Compiled Auditing Standard | ASA 315 (June 2011) |
Auditing Standard ASA 315
Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment
This compilation was prepared on 27 June 2011 taking into account amendments made by ASA 2011-1
Prepared by the Auditing and Assurance Standards Board
Obtaining a Copy of this Auditing Standard
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ISSN 1833-4393
COMPILATION DETAILS
AUTHORITY STATEMENT
Paragraphs
Application ............................... Aus 0.1-Aus 0.2
Operative Date............................. Aus 0.3
Introduction
Scope of this Auditing Standard.................. 1
Effective Date.............................. 2
Objective................................. 3
Definitions................................ 4
Requirements
Risk Assessment Procedures and Related Activities..... 5-10
The Required Understanding of the Entity and its Environment, Including the Entity’s Internal Control 11-24
Identifying and Assessing the Risks of Material Misstatement 25-31
Documentation............................. 32
Application and Other Explanatory Material
Risk Assessment Procedures and Related Activities ..... A1-A16
The Required Understanding of the Entity and Its Environment, Including the Entity’s Internal Control A17-A104
Identifying and Assessing the Risks of Material Misstatement A105-A130
Documentation............................. A131-A134
Conformity with International Standards on Auditing
Appendix 1: Internal Control Components
Appendix 2: Conditions and Events That May Indicate Risks of Material Misstatement
Auditing Standard ASA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment as Amended
This compilation takes into account amendments made up to and including 27 June 2011 and was prepared on 27 June 2011 by the Auditing and Assurance Standards Board (AUASB).
This compilation is not a separate Auditing Standard made by the AUASB. Instead, it is a representation of ASA 315 (October 2009) as amended by another Auditing Standard which is listed in the Table below.
Standard | Date made | Operative date |
ASA 315 | 27 October 2009 | 1 January 2010 |
ASA 2011-1 | 27 June 2011 | 1 July 2011 |
Paragraph affected | How affected | By … [paragraph] |
A26 | Amended | ASA 2011-1 [28] |
Appendix 1 Para. 3 |
Amended |
ASA 2011-1 [29] |
Appendix 1 Sub-heading above Para. 5 |
Amended |
ASA 2011-1 [30] |
Auditing Standard ASA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment (as amended at 27 June 2011) is set out in paragraphs
1 to A134 and Appendices 1 and 2.
This Auditing Standard is to be read in conjunction with ASA 101 Preamble to Australian Auditing Standards, which sets out the intentions of the AUASB on how the Australian Auditing Standards, operative for financial reporting periods commencing on or after 1 January 2010, are to be understood, interpreted and applied. This Auditing Standard is to be read also in conjunction with ASA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Australian Auditing Standards.
Dated: 27 June 2011 M H Kelsall
Chairman - AUASB
Aus 0.1 This Auditing Standard applies to:
(a) an audit of a financial report for a financial year, or an audit of a financial report for a half-year, in accordance with the Corporations Act 2001; and
(b) an audit of a financial report, or a complete set of financial statements, for any other purpose.
Aus 0.2 This Auditing Standard also applies, as appropriate, to an audit of other historical financial information.
Aus 0.3 This Auditing Standard is operative for financial reporting periods commencing on or after 1 January 2010. [Note: For operative dates of paragraphs changed or added by an amending Standard, see Compilation Details.]
2. [Deleted by the AUASB. Refer Aus 0.3]
3. The objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial report and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement.
4. For purposes of the Australian Auditing Standards, the following terms have the meanings attributed below:
(a) Assertions means representations by management and those charged with governance, explicit or otherwise, that are embodied in the financial report, as used by the auditor to consider the different types of potential misstatements that may occur.
(b) Business risk means a risk resulting from significant conditions, events, circumstances, actions or inactions that could adversely affect an entity’s ability to achieve its objectives and execute its strategies, or from the setting of inappropriate objectives and strategies.
(c) Internal control means the process designed, implemented and maintained by those charged with governance, management and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations. The term “controls” refers to any aspects of one or more of the components of internal control.
(d) Risk assessment procedures means the audit procedures performed to obtain an understanding of the entity and its environment, including the entity’s internal control, to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial report and assertion levels.
(e) Significant risk means an identified and assessed risk of material misstatement that, in the auditor’s judgement, requires special audit consideration.
5. The auditor shall perform risk assessment procedures to provide a basis for the identification and assessment of risks of material misstatement at the financial report and assertion levels. Risk assessment procedures by themselves, however, do not provide sufficient appropriate audit evidence on which to base the audit opinion. (Ref: Para. A1-A5)
6. The risk assessment procedures shall include the following:
(a) Enquiries of management, and of others within the entity who in the auditor’s judgement may have information that is likely to assist in identifying risks of material misstatement due to fraud or error. (Ref: Para. A6)
(b) Analytical procedures. (Ref: Para. A7-A10)
(c) Observation and inspection. (Ref: Para. A11)
7. The auditor shall consider whether information obtained from the auditor’s client acceptance or continuance process is relevant to identifying risks of material misstatement.
8. If the engagement partner has performed other engagements for the entity, the engagement partner shall consider whether information obtained is relevant to identifying risks of material misstatement.
9. Where the auditor intends to use information obtained from the auditor’s previous experience with the entity and from audit procedures performed in previous audits, the auditor shall determine whether changes have occurred since the previous audit that may affect its relevance to the current audit. (Ref: Para. A12-A13)
10. The engagement partner and other key engagement team members shall discuss the susceptibility of the entity’s financial report to material misstatement, and the application of the applicable financial reporting framework to the entity’s facts and circumstances. The engagement partner shall determine which matters are to be communicated to engagement team members not involved in the discussion. (Ref: Para. A14-A16)
11. The auditor shall obtain an understanding of the following:
(a) Relevant industry, regulatory, and other external factors and the applicable financial reporting framework.
(Ref: Para. A17-A22)
(b) The nature of the entity, including:
(i) its operations;
(ii) its ownership and governance structures;
(iii) the types of investments that the entity is making and plans to make, including investments in special-purpose entities; and
(iv) the way that the entity is structured and how it is financed
to enable the auditor to understand the classes of transactions, account balances, and disclosures to be expected in the financial report. (Ref: Para. A23-A27)
(c) The entity’s selection and application of accounting policies, including the reasons for changes thereto. The auditor shall evaluate whether the entity’s accounting policies are appropriate for its business and consistent with the applicable financial reporting framework and accounting policies used in the relevant industry.
(Ref: Para. A28)
(d) The entity’s objectives and strategies, and those related business risks that may result in risks of material misstatement. (Ref: Para. A29-A35)
(e) The measurement and review of the entity’s financial performance. (Ref: Para. A36-A41)
12. The auditor shall obtain an understanding of internal control relevant to the audit. Although most controls relevant to the audit are likely to relate to financial reporting, not all controls that relate to financial reporting are relevant to the audit. It is a matter of the auditor’s professional judgement whether a control, individually or in combination with others, is relevant to the audit. (Ref: Para. A42-A65)
13. When obtaining an understanding of controls that are relevant to the audit, the auditor shall evaluate the design of those controls and determine whether they have been implemented, by performing procedures in addition to enquiry of the entity’s personnel.
(Ref: Para. A66-A68)
14. The auditor shall obtain an understanding of the control environment. As part of obtaining this understanding, the auditor shall evaluate whether:
(a) Management, with the oversight of those charged with governance, has created and maintained a culture of honesty and ethical behaviour; and
(b) The strengths in the control environment elements collectively provide an appropriate foundation for the other components of internal control, and whether those other components are not undermined by control environment weaknesses. (Ref: Para. A69-A78)
15. The auditor shall obtain an understanding of whether the entity has a process for:
(a) Identifying business risks relevant to financial reporting objectives;
(b) Estimating the significance of the risks;
(c) Assessing the likelihood of their occurrence; and
(d) Deciding about actions to address those risks. (Ref: Para. A79)
16. If the entity has established such a process (referred to hereafter as the “entity’s risk assessment process”), the auditor shall obtain an understanding of it, and the results thereof. If the auditor identifies risks of material misstatement that management failed to identify, the auditor shall evaluate whether there was an underlying risk of a kind that the auditor expects would have been identified by the entity’s risk assessment process. If there is such a risk, the auditor shall obtain an understanding of why that process failed to identify it, and evaluate whether the process is appropriate to its circumstances or determine if there is a significant deficiency in internal control with regard to the entity’s risk assessment process.
17. If the entity has not established such a process or has an ad hoc undocumented process, the auditor shall discuss with management whether business risks relevant to financial reporting objectives have been identified and how they have been addressed. The auditor shall evaluate whether the absence of a documented risk assessment process is appropriate in the circumstances, or determine whether it represents a significant deficiency in internal control. (Ref: Para. A80)
18. The auditor shall obtain an understanding of the information system, including the related business processes, relevant to financial reporting, including the following areas:
(a) The classes of transactions in the entity’s operations that are significant to the financial report;
(b) The procedures, within both information technology (IT) and manual systems, by which those transactions are initiated, recorded, processed, corrected as necessary, transferred to the general ledger and reported in the financial report;
(c) The related accounting records, supporting information and specific accounts in the financial report that are used to initiate, record, process and report transactions; this includes the correction of incorrect information and how information is transferred to the general ledger. The records may be in either manual or electronic form;
(d) How the information system captures events and conditions, other than transactions, that are significant to the financial report;
(e) The financial reporting process used to prepare the entity’s financial report, including significant accounting estimates and disclosures; and
(f) Controls surrounding journal entries, including
non-standard journal entries used to record non-recurring, unusual transactions or adjustments. (Ref: Para. A81-A85)
19. The auditor shall obtain an understanding of how the entity communicates financial reporting roles and responsibilities and significant matters relating to financial reporting, including:
(Ref: Para. A86-A87)
(a) Communications between management and those charged with governance; and
(b) External communications, such as those with regulatory authorities.
20. The auditor shall obtain an understanding of control activities relevant to the audit, being those the auditor judges it necessary to understand in order to assess the risks of material misstatement at the assertion level and design further audit procedures responsive to assessed risks. An audit does not require an understanding of all the control activities related to each significant class of transactions, account balance, and disclosure in the financial report or to every assertion relevant to them. (Ref: Para. A88-A94)
21. In understanding the entity’s control activities, the auditor shall obtain an understanding of how the entity has responded to risks arising from IT. (Ref: Para. A95-A97)
22. The auditor shall obtain an understanding of the major activities that the entity uses to monitor internal control over financial reporting, including those related to those control activities relevant to the audit, and how the entity initiates remedial actions to address deficiencies in its controls. (Ref: Para. A98-A100)
23. If the entity has an internal audit function,[1] the auditor shall obtain an understanding of the following in order to determine whether the internal audit function is likely to be relevant to the audit:
(a) The nature of the internal audit function’s responsibilities and how the internal audit function fits in the entity’s organisational structure; and
(b) The activities performed, or to be performed, by the internal audit function. (Ref Para. A101-A103)
24. The auditor shall obtain an understanding of the sources of the information used in the entity’s monitoring activities, and the basis upon which management considers the information to be sufficiently reliable for the purpose. (Ref: Para. A104)
25. The auditor shall identify and assess the risks of material misstatement at:
(a) the financial report level; and (Ref: Para. A105-A108)
(b) the assertion level for classes of transactions, account balances, and disclosures (Ref: Para. A109-A113)
to provide a basis for designing and performing further audit procedures.
26. For this purpose, the auditor shall:
(a) Identify risks throughout the process of obtaining an understanding of the entity and its environment, including relevant controls that relate to the risks, and by considering the classes of transactions, account balances, and disclosures in the financial report; (Ref: Para. A114-A115)
(b) Assess the identified risks, and evaluate whether they relate more pervasively to the financial report as a whole and potentially affect many assertions;
(c) Relate the identified risks to what can go wrong at the assertion level, taking account of relevant controls that the auditor intends to test; and (Ref: Para. A116-A118)
(d) Consider the likelihood of misstatement, including the possibility of multiple misstatements, and whether the potential misstatement is of a magnitude that could result in a material misstatement.
27. As part of the risk assessment as described in paragraph 25 of this Auditing Standard, the auditor shall determine whether any of the risks identified are, in the auditor’s judgement, a significant risk. In exercising this judgement, the auditor shall exclude the effects of identified controls related to the risk.
28. In exercising judgement as to which risks are significant risks, the auditor shall consider at least the following:
(a) Whether the risk is a risk of fraud;
(b) Whether the risk is related to recent significant economic, accounting or other developments and, therefore, requires specific attention;
(c) The complexity of transactions;
(d) Whether the risk involves significant transactions with related parties;
(e) The degree of subjectivity in the measurement of financial information related to the risk, especially those measurements involving a wide range of measurement uncertainty; and
(f) Whether the risk involves significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual. (Ref: Para. A119-A123)
29. If the auditor has determined that a significant risk exists, the auditor shall obtain an understanding of the entity’s controls, including control activities, relevant to that risk. (Ref: Para. A124-A126)
30. In respect of some risks, the auditor may judge that it is not possible or practicable to obtain sufficient appropriate audit evidence only from substantive procedures. Such risks may relate to the inaccurate or incomplete recording of routine and significant classes of transactions or account balances, the characteristics of which often permit highly automated processing with little or no manual intervention. In such cases, the entity’s controls over such risks are relevant to the audit and the auditor shall obtain an understanding of them. (Ref: Para. A127-A129)
31. The auditor’s assessment of the risks of material misstatement at the assertion level may change during the course of the audit as additional audit evidence is obtained. In circumstances where the auditor obtains audit evidence from performing further audit procedures, or if new information is obtained, either of which is inconsistent with the audit evidence on which the auditor originally based the assessment, the auditor shall revise the assessment and modify the further planned audit procedures accordingly.
(Ref: Para. A130)
32. The auditor shall include in the audit documentation:[1]
(a) The discussion among the engagement team where required by paragraph 10 of this Auditing Standard, and the significant decisions reached;
(b) Key elements of the understanding obtained regarding each of the aspects of the entity and its environment specified in paragraph 11 of this Auditing Standard and of each of the internal control components specified in paragraphs 14-24 of this Auditing Standard; the sources of information from which the understanding was obtained; and the risk assessment procedures performed;
(c) The identified and assessed risks of material misstatement at the financial report level and at the assertion level as required by paragraph 25 of this Auditing Standard; and
(d) The risks identified, and related controls about which the auditor has obtained an understanding, as a result of the requirements in paragraphs 27-30 of this Auditing Standard. (Ref: Para. A131-A134)
* * *
A1. Obtaining an understanding of the entity and its environment, including the entity’s internal control (referred to hereafter as an “understanding of the entity”), is a continuous, dynamic process of gathering, updating and analysing information throughout the audit. The understanding establishes a frame of reference within which the auditor plans the audit and exercises professional judgement throughout the audit, for example, when:
A2. Information obtained by performing risk assessment procedures and related activities may be used by the auditor as audit evidence to support assessments of the risks of material misstatement. In addition, the auditor may obtain audit evidence about classes of transactions, account balances, or disclosures and related assertions and about the operating effectiveness of controls, even though such procedures were not specifically planned as substantive procedures or as tests of controls. The auditor also may choose to perform substantive procedures or tests of controls concurrently with risk assessment procedures because it is efficient to do so.
A3. The auditor uses professional judgement to determine the extent of the understanding required. The auditor’s primary consideration is whether the understanding that has been obtained is sufficient to meet the objective stated in this Auditing Standard. The depth of the overall understanding that is required by the auditor is less than that possessed by management in managing the entity.
A4. The risks to be assessed include both those due to error and those due to fraud, and both are covered by this Auditing Standard. However, the significance of fraud is such that further requirements and guidance are included in ASA 240, in relation to risk assessment procedures and related activities to obtain information that is used to identify the risks of material misstatement due to fraud.[3]
A5. Although the auditor is required to perform all the risk assessment procedures described in paragraph 6 in the course of obtaining the required understanding of the entity (see paragraphs 11-24), the auditor is not required to perform all of them for each aspect of that understanding. Other procedures may be performed where the information to be obtained therefrom may be helpful in identifying risks of material misstatement. Examples of such procedures include:
A6. Much of the information obtained by the auditor’s enquiries is obtained from management and those responsible for financial reporting. However, 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:
A7. 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.
A8. 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.
A9. 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.
A10. 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.
A11. 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:
A12. 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:
A13. 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.
A14. The discussion among the engagement team about the susceptibility of the entity’s financial report to material misstatement:
ASA 240 provides further requirements and guidance in relation to the discussion among the engagement team about the risks of fraud.[4]
A15. 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.
A16. 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.
A17. 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:
A18. 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.[5]
A19. 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:
A20. 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.[6]
A21. 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.
A22. 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.
A23. An understanding of the nature of an entity enables the auditor to understand such matters as:
A24. Examples of matters that the auditor may consider when obtaining an understanding of the nature of the entity include:
○ 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.
○ 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.
○ 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.
○ Accounting principles and industry specific practices, including industry-specific significant categories (for example, loans and investments for banks, or research and development for pharmaceuticals).
○ Revenue recognition practices.
○ Accounting for fair values.
○ Foreign currency assets, liabilities and transactions.
○ Accounting for unusual or complex transactions including those in controversial or emerging areas (for example, accounting for share-based compensation).
Aus A24.1 Ownership and Governance arrangements such as:
○ The role of the board of directors and those charged with governance in determining policies for the levels of risk that the entity is willing to accept in its daily operations.
○ The role of senior management in designing, implementing, and monitoring effective risk management systems to implement the policies prescribed by the board of directors.
○ The presence of non-executive directors on the board and an independent compensation committee that reviews incentive plans, including commissions, discretionary bonuses, directors’ service contracts, and profit-sharing plans.
○ The role of line management in carrying out the prescribed procedures and control activities.
○ The strength of the internal audit function and the audit committee and their role as an independent appraisal function.
○ The strength of other significant committees, for example, risk management committee, asset and liability management committee, or general management committee.
○ The adequacy of segregation of duties.
○ Prior period financial reporting disclosures include the form, classification, terminology, basis of amounts and level of detail provided.
A25. Significant changes in the entity from prior periods may give rise to, or change, risks of material misstatement.
A26. 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 derecognition 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.[8]
A27. 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.
A28. An understanding of the entity’s selection and application of accounting policies may encompass such matters as:
A29. 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.
A30. 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:
A31. 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.
A32. 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:
A33. 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.
A34. 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 A79-A80.
A35. 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.
A36. 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.
A37. 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 A98-A104), though their purposes may overlap:
In some cases, however, performance indicators also provide information that enables management to identify deficiencies in internal control.
A38. Examples of internally-generated information used by management for measuring and reviewing financial performance, and which the auditor may consider, include:
A39. 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.
A40. 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.
A41. 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.
A42. 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.
A43. The following application material on internal control is presented in four sections, as follows:
A44. 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 way in which internal control is designed, implemented and maintained varies with an entity’s size and complexity.
A45. Smaller entities may use less structured means and simpler processes and procedures to achieve their objectives.
A46. 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.
A47. 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.
A48. 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.
A49. 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.
A50. 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.
A51. The division of internal control into the following five components, for purposes of Australian Auditing Standards, provides a useful framework for auditors to consider how different aspects of an entity’s internal control may affect the audit:
(a) The control environment;
(b) The entity’s risk assessment process;
(c) The information system, including the related business processes, relevant to financial reporting, and communication;
(d) Control activities; and
(e) Monitoring of controls.
The division does not necessarily reflect how an entity designs, implements and maintains internal control, or how it may classify any particular component. Auditors may use different terminology or frameworks to describe the various aspects of internal control, and their effect on the audit than those used in this Auditing Standard, provided all the components described in this Auditing Standard are addressed.
A52. Application material relating to the five components of internal control as they relate to a financial report audit is set out in paragraphs A69-A104 below. Appendix 1 provides further explanation of these components of internal control.
A53. 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.
A54. The use of manual or automated elements in internal control also affects the manner in which transactions are initiated, recorded, processed, and reported:
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.
A55. Generally, IT benefits an entity’s internal control by enabling an entity to:
A56. IT also poses specific risks to an entity’s internal control, including, for example:
A57. Manual elements in internal control may be more suitable where judgement and discretion are required such as for the following circumstances:
A58. 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:
A59. 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.
A60. 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.
A61. 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:
A62. 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.
A63. 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.
A64. 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.
A65. 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.
A66. 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.
A67. Risk assessment procedures to obtain audit evidence about the design and implementation of relevant controls may include:
Enquiry alone, however, is not sufficient for such purposes.
A68. 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 A55), 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.[9]
A69. 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.
A70. Elements of the control environment that may be relevant when obtaining an understanding of the control environment include the following:
(a) Communication and enforcement of integrity and ethical values – These are essential elements that influence the effectiveness of the design, administration and monitoring of controls.
(b) Commitment to competence – Matters such as management’s consideration of the competence levels for particular jobs and how those levels translate into requisite skills and knowledge.
(c) Participation by those charged with governance
– Attributes of those charged with governance such as:
(d) Management’s philosophy and operating style
– Characteristics such as management’s:
(e) Organisational structure – The framework within which an entity’s activities for achieving its objectives are planned, executed, controlled, and reviewed.
(f) Assignment of authority and responsibility – Matters such as how authority and responsibility for operating activities are assigned and how reporting relationships and authorisation hierarchies are established.
(g) Human resource policies and practices – Policies and practices that relate to, for example, recruitment, orientation, training, evaluation, counselling, promotion, compensation, and remedial actions.
A71. 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.
A72. 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:
A73. 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.
A74. 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.[10]
A75. 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.
A76. 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.
A77. 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.
A78. 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.
A79. 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.
A80. 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.
A81. The information system relevant to financial reporting objectives, which includes the accounting system, consists of the procedures and records designed and established to:
A82. 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.
A83. 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.
A84. An entity’s business processes are the activities designed to:
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.
A85. Information systems and related business processes relevant to financial reporting in small entities are likely to be less sophisticated than in larger entities, but their 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 systems and processes 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.
A86. 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.
A87. 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.
A88. 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:
A89. Control activities that are relevant to the audit are:
A90. 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.
A91. 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.
A92. 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.
A93. 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.
A94. 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.
A95. 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.
A96. 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:
They are generally implemented to deal with the risks referred to in paragraph A56 above.
A97. 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.
A98. 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.
A99. 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.
A100. 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.
A101. The entity’s internal audit function is likely to be relevant to the audit if the nature of the internal audit function’s responsibilities and activities are related to the entity’s financial reporting, and the auditor expects to use the work of the internal auditors to modify the nature or timing, or reduce the extent, of audit procedures to be performed. If the auditor determines that the internal audit function is likely to be relevant to the audit, ASA 610 applies.
A102. The objectives of an internal audit function, and therefore the nature of its responsibilities and its status within the organisation, vary widely and depend on the size and structure of the entity and the requirements of management and, where applicable, those charged with governance. The responsibilities of an internal audit function may include, for example, monitoring of internal control, risk management, and review of compliance with laws and regulations. On the other hand, the responsibilities of the internal audit function may be limited to the review of the economy, efficiency and effectiveness of operations, for example, and accordingly, may not relate to the entity’s financial reporting.
A103. If the nature of the internal audit function’s responsibilities are related to the entity’s financial reporting, the external auditor’s consideration of the activities performed, or to be performed by, the internal audit function may include review of the internal audit function’s audit plan for the period, if any, and discussion of that plan with the internal auditors.
A104. 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:
is required as part of the auditor’s understanding of the entity’s monitoring activities as a component of internal control.
A105. 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.
A106. 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 management’s lack of competence may have a more pervasive effect on the financial report and may require an overall response by the auditor.
A107. The auditor’s understanding of internal control may raise doubts about the auditability of an entity’s financial report. For example:
A108. ASA 705[11] 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.
A109. 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.
A110. In representing that the financial report is in accordance with the applicable financial reporting framework, management or where appropriate those charged with governance implicitly or explicitly makes assertions regarding the recognition, measurement, presentation and disclosure of the various elements of the financial report and related disclosures.
A111. Assertions used by the auditor to consider the different types of potential misstatements that may occur fall into the following three categories and may take the following forms:
(a) Assertions about classes of transactions and events for the period under audit:
(i) Occurrence—transactions and events that have been recorded have occurred and pertain to the entity.
(ii) Completeness—all transactions and events that should have been recorded have been recorded.
(iii) Accuracy—amounts and other data relating to recorded transactions and events have been recorded appropriately.
(iv) Cut-off—transactions and events have been recorded in the correct accounting period.
(v) Classification—transactions and events have been recorded in the proper accounts.
(b) Assertions about account balances at the period end:
(i) Existence—assets, liabilities, and equity interests exist.
(ii) Rights and obligations—the entity holds or controls the rights to assets, and liabilities are the obligations of the entity.
(iii) Completeness—all assets, liabilities and equity interests that should have been recorded have been recorded.
(iv) Valuation and allocation—assets, liabilities, and equity interests are included in the financial report at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.
(c) Assertions about presentation and disclosure:
(i) Occurrence and rights and obligations—disclosed events, transactions, and other matters have occurred and pertain to the entity.
(ii) Completeness—all disclosures that should have been included in the financial report have been included.
(iii) Classification and understandability—financial information is appropriately presented and described, and disclosures are clearly expressed.
(iv) Accuracy and valuation—financial and other information are disclosed fairly and at appropriate amounts.
A112. The auditor may use the assertions as described above or may express them differently provided all aspects described above have been covered. For example, the auditor may choose to combine the assertions about transactions and events with the assertions about account balances.
A113. When making assertions about the financial report of public sector entities, in addition to those assertions set out in paragraph A111, 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.
A114. 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.
A115. Appendix 2 provides examples of conditions and events that may indicate the existence of risks of material misstatement.
A116. 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.
A117. 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.
A118. 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.
A119. 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.
A120. Risks of material misstatement may be greater for significant
non-routine transactions arising from matters such as the following:
A121. 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:
A122. ASA 330 describes the consequences for further audit procedures of identifying a risk as significant.[12]
A123. ASA 240 provides further requirements and guidance in relation to the identification and assessment of the risks of material misstatement due to fraud.[13]
A124. 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:
A125. 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.
A126. 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.[14]
A127. 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.
A128. 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:
A129. The consequences for further audit procedures of identifying such risks are described in ASA 330.[15]
A130. 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.
A131. 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.[16] 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.[17] 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.
A132. 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.
A133. 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.
A134. For recurring audits, certain documentation may be carried forward, updated as necessary to reflect changes in the entity’s business or processes.
This Auditing Standard conforms with International Standard on Auditing ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment, issued by the International Auditing and Assurance Standards Board (IAASB), an independent standard-setting board of the International Federation of Accountants (IFAC).
Paragraphs that have been added to this Auditing Standard (and do not appear in the text of the equivalent ISA) are identified with the prefix “Aus”.
Compliance with this Auditing Standard enables compliance with ISA 315.
(Ref: Para. 4(c), 14-24 and A69-A104)
2. The control environment encompasses the following elements:
(a) Communication and enforcement of integrity and ethical values. The effectiveness of controls cannot rise above the integrity and ethical values of the people who create, administer, and monitor them. Integrity and ethical behaviour are the product of the entity’s ethical and behavioural standards, how they are communicated, and how they are reinforced in practice. The enforcement of integrity and ethical values includes, for example, management actions to eliminate or mitigate incentives or temptations that might prompt personnel to engage in dishonest, illegal, or unethical acts. The communication of entity policies on integrity and ethical values may include the communication of behavioural standards to personnel through policy statements and codes of conduct and by example.
(b) Commitment to competence. Competence is the knowledge and skills necessary to accomplish tasks that define the individual’s job.
(c) Participation by those charged with governance. An entity’s control consciousness is influenced significantly by those charged with governance. The importance of the responsibilities of those charged with governance is recognised in codes of practice and other laws and regulations or guidance produced for the benefit of those charged with governance. Other responsibilities of those charged with governance include oversight of the design and effective operation of whistle blower procedures and the process for reviewing the effectiveness of the entity’s internal control.
(d) Management’s philosophy and operating style. Management’s philosophy and operating style encompass a broad range of characteristics. For example, management’s attitudes and actions toward financial reporting may manifest themselves through conservative or aggressive selection from available alternative accounting principles, or conscientiousness and conservatism with which accounting estimates are developed.
(e) Organisational structure. Establishing a relevant organisational structure includes considering key areas of authority and responsibility and appropriate lines of reporting. The appropriateness of an entity’s organisational structure depends, in part, on its size and the nature of its activities.
(f) Assignment of authority and responsibility. The assignment of authority and responsibility may include policies relating to appropriate business practices, knowledge and experience of key personnel, and resources provided for carrying out duties. In addition, it may include policies and communications directed at ensuring that all personnel understand the entity’s objectives, know how their individual actions interrelate and contribute to those objectives, and recognise how and for what they will be held accountable.
(g) Human resource policies and practices. Human resource policies and practices often demonstrate important matters in relation to the control consciousness of an entity. For example, standards for recruiting the most qualified individuals – with emphasis on educational background, prior work experience, past accomplishments, and evidence of integrity and ethical behaviour – demonstrate an entity’s commitment to competent and trustworthy people. Training policies that communicate prospective roles and responsibilities and include practices such as training schools and seminars illustrate expected levels of performance and behaviour. Promotions driven by periodic performance appraisals demonstrate the entity’s commitment to the advancement of qualified personnel to higher levels of responsibility.
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:
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:
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.
9. Generally, control activities that may be relevant to an audit may be categorised as policies and procedures that pertain to the following:
○ The physical security of assets, including adequate safeguards such as secured facilities over access to assets and records.
○ The authorisation for access to computer programs and data files.
○ 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).
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.
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.
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.
(Ref: Para. A33 and A115)
The following are examples of conditions and events that may indicate the existence of risks of material misstatement. The examples provided cover a broad range of conditions and events; however, not all conditions and events are relevant to every audit engagement and the list of examples is not necessarily complete.
[1] See ASA 610 Using the Work of Internal Auditors, paragraph 7(a).
[1] See ASA 230 Audit Documentation, paragraphs 8-11 and paragraph A6.
[2] See ASA 320 Materiality in Planning and Performing an Audit.
[3] See ASA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of a Financial Report, paragraphs 12-24.
[4] See ASA 240, paragraph 15.
[5] See ASA 220 Quality Control for an Audit of a Financial Report and Other Historical Financial Information, paragraph 14.
[6] See ASA 250 Consideration of Laws and Regulations in the Audit of a Financial Report, paragraph 12.
[7] See ASA 550 Related Parties.
[8] See ASA 550, paragraph A7.
[9] See ASA 330 The Auditor’s Responses to Assessed Risks.
[10] See ASA 330, paragraphs A2-A3.
[11] See ASA 705 Modifications to the Opinion in the Independent Auditor’s Report.
[12] See ASA 330, paragraphs 15 and 21.
[13] See ASA 240, paragraphs 25-27.
[14] See ASA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management, paragraph A7.
[15] See ASA 330, paragraph 8.
[16] See ASA 300 Planning an Audit of a Financial Report, paragraphs 7 and 9.
[17] See ASA 330, paragraph 28.