation of further procedures.[25] 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.
[24] See ASA 300 Planning an Audit of a Financial Report, paragraphs 7 and 9.
[25] See ASA 330, paragraph 28.
A153.For entities that have uncomplicated businesses and processes relevant to financial reporting, the documentation may be simple in form and relatively brief. It is not necessary to document the entirety of the auditor’s understanding of the entity and matters related to it. Key elements of understanding documented by the auditor include those on which the auditor based the assessment of the risks of material misstatement.
A154.The extent of documentation may also reflect the experience and capabilities of the members of the audit engagement team. Provided the requirements of ASA 230 are always met, an audit undertaken by an engagement team comprising less experienced individuals may require more detailed documentation to assist them to obtain an appropriate understanding of the entity than one that includes experienced individuals.
A155.For recurring audits, certain documentation may be carried forward, updated as necessary to reflect changes in the entity’s business or processes.
Appendix 1
(Ref: Para. 4(c), 14‑24 and A77‑A121 )
Internal Control Components
This appendix further explains the components of internal control, as set out in paragraphs 4(c), 14-24 and A77-A121 as they relate to a financial report audit.
Control Environment
The control environment encompasses the following elements:
(a)Communication and enforcement of integrity and ethical values. The effectiveness of controls cannot rise above the integrity and ethical values of the people who create, administer, and monitor them. Integrity and ethical behaviour are the product of the entity’s ethical and behavioural standards, how they are communicated, and how they are reinforced in practice. The enforcement of integrity and ethical values includes, for example, management actions to eliminate or mitigate incentives or temptations that might prompt personnel to engage in dishonest, illegal, or unethical acts. The communication of entity policies on integrity and ethical values may include the communication of behavioural standards to personnel through policy statements and codes of conduct and by example.
(b)Commitment to competence. Competence is the knowledge and skills necessary to accomplish tasks that define the individual’s job.
(c)Participation by those charged with governance. An entity’s control consciousness is influenced significantly by those charged with governance. The importance of the responsibilities of those charged with governance is recognised in codes of practice and other laws and regulations or guidance produced for the benefit of those charged with governance. Other responsibilities of those charged with governance include oversight of the design and effective operation of whistle blower procedures and the process for reviewing the effectiveness of the entity’s internal control.
(d)Management’s philosophy and operating style. Management’s philosophy and operating style encompass a broad range of characteristics. For example, management’s attitudes and actions toward financial reporting may manifest themselves through conservative or aggressive selection from available alternative accounting principles, or conscientiousness and conservatism with which accounting estimates are developed.
(e)Organisational structure. Establishing a relevant organisational structure includes considering key areas of authority and responsibility and appropriate lines of reporting. The appropriateness of an entity’s organisational structure depends, in part, on its size and the nature of its activities.
(f)Assignment of authority and responsibility. The assignment of authority and responsibility may include policies relating to appropriate business practices, knowledge and experience of key personnel, and resources provided for carrying out duties. In addition, it may include policies and communications directed at ensuring that all personnel understand the entity’s objectives, know how their individual actions interrelate and contribute to those objectives, and recognise how and for what they will be held accountable.
(g)Human resource policies and practices. Human resource policies and practices often demonstrate important matters in relation to the control consciousness of an entity. For example, standards for recruiting the most qualified individuals – with emphasis on educational background, prior work experience, past accomplishments, and evidence of integrity and ethical behaviour – demonstrate an entity’s commitment to competent and trustworthy people. Training policies that communicate prospective roles and responsibilities and include practices such as training schools and seminars illustrate expected levels of performance and behaviour. Promotions driven by periodic performance appraisals demonstrate the entity’s commitment to the advancement of qualified personnel to higher levels of responsibility.
Entity’s Risk Assessment Process
For financial reporting purposes, the entity’s risk assessment process includes how management identifies business risks relevant to the preparation of the financial report in accordance with the entity’s applicable financial reporting framework, estimates their significance, assesses the likelihood of their occurrence, and decides upon actions to respond to and manage them and the results thereof. For example, the entity’s risk assessment process may address how the entity considers the possibility of unrecorded transactions or identifies and analyses significant estimates recorded in the financial report.
Risks relevant to reliable financial reporting include external and internal events, transactions or circumstances that may occur and adversely affect an entity’s ability to initiate, record, process, and report financial data consistent with the assertions of management in the financial report. Management may initiate plans, programs, or actions to address specific risks or it may decide to accept a risk because of cost or other considerations. Risks can arise or change due to circumstances such as the following:
·Changes in operating environment. Changes in the regulatory or operating environment can result in changes in competitive pressures and significantly different risks.
·New personnel. New personnel may have a different focus on or understanding of internal control.
·New or revamped information systems. Significant and rapid changes in information systems can change the risk relating to internal control.
·Rapid growth. Significant and rapid expansion of operations can strain controls and increase the risk of a breakdown in controls.
·New technology. Incorporating new technologies into production processes or information systems may change the risk associated with internal control.
·New business models, products, or activities. Entering into business areas or transactions with which an entity has little experience may introduce new risks associated with internal control.
·Corporate restructurings. Restructurings may be accompanied by staff reductions and changes in supervision and segregation of duties that may change the risk associated with internal control.
·Expanded foreign operations. The expansion or acquisition of foreign operations carries new and often unique risks that may affect internal control, for example, additional or changed risks from foreign currency transactions.
·New accounting pronouncements. Adoption of new accounting principles or changing accounting principles may affect risks in preparing the financial report.
Information System, Including the Related Business Processes, Relevant to Financial Reporting, and Communication
An information system consists of infrastructure (physical and hardware components), software, people, procedures, and data. Many information systems make extensive use of information technology (IT).
The information system relevant to financial reporting objectives, which includes the financial reporting system, encompasses methods and records that:
·Identify and record all valid transactions.
·Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions for financial reporting.
·Measure the value of transactions in a manner that permits recording their proper monetary value in the financial report.
·Determine the time period in which transactions occurred to permit recording of transactions in the proper accounting period.
·Present properly the transactions and related disclosures in the financial report.
The quality of system‑generated information affects management’s ability to make appropriate decisions in managing and controlling the entity’s activities and to prepare reliable financial reports.
Communication, which involves providing an understanding of individual roles and responsibilities pertaining to internal control over financial reporting, may take such forms as policy manuals, accounting and financial reporting manuals, and memoranda. Communication also can be made electronically, orally, and through the actions of management.
Control Activities
Generally, control activities that may be relevant to an audit may be categorised as policies and procedures that pertain to the following:
·Performance reviews. These control activities include reviews and analyses of actual performance versus budgets, forecasts, and prior period performance; relating different sets of data – operating or financial – to one another, together with analyses of the relationships and investigative and corrective actions; comparing internal data with external sources of information; and review of functional or activity performance.
·Information processing. The two broad groupings of information systems control activities are application controls, which apply to the processing of individual applications, and general IT‑controls, which are policies and procedures that relate to many applications and support the effective functioning of application controls by helping to ensure the continued proper operation of information systems. Examples of application controls include checking the arithmetical accuracy of records, maintaining and reviewing accounts and trial balances, automated controls such as edit checks of input data and numerical sequence checks, and manual follow‑up of exception reports. Examples of general IT‑controls are program change controls, controls that restrict access to programs or data, controls over the implementation of new releases of packaged software applications, and controls over system software that restrict access to or monitor the use of system utilities that could change financial data or records without leaving an audit trail.
·Physical controls. Controls that encompass:
oThe physical security of assets, including adequate safeguards such as secured facilities over access to assets and records.
oThe authorisation for access to computer programs and data files.
oThe periodic counting and comparison with amounts shown on control records (for example comparing the results of cash, security and inventory counts with accounting records).
The extent to which physical controls intended to prevent theft of assets are relevant to the reliability of financial report preparation, and therefore the audit, depends on circumstances such as when assets are highly susceptible to misappropriation.
·Segregation of duties. Assigning different people the responsibilities of authorising transactions, recording transactions, and maintaining custody of assets. Segregation of duties is intended to reduce the opportunities to allow any person to be in a position to both perpetrate and conceal errors or fraud in the normal course of the person’s duties.
Certain control activities may depend on the existence of appropriate higher level policies established by management or those charged with governance. For example, authorisation controls may be delegated under established guidelines, such as investment criteria set by those charged with governance; alternatively, non‑routine transactions such as major acquisitions or divestments may require specific high level approval, including in some cases that of shareholders.
Monitoring of Controls
An important management responsibility is to establish and maintain internal control on an ongoing basis. Management’s monitoring of controls includes considering whether they are operating as intended and that they are modified as appropriate for changes in conditions. Monitoring of controls may include activities such as management’s review of whether bank reconciliations are being prepared on a timely basis, internal auditors’ evaluation of sales personnel’s compliance with the entity’s policies on terms of sales contracts, and a legal department’s oversight of compliance with the entity’s ethical or business practice policies. Monitoring is done also to ensure that controls continue to operate effectively over time. For example, if the timeliness and accuracy of bank reconciliations are not monitored, personnel are likely to stop preparing them.
Internal auditors or personnel performing similar functions may contribute to the monitoring of an entity’s controls through separate evaluations. Ordinarily, they regularly provide information about the functioning of internal control, focusing considerable attention on evaluating the effectiveness of internal control, and communicate information about strengths and deficiencies in internal control and recommendations for improving internal control.
Monitoring activities may include using information from communications from external parties that may indicate problems or highlight areas in need of improvement. Customers implicitly corroborate billing data by paying their invoices or complaining about their charges. In addition, regulators may communicate with the entity concerning matters that affect the functioning of internal control, for example, communications concerning examinations by bank regulatory agencies. Also, management may consider communications relating to internal control from external auditors in performing monitoring activities.
Appendix 2
(Ref: Para. A41 and A133 )
Conditions and Events That May Indicate Risks of Material Misstatement
The following are examples of conditions and events that may indicate the existence of risks of material misstatement in the financial report. 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, for example, countries with significant currency devaluation or highly inflationary economies.
Operations exposed to volatile markets, for example, futures trading.
Operations that are subject to a 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 reorganisations or other unusual events.
Entities or business segments likely to be sold.
The existence of complex alliances and joint ventures.
Use of off‑balance‑sheet finance, special‑purpose entities, and other complex financing arrangements.
Significant transactions with related parties.
Lack of personnel with appropriate accounting and financial reporting skills.
Changes in key personnel including departure of key executives.
Deficiencies in internal control, especially those not addressed by management.
Incentives for management and employees to engage in fraudulent financial reporting.
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.
Enquiries 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.
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, and related disclosures.
Omission, or obscuring, of significant information in disclosures.
Pending litigation and contingent liabilities, for example, sales warranties, financial guarantees and environmental remediation.
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