(Ref: Para. 5)

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]
• 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.

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.

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.

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]

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))

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.

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.
• 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.

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

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.

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.

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. 

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))

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))

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.

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.

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

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))

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)

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.

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)

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]

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.

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

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 Entity and Its Environment

Industry, Regulatory and Other External Factors (Ref: Para. 11(a))

Industry Factors

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.

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]

Regulatory Factors

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.

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]

Considerations specific to public sector entities

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

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))

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.

Examples of matters that the auditor may consider when obtaining an understanding of the nature of the entity include:

• Business operations such as:
  • Nature of revenue sources, products or services, and markets, including involvement in electronic commerce such as Internet sales and marketing activities.
  • Conduct of operations (for example, stages and methods of production, or activities exposed to environmental risks).
  • Alliances, joint ventures, and outsourcing activities.
  • Geographic dispersion and industry segmentation.
  • Location of production facilities, warehouses, and offices, and location and quantities of inventories.
  • Key customers and important suppliers of goods and services, employment arrangements (including the existence of union contracts, superannuation and other post-employment benefits, share option or incentive bonus arrangements, and government regulation related to employment matters).
  • Research and development activities and expenditures.
  • Transactions with related parties.
• Investments and investment activities such as:
  • Planned or recently executed acquisitions or divestitures.
  • Investments and dispositions of securities and loans.
  • Capital investment activities.
  • Investments in non consolidated entities, including partnerships, joint ventures and special purpose entities.
• Financing and financing activities such as:
  • Major subsidiaries and associated entities, including consolidated and non consolidated structures.
  • Debt structure and related terms, including off balance sheet financing arrangements and leasing arrangements.
  • Beneficial owners (local, foreign, business reputation and experience) and related parties.
  • Use of derivative financial instruments.
• Financial reporting practices such as:
  • Accounting 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).
  • Revenue recognition.
  • Accounting for fair values.
  • Foreign currency assets, liabilities and transactions.
  • Accounting for unusual or complex transactions including those in controversial or emerging areas (for example, accounting for share based compensation).

Significant changes in the entity from prior periods may give rise to, or change, risks of material misstatement.

Nature of Special Purpose Entities

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]

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))

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))

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.

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.

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.

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).

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.

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

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))

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.

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.

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.

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.

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

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)

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.

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

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

Smaller entities may use less structured means and simpler processes and procedures to achieve their objectives.

Limitations of Internal Control

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.

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.

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

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.

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

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:

1. The control environment;
2. The entity’s risk assessment process;
3. The information system, including the related business processes, relevant to financial reporting, and communication;
4. Control activities; and
5. 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.

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

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.

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.

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.

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.

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.

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.

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

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.

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.

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.

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.

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

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)

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.

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.

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]

Components of Internal Control—Control Environment (Ref: Para. 14)

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.

Elements of the control environment that may be relevant when obtaining an understanding of the control environment include the following:

1. Communication and enforcement of integrity and ethical values – These are essential elements that influence the effectiveness of the design, administration and monitoring of controls.
2. 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.
3. 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.
4. 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.
5. Organisational structure – The framework within which an entity’s activities for achieving its objectives are planned, executed, controlled, and reviewed.
6. 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.
7. Human resource policies and practices – Policies and practices that relate to, for example, recruitment, orientation, training, evaluation, counselling, promotion, compensation, and remedial actions.

Audit Evidence for Elements of the Control Environment

Relevant audit evidence may be obtained through a combination of enquiries and other risk assessment procedures such as corroborating enquiries through observation or inspection of documents. For example, through enquiries of management and employees, the auditor may obtain an understanding of how management communicates to employees its views on business practices and ethical behaviour. The auditor may then determine whether relevant controls have been implemented by considering, for example, whether management has a written code of conduct and whether it acts in a manner that supports the code.

The auditor may also consider how management has responded to the findings and recommendations of the internal audit function regarding identified deficiencies in internal control relevant to the audit, including whether and how such responses have been implemented, and whether they have been subsequently evaluated by the internal audit function.

Effect of the Control Environment on the Assessment of the Risks of Material Misstatement

Some elements of an entity’s control environment have a pervasive effect on assessing the risks of material misstatement. For example, an entity’s control consciousness is influenced significantly by those charged with governance, because one of their roles is to counterbalance pressures on management in relation to financial reporting that may arise from market demands or remuneration schemes. The effectiveness of the design of the control environment in relation to participation by those charged with governance is therefore influenced by such matters as:

• Their independence from management and their ability to evaluate the actions of management.
• Whether they understand the entity’s business transactions.
• The extent to which they evaluate whether the financial report is prepared in accordance with the applicable financial reporting framework, including whether the financial report includes adequate disclosures.

An active and independent board of directors may influence the philosophy and operating style of senior management. However, other elements may be more limited in their effect. For example, although human resource policies and practices directed toward hiring competent financial, accounting, and IT personnel may reduce the risk of errors in processing financial information, they may not mitigate a strong bias by top management to overstate earnings.

The existence of a satisfactory control environment can be a positive factor when the auditor assesses the risks of material misstatement.  However, although it may help reduce the risk of fraud, a satisfactory control environment is not an absolute deterrent to fraud.  Conversely, deficiencies in the control environment may undermine the effectiveness of controls, in particular in relation to fraud.  For example, management’s failure to commit sufficient resources to address IT security risks may adversely affect internal control by allowing improper changes to be made to computer programs or to data, or unauthorised transactions to be processed.  As explained in ASA 330, the control environment also influences the nature, timing, and extent of the auditor’s further procedures.^[14]

The control environment in itself does not prevent, or detect and correct, a material misstatement. It may, however, influence the auditor’s evaluation of the effectiveness of other controls (for example, the monitoring of controls and the operation of specific control activities) and thereby, the auditor’s assessment of the risks of material misstatement.

Considerations Specific to Smaller Entities

The control environment within small entities is likely to differ from larger entities. For example, those charged with governance in small entities may not include an independent or outside member, and the role of governance may be undertaken directly by the owner manager where there are no other owners. The nature of the control environment may also influence the significance of other controls, or their absence. For example, the active involvement of an owner manager may mitigate certain of the risks arising from a lack of segregation of duties in a small business; it may, however, increase other risks, for example, the risk of override of controls.

In addition, audit evidence for elements of the control environment in smaller entities may not be available in documentary form, in particular where communication between management and other personnel may be informal, yet effective. For example, small entities might not have a written code of conduct but, instead, develop a culture that emphasises the importance of integrity and ethical behaviour through oral communication and by management example.

Consequently, the attitudes, awareness and actions of management or the owner manager are of particular importance to the auditor’s understanding of a smaller entity’s control environment.

Components of Internal Control—The Entity’s Risk Assessment Process (Ref: Para. 15)

The entity’s risk assessment process forms the basis for how management determines the risks to be managed. If that process is appropriate to the circumstances, including the nature, size and complexity of the entity, it assists the auditor in identifying risks of material misstatement. Whether the entity’s risk assessment process is appropriate to the circumstances is a matter of judgement.

Considerations Specific to Smaller Entities (Ref: Para. 17)

There is unlikely to be an established risk assessment process in a small entity. In such cases, it is likely that management will identify risks through direct personal involvement in the business. Irrespective of the circumstances, however, enquiry about identified risks and how they are addressed by management is still necessary.

Components of Internal Control—The Information System, Including the Related Business Processes, Relevant to Financial Reporting, and Communication

The Information System, Including Related Business Processes, Relevant to Financial Reporting (Ref: Para. 18)

The information system relevant to financial reporting objectives, which includes the accounting system, consists of the procedures and records designed and established to:

• Initiate, record, process, and report entity transactions (as well as events and conditions) and to maintain accountability for the related assets, liabilities, and equity;
• Resolve incorrect processing of transactions, for example, automated suspense files and procedures followed to clear suspense items out on a timely basis;
• Process and account for system overrides or bypasses to controls;
• Transfer information from transaction processing systems to the general ledger;
• Capture information relevant to financial reporting for events and conditions other than transactions, such as the depreciation and amortisation of assets and changes in the recoverability of accounts receivables; and
• Ensure information required to be disclosed by the applicable financial reporting framework is accumulated, recorded, processed, summarised and appropriately reported in the financial report.

The financial report may contain information that is obtained from outside of the general and subsidiary ledgers.  Examples of such information may include:

• Information obtained from lease agreements disclosed in the financial report, such as renewal options or future lease payments.
• Information disclosed in the financial report that is produced by an entity’s risk management system.
• Fair value information produced by management’s experts and disclosed in the financial report.
• Information disclosed in the financial report that has been obtained from models, or from other calculations used to develop estimates recognised or disclosed in the financial report, including information relating to the underlying data and assumptions used in those models, such as:
  • Assumptions developed internally that may affect an asset’s useful life; or
  • Data such as interest rates that are affected by factors outside the control of the entity.
• Information disclosed in the financial report about sensitivity analyses derived from financial models that demonstrates that management has considered alternative assumptions.
• Information recognised or disclosed in the financial report that has been obtained from an entity’s tax returns and records.
• Information disclosed in the financial report that has been obtained from analyses prepared to support management’s assessment of the entity’s ability to continue as a going concern, such as disclosures, if any, related to events or conditions that have been identified that may cast significant doubt on the entity’s ability to continue as a going concern. ^[15]

The understanding of the information system relevant to financial reporting required by paragraph 18 of this Auditing Standard (including the understanding of 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) is a matter of the auditor’s professional judgement. For example, certain amounts or disclosures in the entity’s financial report (such as disclosures about credit risk, liquidity risk, and market risk) may be based on information obtained from the entity’s risk management system. However, the auditor is not required to understand all aspects of the risk management system, and uses professional judgement in determining the necessary understanding.

Journal entries

An entity’s information system typically includes the use of standard journal entries that are required on a recurring basis to record transactions. Examples might be journal entries to record sales, purchases, and cash disbursements in the general ledger, or to record accounting estimates that are periodically made by management, such as changes in the estimate of uncollectible accounts receivable.

An entity’s financial reporting process also includes the use of non standard journal entries to record non recurring, unusual transactions or adjustments. Examples of such entries include consolidating adjustments and entries for a business combination or disposal or non recurring estimates such as the impairment of an asset. In manual general ledger systems, non standard journal entries may be identified through inspection of ledgers, journals, and supporting documentation. When automated procedures are used to maintain the general ledger and prepare a financial report, such entries may exist only in electronic form and may therefore be more easily identified through the use of computer assisted audit techniques.

Related business processes

An entity’s business processes are the activities designed to:

• Develop, purchase, produce, sell and distribute an entity’s products and services;
• Ensure compliance with laws and regulations; and
• Record information, including accounting and financial reporting information.

Business processes result in the transactions that are recorded, processed and reported by the information system. Obtaining an understanding of the entity’s business processes, which include how transactions are originated, assists the auditor obtain an understanding of the entity’s information system relevant to financial reporting in a manner that is appropriate to the entity’s circumstances.

Considerations specific to smaller entities

The information system and related business processes relevant to financial reporting in small entities, including 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, is likely to be less sophisticated than in larger entities, but its role is just as significant. Small entities with active management involvement may not need extensive descriptions of accounting procedures, sophisticated accounting records, or written policies. Understanding the entity’s information system relevant to financial reporting may therefore be easier in an audit of smaller entities, and may be more dependent on enquiry than on review of documentation. The need to obtain an understanding, however, remains important.

Communication (Ref: Para. 19)

Communication by the entity of the financial reporting roles and responsibilities and of significant matters relating to financial reporting involves providing an understanding of individual roles and responsibilities pertaining to internal control over financial reporting. It includes such matters as the extent to which personnel understand how their activities in the financial reporting information system relate to the work of others and the means of reporting exceptions to an appropriate higher level within the entity. Communication may take such forms as policy manuals and financial reporting manuals. Open communication channels help ensure that exceptions are reported and acted on.

Considerations specific to smaller entities

Communication may be less structured and easier to achieve in a small entity than in a larger entity due to fewer levels of responsibility and management’s greater visibility and availability.

Components of Internal Control—Control Activities (Ref: Para. 20)

Control activities are the policies and procedures that help ensure that management directives are carried out. Control activities, whether within IT or manual systems, have various objectives and are applied at various organisational and functional levels. Examples of specific control activities include those relating to the following:

• Authorisation.
• Performance reviews.
• Information processing.
• Physical controls.
• Segregation of duties.

Control activities that are relevant to the audit are:

• Those that are required to be treated as such, being control activities that relate to significant risks and those that relate to risks for which substantive procedures alone do not provide sufficient appropriate audit evidence, as required by paragraphs 29 and 30, respectively; or
• Those that are considered to be relevant in the judgement of the auditor.

The auditor’s judgement about whether a control activity is relevant to the audit is influenced by the risk that the auditor has identified that may give rise to a material misstatement and whether the auditor thinks it is likely to be appropriate to test the operating effectiveness of the control in determining the extent of substantive testing.

The auditor’s emphasis may be on identifying and obtaining an understanding of control activities that address the areas where the auditor considers that risks of material misstatement are likely to be higher. When multiple control activities each achieve the same objective, it is unnecessary to obtain an understanding of each of the control activities related to such objective.

Control activities relevant to the audit may include controls established by management that address risks of material misstatement related to disclosures not being prepared in accordance with the applicable financial reporting framework, in addition to controls that address risks related to account balances and transactions. Such control activities may relate to information included in the financial report that is obtained from outside of the general and subsidiary ledgers.

The auditor’s knowledge about the presence or absence of control activities obtained from the understanding of the other components of internal control assists the auditor in determining whether it is necessary to devote additional attention to obtaining an understanding of control activities.

Considerations Specific to Smaller Entities

The concepts underlying control activities in small entities are likely to be similar to those in larger entities, but the formality with which they operate may vary. Further, small entities may find that certain types of control activities are not relevant because of controls applied by management. For example, management’s sole authority for granting credit to customers and approving significant purchases can provide strong control over important account balances and transactions, lessening or removing the need for more detailed control activities.

Control activities relevant to the audit of a smaller entity are likely to relate to the main transaction cycles such as revenues, purchases and employment expenses.

Risks Arising From IT (Ref: Para. 21)

The use of IT affects the way that control activities are implemented. From the auditor’s perspective, controls over IT systems are effective when they maintain the integrity of information and the security of the data such systems process, and include effective general IT controls and application controls.

General IT controls are policies and procedures that relate to many applications and support the effective functioning of application controls. They apply to mainframe, miniframe, and end user environments. General IT controls that maintain the integrity of information and security of data commonly include controls over the following:

• Data centre and network operations.
• System software acquisition, change and maintenance.
• Program change.
• Access security.
• Application system acquisition, development, and maintenance.

They are generally implemented to deal with the risks referred to in paragraph A64 above.

Application controls are manual or automated procedures that typically operate at a business process level and apply to the processing of transactions by individual applications. Application controls can be preventive or detective in nature and are designed to ensure the integrity of the accounting records. Accordingly, application controls relate to procedures used to initiate, record, process and report transactions or other financial data. These controls help ensure that transactions occurred, are authorised, and are completely and accurately recorded and processed. Examples include edit checks of input data, and numerical sequence checks with manual follow up of exception reports or correction at the point of data entry.

Components of Internal Control—Monitoring of Controls (Ref: Para. 22)

Monitoring of controls is a process to assess the effectiveness of internal control performance over time. It involves assessing the effectiveness of controls on a timely basis and taking necessary remedial actions. Management accomplishes monitoring of controls through ongoing activities, separate evaluations, or a combination of the two. Ongoing monitoring activities are often built into the normal recurring activities of an entity and include regular management and supervisory activities.

Management’s monitoring activities may also include using information from communications from external parties such as customer complaints and regulator comments that may indicate problems or highlight areas in need of improvement.

Considerations Specific to Smaller Entities

Management’s monitoring of control is often accomplished by management’s or the owner manager’s close involvement in operations. This involvement often will identify significant variances from expectations and inaccuracies in financial data leading to remedial action to the control.

The Entity’s Internal Audit Function (Ref: Para. 23)

If the entity has an internal audit function, obtaining an understanding of that function contributes to the auditor’s understanding of the entity and its environment, including internal control, in particular the role that the function plays in the entity’s monitoring of internal control over financial reporting. This understanding, together with the information obtained from the auditor’s enquiries in paragraph 6(a), may also provide information that is directly relevant to the auditor’s identification and assessment of the risks of material misstatement.

The objectives and scope of an internal audit function, the nature of its responsibilities and its status within the organisation, including the function’s authority and accountability, vary widely and depend on the size and structure of the entity and the requirements of management and, where applicable, those charged with governance. These matters may be out in an internal audit charter or terms of reference.

The responsibilities of an internal audit function may include performing procedures and evaluating the results to provide assurance to management and those charged with governance regarding the design and effectiveness of risk management, internal control and governance processes. If so, the internal audit function may play an important role in the entity’s monitoring of internal control over financial reporting. However, the responsibilities of the internal audit function may be focussed on evaluating the economy, efficiency and effectiveness of operations and, if so, the work of the function may not directly relate to the entity’s financial reporting.

The auditor’s enquiries of appropriate individuals within the internal audit function in accordance with paragraph 6(a) help the auditor obtain an understanding of the nature of the internal audit function’s responsibilities. If the auditor determines that the function’s responsibilities are related to the entity’s financial reporting, the auditor may obtain further understanding of the activities performed, or to be performed, by the internal audit function by reviewing the internal audit function’s audit plan for the period, if any, and discussing that plan with the appropriate individuals within that function.

If the nature of the internal audit function’s responsibilities and assurance activities are related to the entity’s financial reporting, the auditor may also be able 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 directly by the auditor in obtaining audit evidence. Auditors may be more likely to be able to use the work of an entity’s internal audit function when it appears, for example, based on experience in previous audits or the auditor’s risk assessment procedures, that the entity has an internal audit function that is adequately and appropriately resourced relative to the size of the entity and the nature of its operations, and has a direct reporting relationship to those charged with governance.

If, based on the auditor’s preliminary understanding of the internal audit function, 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, ASA 610 applies.

As is further discussed in ASA 610, the activities of an internal audit function are distinct from other monitoring controls that may be relevant to financial reporting, such as reviews of management accounting information that are designed to contribute to how the entity prevents or detects misstatements.

Establishing communications with the appropriate individuals within an entity’s internal audit function early in the engagement, and maintaining such communications throughout the engagement, can facilitate effective sharing of information. It creates an environment in which the auditor can be informed of significant matters that may come to the attention of the internal audit function when such matters may affect the work of the auditor. ASA 200 discusses the importance of the auditor planning and performing the audit with professional scepticism, including being alert to information that brings into question the reliability of documents and responses to enquiries to be used as audit evidence. Accordingly, communication with the internal audit function throughout the engagement may provide opportunities for internal auditors to bring such information to the auditor’s attention. The auditor is then able to take such information into account in the auditor’s identification and assessment of risks of material misstatement.

Sources of Information (Ref: Para. 24)

Much of the information used in monitoring may be produced by the entity’s information system. If management assumes that data used for monitoring are accurate without having a basis for that assumption, errors that may exist in the information could potentially lead management to incorrect conclusions from its monitoring activities. Accordingly, an understanding of:

• the sources of the information related to the entity’s monitoring activities; and
• the basis upon which management considers the information to be sufficiently reliable for the purpose

is required as part of the auditor’s understanding of the entity’s monitoring activities as a component of internal control.

Assessment of Risks of Material Misstatement at the Financial Report Level (Ref: Para. 25(a))

Risks of material misstatement at the financial report level refer to risks that relate pervasively to the financial report as a whole and potentially affect many assertions. Risks of this nature are not necessarily risks identifiable with specific assertions at the class of transactions, account balance, or disclosure level. Rather, they represent circumstances that may increase the risks of material misstatement at the assertion level, for example, through management override of internal control. Financial report level risks may be especially relevant to the auditor’s consideration of the risks of material misstatement arising from fraud.

Risks at the financial report level may derive in particular from a deficient control environment (although these risks may also relate to other factors, such as declining economic conditions). For example, deficiencies such as a lack of management competence or lack of oversight over the preparation of the financial report may have a more pervasive effect on the financial report and may require an overall response by the auditor.

The auditor’s understanding of internal control may raise doubts about the auditability of an entity’s financial report. For example:

• Concerns about the integrity of the entity’s management may be so serious as to cause the auditor to conclude that the risk of management misrepresentation in the financial report is such that an audit cannot be conducted.
• Concerns about the condition and reliability of an entity’s records may cause the auditor to conclude that it is unlikely that sufficient appropriate audit evidence will be available to support an unqualified opinion on the financial report.

ASA 705^[16] establishes requirements and provides guidance in determining whether there is a need for the auditor to express a qualified opinion or disclaim an opinion or, as may be required in some cases, to withdraw from the engagement where withdrawal is possible under applicable law or regulation.

Assessment of Risks of Material Misstatement at the Assertion Level (Ref: Para. 25(b))

Risks of material misstatement at the assertion level for classes of transactions, account balances, and disclosures need to be considered because such consideration directly assists in determining the nature, timing, and extent of further audit procedures at the assertion level necessary to obtain sufficient appropriate audit evidence. In identifying and assessing risks of material misstatement at the assertion level, the auditor may conclude that the identified risks relate more pervasively to the financial report as a whole and potentially affect many assertions.

The Use of Assertions

In representing that the financial report is in accordance with the applicable financial reporting framework, and other statutory reporting requirements, management or where appropriate those charged with governance implicitly or explicitly makes assertions regarding the recognition, measurement and presentation of classes of transactions and events, account balances and disclosures.

Assertions about classes of transactions, account balances, and related disclosures

Assertions used by the auditor in considering the different types of potential misstatements that may occur fall into the following categories:

1. Assertions about classes of transactions and events, and related disclosures, for the period under audit:
   1. Occurrence—transactions and events that have been recorded or disclosed, have occurred and such transactions and events pertain to the entity.
   2. Completeness—all transactions and events that should have been recorded have been recorded, and all related disclosures that should have been included in the financial report have been included.
   3. Accuracy—amounts and other data relating to recorded transactions and events have been recorded appropriately, and related disclosures have been appropriately measured and described.
   4. Cut off—transactions and events have been recorded in the correct accounting period.
   5. Classification—transactions and events have been recorded in the proper accounts.
   6. Presentation—transactions and events are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework.
2. Assertions about account balances, and related disclosures, at the period end:
   1. Existence—assets, liabilities, and equity interests exist.
   2. Rights and obligations—the entity holds or controls the rights to assets, and liabilities are the obligations of the entity.
   3. Completeness—all assets, liabilities and equity interests that should have been recorded have been recorded, and all related disclosures that should have been included in the financial report have been included.
   4. Accuracy, valuation and allocation—assets, liabilities, and equity interests have been included in the financial report at appropriate amounts and any resulting valuation or allocation adjustments have been appropriately recorded, and related disclosures have been appropriately measured and described.
   5. Classification—assets, liabilities and equity interests have been recorded in the proper accounts.
   6. Presentation— assets, liabilities and equity interests are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework.

Assertions about other disclosures

The assertions described in paragraph A128(a)–(b) above, adapted as appropriate, may also be used by the auditor in considering the different types of potential misstatements that may occur in disclosures not directly related to recorded classes of transactions, events, or account balances. As an example of such a disclosure, the entity may be required to describe its exposure to risks arising from financial instruments, including how the risks arise; the objectives, policies and processes for managing the risks; and the methods used to measure the risks.

Considerations specific to public sector entities

When making assertions about the financial report of public sector entities, in addition to those assertions set out in paragraph A128, management or those charged with governance may often assert that transactions and events have been carried out in accordance with law, regulation or other authority. Such assertions may fall within the scope of the financial report audit.

Process of Identifying Risks of Material Misstatement (Ref: Para. 26(a))

Information gathered by performing risk assessment procedures, including the audit evidence obtained in evaluating the design of controls and determining whether they have been implemented, is used as audit evidence to support the risk assessment.  The risk assessment determines the nature, timing, and extent of further audit procedures to be performed. In identifying the risks of material misstatement in the financial report, the auditor exercises professional scepticism in accordance with ASA 200.^[17]

Appendix 2 provides examples of conditions and events that may indicate the existence of risks of material misstatement, including risks of material misstatement relating to disclosures.

As explained in ASA 320,^[18] materiality and audit risk are considered when identifying and assessing the risks of material misstatement in classes of transactions, account balances and disclosures.  The auditor’s determination of materiality is a matter of professional judgement, and is affected by the auditor’s perception of the financial reporting needs of users of the financial report.^[19]

The auditor’s consideration of disclosures in the financial report when identifying risks includes quantitative and qualitative disclosures, the misstatement of which could be material (i.e., in general, misstatements are considered to be material if they could reasonably be expected to influence the economic decisions of users taken on the basis of the financial report as a whole). Depending on the circumstances of the entity and the engagement, examples of disclosures that will have qualitative aspects and that may be relevant when assessing the risks of material misstatement include disclosures about:

• Liquidity and debt covenants of an entity in financial distress.
• Events or circumstances that have led to the recognition of an impairment loss.
• Key sources of estimation uncertainty, including assumptions about the future.
• The nature of a change in accounting policy, and other relevant disclosures required by the applicable financial reporting framework, where, for example, new financial reporting requirements are expected to have a significant impact on the financial position and financial performance of the entity.
• Share based payment arrangements, including information about how any amounts recognised were determined, and other relevant disclosures.
• Related parties, and related party transactions.
• Sensitivity analysis, including the effects of changes in assumptions used in the entity’s valuation techniques intended to enable users to understand the underlying measurement uncertainty of a recorded or disclosed amount.

Considerations specific to smaller entities

Disclosures in the financial report of smaller entities may be less detailed or less complex (e.g., some financial reporting frameworks allow smaller entities to provide fewer disclosures in the financial report). However, this does not relieve the auditor of the responsibility to obtain an understanding of the entity and its environment, including internal control, as it relates to disclosures.

Material Misstatements

Potential misstatements in individual statements and disclosures may be judged to be material due to size, nature or circumstances. (Ref: Para. 26(d))

Relating Controls to Assertions (Ref: Para. 26(c))

In making risk assessments, the auditor may identify the controls that are likely to prevent, or detect and correct, material misstatement in specific assertions. Generally, it is useful to obtain an understanding of controls and relate them to assertions in the context of processes and systems in which they exist because individual control activities often do not in themselves address a risk. Often, only multiple control activities, together with other components of internal control, will be sufficient to address a risk.

Conversely, some control activities may have a specific effect on an individual assertion embodied in a particular class of transactions or account balance. For example, the control activities that an entity established to ensure that its personnel are properly counting and recording the annual physical inventory relate directly to the existence and completeness assertions for the inventory account balance.

Controls can be either directly or indirectly related to an assertion. The more indirect the relationship, the less effective that control may be in preventing, or detecting and correcting, misstatements in that assertion. For example, a sales manager’s review of a summary of sales activity for specific stores by region ordinarily is only indirectly related to the completeness assertion for sales revenue. Accordingly, it may be less effective in reducing risk for that assertion than controls more directly related to that assertion, such as matching shipping documents with billing documents.

Significant Risks

Identifying Significant Risks (Ref: Para. 28)

Significant risks often relate to significant non routine transactions or judgemental matters. Non routine transactions are transactions that are unusual, due to either size or nature, and that therefore occur infrequently. Judgemental matters may include the development of accounting estimates for which there is significant measurement uncertainty. Routine, non complex transactions that are subject to systematic processing are less likely to give rise to significant risks.

Risks of material misstatement may be greater for significant non routine transactions arising from matters such as the following:

• Greater management intervention to specify the accounting treatment.
• Greater manual intervention for data collection and processing.
• Complex calculations or accounting principles.
• The nature of non routine transactions, which may make it difficult for the entity to implement effective controls over the risks.

Risks of material misstatement may be greater for significant judgemental matters that require the development of accounting estimates, arising from matters such as the following:

• Accounting principles for accounting estimates or revenue recognition may be subject to differing interpretation.
• Required judgement may be subjective or complex, or require assumptions about the effects of future events, for example, judgement about fair value.

ASA 330 describes the consequences for further audit procedures of identifying a risk as significant.^[20]

Significant risks relating to the risks of material misstatement due to fraud

ASA 240 provides further requirements and guidance in relation to the identification and assessment of the risks of material misstatement due to fraud.^[21]

Understanding Controls Related to Significant Risks (Ref: Para. 29)

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.

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.

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]

Risks for Which Substantive Procedures Alone Do Not Provide Sufficient Appropriate Audit Evidence (Ref: Para. 30)

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.

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.

The consequences for further audit procedures of identifying such risks are described in ASA 330.^[23]

Revision of Risk Assessment (Ref: Para. 31)

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.

(Ref: Para. 32)

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.

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.

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.

For recurring audits, certain documentation may be carried forward, updated as necessary to reflect changes in the entity’s business or processes.

(Ref: Para. 4(c), 14-24 and A77-A121)

1. 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

2. The control environment encompasses the following elements:
   1. 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.
   2. Commitment to competence. Competence is the knowledge and skills necessary to accomplish tasks that define the individual’s job.
   3. 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.
   4. 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.
   5. 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.
   6. 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.
   7. 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

3. 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.
4. 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:
   1. Changes in operating environment. Changes in the regulatory or operating environment can result in changes in competitive pressures and significantly different risks.
   2. New personnel. New personnel may have a different focus on or understanding of internal control.
   3. New or revamped information systems. Significant and rapid changes in information systems can change the risk relating to internal control.
   4. Rapid growth. Significant and rapid expansion of operations can strain controls and increase the risk of a breakdown in controls.
   5. New technology. Incorporating new technologies into production processes or information systems may change the risk associated with internal control.
   6. 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.
   7. 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.
   8. 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.
   9. 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

5. 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).
6. The information system relevant to financial reporting objectives, which includes the financial reporting system, encompasses methods and records that:
   1. Identify and record all valid transactions.
   2. Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions for financial reporting.
   3. Measure the value of transactions in a manner that permits recording their proper monetary value in the financial report.
   4. Determine the time period in which transactions occurred to permit recording of transactions in the proper accounting period.
   5. Present properly the transactions and related disclosures in the financial report.
7. 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.
8. 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

9. Generally, control activities that may be relevant to an audit may be categorised as policies and procedures that pertain to the following:
   1. 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.
   2. 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.
   3. Physical controls. Controls that encompass:
      1. The physical security of assets, including adequate safeguards such as secured facilities over access to assets and records.
      2. The authorisation for access to computer programs and data files.
      3. The periodic counting and comparison with amounts shown on control records (for example comparing the results of cash, security and inventory counts with accounting records).
   4. 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.
   5. 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.
10. 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 Controls

11. 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.
12. 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.
13. 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.

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.

1. Operations in regions that are economically unstable, for example, countries with significant currency devaluation or highly inflationary economies.
2. Operations exposed to volatile markets, for example, futures trading.
3. Operations that are subject to a high degree of complex regulation.
4. Going concern and liquidity issues including loss of significant customers.
5. Constraints on the availability of capital and credit.
6. Changes in the industry in which the entity operates.
7. Changes in the supply chain.
8. Developing or offering new products or services, or moving into new lines of business.
9. Expanding into new locations.
10. Changes in the entity such as large acquisitions or reorganisations or other unusual events.
11. Entities or business segments likely to be sold.
12. The existence of complex alliances and joint ventures.
13. Use of off-balance-sheet finance, special-purpose entities, and other complex financing arrangements.
14. Significant transactions with related parties.
15. Lack of personnel with appropriate accounting and financial reporting skills.
16. Changes in key personnel including departure of key executives.
17. Deficiencies in internal control, especially those not addressed by management.
18. Incentives for management and employees to engage in fraudulent financial reporting.
19. Inconsistencies between the entity’s IT strategy and its business strategies.
20. Changes in the IT environment.
21. Installation of significant new IT systems related to financial reporting.
22. Enquiries into the entity’s operations or financial results by regulatory or government bodies.
23. Past misstatements, history of errors or a significant amount of adjustments at period end.
24. Significant amount of non-routine or non-systematic transactions including intercompany transactions and large revenue transactions at period end.
25. Transactions that are recorded based on management’s intent, for example, debt refinancing, assets to be sold and classification of marketable securities.
26. Application of new accounting pronouncements.
27. Accounting measurements that involve complex processes.
28. Events or transactions that involve significant measurement uncertainty, including accounting estimates, and related disclosures.
29. Omission, or obscuring, of significant information in disclosures.
30. Pending litigation and contingent liabilities, for example, sales warranties, financial guarantees and environmental remediation.