SA 315 Risks of Misstatement
SA 315*
Identifying and Assessing the
Risks of Material Misstatement Through
Understanding the Entity and its
Environment
(Effective for audits of financial statementsfor periods
beginning on or after April 1, 2008)
Contents
Paragraph(s)
Introduction
Scope of this SA......................................................................................... 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-A22
The Required Understanding of the Entity and its Environment,
Including the Entity’s Internal Control ......................................... A23-A116
Identifying and Assessing the Risks of Material
Misstatement.. ............................................................................ A117-A142
Documentation .......................................................................... A143-A146
* Published in February, 2008 issue of the Journal.
Handbook of Auditing Pronouncements-I.A
Material Modifications to ISA 315, “Identifying and Assessing the Risks of
Material Misstatement Through Understanding the Entity and Its
Environment”
Appendices:
1. Internal Control Components
2. Conditions and Events that May Indicate Risks of Material
Misstatement
Standard on Auditing (SA) 315, “Identifying and Assessing the Risks of
Material Misstatement Through Understanding the Entity and Its
Environment” should be read in the context of the “Preface to the
Standards on Quality Control, Auditing, Review, Other Assurance and
Related Services”, which sets out the authority of SAs and SA 200,
“Overall Objectives of the Independent Auditor and the Conduct of an
Audit in Accordance with Standards on Auditing”.
SA 315 2
Introduction
Scope of this SA
1. This Standard on Auditing (SA) deals with the auditor’s responsibility to
identify and assess the risks of material misstatement in the financial statements,
through understanding the entity and its environment, including the entity’s
internal control.
Effective Date
2. This SA is effective for audits of financial statements for periods beginning
on or after April 1, 2008.
Objective
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 statement 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. This will
help the auditor to reduce the risk of material misstatement to an acceptably low
level.
Definitions
4. For purposes of the SAs, the following terms have the meanings attributed
below:
(a) Assertions – Representations by management, explicit or otherwise, that
are embodied in the financial statements, as used by the auditor to
consider the different types of potential misstatements that may occur.
(b) Business risk – 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 – 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, safeguarding of assets, 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 – The audit procedures performed to obtain
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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 statement and assertion
levels.
(e) Significant risk – An identified and assessed risk of material misstatement
that, in the auditor’s judgment, requires special audit consideration.
Requirements
Risk Assessment Procedures and Related Activities
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 statement 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) Inquiries of management, of appropriate individuals within the internal audit
function (if the function exists), and of others within the entity who in the
auditor’s judgment may have information that is likely to assist in identifying
risks of material misstatement due to fraud or error. (Ref: Para. A6-A12)
(b) Analytical procedures. (Ref: Para. A13-A16)
(c) Observation and inspection. (Ref: Para. A17)
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. Where 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. When 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. A18-A19)
10. The engagement partner and other key engagement team members shall
discuss the susceptibility of the entity’s financial statements 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. A20-A22)
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The Required Understanding of the Entity and its Environment,
Including the Entity’s Internal Control
The Entity and Its Environment
11. The auditor shall obtain an understanding of the following:
(a) Relevant industry, regulatory, and other external factors including the
applicable financial reporting framework. (Ref: Para. A23-A28)
(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 statements. (Ref: Para.
A29-A33)
(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. A34)
(d) The entity’s objectives and strategies, and those related business risks that
may result in risks of material misstatement. (Ref: Para. A35-A41)
(e) The measurement and review of the entity’s financial performance. (Ref:
Para. A42-A47)
The Entity’s Internal Control
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 judgment whether a control,
individually or in combination with others, is relevant to the audit. (Ref: Para.
A48-A71)
Nature and Extent of the Understanding of Relevant Controls
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 inquiry of
the entity’s personnel. (Ref: Para. A72-A74)
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Components of Internal Control
Control environment
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 behavior; 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 deficiencies in the
control environment. (Ref: Para. A75-A85)
The entity’s risk assessment process
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. A86)
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. Where 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 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. A87)
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The information system, including the related business processes, relevant to
financial reporting, and communication
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 statements;
(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 statements;
(c) The related accounting records, supporting information and specific
accounts in the financial statements 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 statements;
(e) The financial reporting process used to prepare the entity’s financial
statements, including significant accounting estimates and disclosures;
(f) Controls surrounding journal entries, including non-standard journal entries
used to record non-recurring, unusual transactions or adjustments. (Ref:
Para. A88-A92)
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:
(a) Communications between management and those charged with
governance; and
(b) External communications, such as those with regulatory authorities. (Ref:
Para. A93-A94)
Control activities relevant to the audit
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 requires an
understanding of only those control activities related to significant class of
transactions, account balance, and disclosure in the financial statements and the
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assertions which the auditor finds relevant in his risk assessment process. (Ref:
Para. A95-A101)
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. A102-A104)
Monitoring of controls
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 deficiencies in its controls. (Ref: Para. A105-A107)
23. If the entity has an internal audit function,1 the auditor shall obtain an
understanding of the nature of the internal audit function’s responsibilities, its
organisational status, and the activities performed, or to be performed. (Ref:
Para. A108-A115)
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.
A116)
Identifying and Assessing the Risks of Material Misstatement
25. The auditor shall identify and assess the risks of material misstatement at:
(a) the financial statement level; and (Ref: Para. A117-A120)
(b) the assertion level for classes of transactions, account balances, and
disclosures; (Ref: Para. A121-A125)
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 statements; (Ref: Para. A126-A127)
(b) Assess the identified risks, and evaluate whether they relate more
pervasively to the financial statements as a whole and potentially affect
many assertions;
(c) Relate the identified risks to what can go wrong at the assertion level,
1 SA 610(Revised), “Using the Work of Internal Auditors”, paragraph 14(a).
SA 315 8
taking account of relevant controls that the auditor intends to test; and (Ref:
Para. A128-A130)
(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.
Risks that Require Special Audit Consideration
27. As part of the risk assessment as described in paragraph 25, the auditor
shall determine whether any of the risks identified are, in the auditor’s judgment,
a significant risk. In exercising this judgment, the auditor shall exclude the effects
of identified controls related to the risk.
28. In exercising judgment 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 like changes in regulatory environment, etc., 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. A131-A135)
29. When 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. A136-A138)
Risks for Which Substantive Procedures Alone Do Not Provide Sufficient
Appropriate Audit Evidence
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. A139-A141)
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Revision of Risk Assessment
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. A142)
Documentation
32. The auditor shall document:
(a) The discussion among the engagement team where required by paragraph
10, 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 and of each of the
internal control components specified in paragraphs 14-24; 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
statement level and at the assertion level as required by paragraph 25; 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. (Ref: Para. A143-A146)
***
Application and Other Explanatory Material
Risk Assessment Procedures and Related Activities (Ref: Para. 5)
A1. Obtaining an understanding of the entity and its environment, including the
entity’s internal control (referred to hereafter as an “understanding of the entity”),
is a continuous, dynamic process of gathering, updating and analysing
information throughout the audit. The understanding establishes a frame of
reference within which the auditor plans the audit and exercises professional
judgment throughout the audit, for example, when:
Assessing risks of material misstatement of the financial statements;
2
Determining materiality in accordance with SA 320 ;
2 SA 320, “Materiality in Planning and Performing an Audit”.
SA 315 10
Considering the appropriateness of the selection and application of
accounting policies, and the adequacy of financial statement disclosures;
Identifying areas where special audit consideration may be necessary, for
example, related party transactions, the appropriateness of management’s
use of the going concern assumption, or considering the business purpose
of transactions;
Developing expectations for use when performing analytical procedures;
Responding to the assessed risks of material misstatement, including
designing and performing further audit procedures to obtain sufficient
appropriate audit evidence; and
Evaluating the sufficiency and appropriateness of audit evidence obtained,
such as the appropriateness of assumptions and of management’s oral and
written representations.
A2. Information obtained by performing risk assessment procedures and related
activities may be used by the auditor as audit evidence to support assessments
of the risks of material misstatement. In addition, the auditor may obtain audit
evidence about classes of transactions, account balances, or disclosures and
related assertions and about the operating effectiveness of controls, even though
such procedures were not specifically planned as substantive procedures or as
tests of controls. The auditor also may choose to perform substantive procedures
or tests of controls concurrently with risk assessment procedures because it is
efficient to do so.
A3. The auditor uses professional judgment to determine the extent of the
understanding required. The auditor’s primary consideration is whether the
understanding that has been obtained is sufficient to meet the objective stated in
this SA. The depth of the overall understanding that is required by the auditor is
less than that possessed by management in managing the entity.
A4. The risks to be assessed include both those due to error and those due to
fraud, and both are covered by this SA. However, the significance of fraud is
such that further requirements and guidance are included in SA 2403, in relation
to risk assessment procedures and related activities to obtain information that is
used to identify the risks of material misstatement due to fraud.
A5. Although the auditor is required to perform all the risk assessment
procedures described in paragraph 6 in the course of obtaining the required
understanding of the entity (see paragraphs 11-24), the auditor is not required to
perform all of them for each aspect of that understanding. Other procedures may
3 SA 240, “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements”,
paragraphs 12-24.
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be performed where the information to be obtained therefrom may be helpful in
identifying risks of material misstatement. Examples of such procedures include:
Reviewing information obtained from external sources such as trade and
economic journals; reports by analysts, banks, or rating agencies; or
regulatory or financial publications.
Making inquiries of the entity’s external legal counsel or of valuation experts
that the entity has used.
Inquiries of Management, the Internal Audit Function and Others Within the
Entity (Ref: Para. 6(a))
A6. Much of the information obtained by the auditor’s inquiries is obtained
from management and those responsible for financial reporting. Information may
also be obtained by the auditor through inquiries with the internal audit function, if
the entity has such a function, and others within the entity.
A7. The auditor may also obtain information, or a different perspective in
identifying risks of material misstatement, through inquiries of others within the
entity and other employees with different levels of authority. For example:
Inquiries directed towards those charged with governance may help the
auditor understand the environment in which the financial statements are
prepared.
Inquiries of employees involved in initiating, processing or recording
complex or unusual transactions may help the auditor to evaluate the
appropriateness of the selection and application of certain accounting
policies.
Inquiries directed toward in-house legal counsel may provide information
about such matters as litigation, compliance with laws and regulations,
knowledge of fraud or suspected fraud affecting the entity, warranties, post-
sales obligations, arrangements (such as joint ventures) with business
partners and the meaning of contract terms.
Inquiries directed towards marketing or sales personnel may provide
information about changes in the entity’s marketing strategies, sales trends,
or contractual arrangements with its customers.
Inquiries of the Internal Audit Function
A8. If an entity has an internal audit function, inquiries of the appropriate
individuals within the function may provide information that is useful to the auditor
in obtaining an understanding of the entity and its environment, and in identifying
and assessing risks of material misstatement at the financial statement and
SA 315 12
assertion levels. In performing its work, the internal audit function is likely to have
obtained insight into the entity’s operations and business risks, and may have
findings based on its work, such as identified control deficiencies or risks, that
may provide valuable input into the auditor’s understanding of the entity, the
auditor’s risk assessments or other aspects of the audit. The auditor’s inquiries
are therefore made whether or not the auditor expects to use the work of the
internal audit function to modify the nature or timing, or reduce the extent, of
audit procedures to be performed.4 Inquiries of particular relevance may be
about matters the internal audit function has raised with those charged with
governance and the outcomes of the function’s own risk assessment process.
A9. If, based on responses to the auditor’s inquiries, it appears that there are
findings that may be relevant to the entity’s financial reporting and the audit, the
auditor may consider it appropriate to read related reports of the internal audit
function. Examples of reports of the internal audit function that may be relevant
include the function’s strategy and planning documents and reports that have
been prepared for management or those charged with governance describing the
findings of the internal audit function’s examinations.
A10. In addition, in accordance with SA 240,5 if the internal audit function
provides information to the auditor regarding any actual, suspected or alleged
fraud, the auditor takes this into account in the auditor’s identification of risk of
material misstatement due to fraud.
A11. Appropriate individuals within the internal audit function with whom inquiries
are made are those who, in the auditor’s judgment, have the appropriate
knowledge, experience and authority, such as the chief internal audit executive
or, depending on the circumstances, other personnel within the function. The
auditor may also consider it appropriate to have periodic meetings with these
individuals.
Considerations specific to public sector entities (Ref: Para 6(a))
A12. Auditors of public sector entities often have additional responsibilities with
regard to internal control and compliance with applicable laws and regulations.
Inquiries of appropriate individuals in the internal audit function can assist the
auditors in identifying the risk of material non-compliance with applicable laws
and regulations and the risk of deficiencies in internal control over financial
reporting.
4 The relevant requirements are contained in SA 610(Revised).
5 SA 240, paragraph 19.
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Analytical Procedures (Ref: Para. 6(b))
A13. Analytical procedures performed as risk assessment procedures may
identify aspects of the entity of which the auditor was unaware and may assist in
assessing the risks of material misstatement in order to provide a basis for
designing and implementing responses to the assessed risks*. Analytical
procedures performed as risk assessment procedures may include both financial
and non-financial information, for example, the relationship between sales and
square footage of selling space or volume of goods sold.
A14. Analytical procedures may help identify the existence of unusual
transactions or events, and amounts, ratios, and trends that might indicate
matters that have audit implications. Unusual or unexpected relationships that
are identified may assist the auditor in identifying risks of material misstatement,
especially risks of material misstatement due to fraud.
A15. However, when such analytical procedures use data aggregated at a high
level (which may be the situation with analytical procedures performed as risk
assessment procedures), the results of those analytical procedures only provide
a broad initial indication about whether a material misstatement may exist.
Accordingly, in such cases, consideration of other information that has been
gathered when identifying the risks of material misstatement together with the
results of such analytical procedures may assist the auditor in understanding and
evaluating the results of the analytical procedures.
Considerations Specific to Smaller Entities
A16. Some smaller entities may not have interim or monthly financial information
that can be used for purposes of analytical procedures. In these circumstances,
although the auditor may be able to perform limited analytical procedures for
purposes of planning the audit or obtain some information through inquiry, the
auditor may need to plan to perform analytical procedures to identify and assess
the risks of material misstatement when an early draft of the entity’s financial
statements is available.
Observation and Inspection (Ref: Para. 6(c))
A17. Observation and inspection may support inquiries of management and
others, and may also provide information about the entity and its environment.
Examples of such audit procedures include observation or inspection of the
following:
* SA 520, “Analytical Procedures”, paragraphs A1-A3 describe the nature of analytical procedures.
SA 315 14
The entity’s operations.
Documents (such as business plans and strategies), records, and internal
control manuals.
Reports prepared by management (such as quarterly management reports
and interim financial statements) and those charged with governance (such
as minutes of board of directors’ meetings).
The entity’s premises and plant facilities.
Information Obtained in Prior Periods (Ref: Para. 9)
A18. The auditor’s previous experience with the entity and audit procedures
performed in previous audits may provide the auditor with information about such
matters as:
Past misstatements and whether they were corrected on a timely basis.
The nature of the entity and its environment, and the entity’s internal control
(including deficiencies in internal control).
Significant changes that the entity or its operations may have undergone
since the prior financial period, which may assist the auditor in gaining a
sufficient understanding of the entity to identify and assess risks of material
misstatement.
A19. The auditor is required to determine whether information obtained in prior
periods remains relevant, if the auditor intends to use that information for the
purposes of the current audit. This is because changes in the control
environment, for example, may affect the relevance of information obtained in the
prior year. To determine whether changes have occurred that may affect the
relevance of such information, the auditor may make inquiries and perform other
appropriate audit procedures, such as walk-throughs of relevant systems.
Discussion Among the Engagement Team (Ref: Para. 10)
A20. The discussion among the engagement team about the susceptibility of the
entity’s financial statements to material misstatement:
Provides an opportunity for more experienced engagement team members,
including the engagement partner, to share their insights based on their
knowledge of the entity.
Allows the engagement team members to exchange information about the
business risks to which the entity is subject and about how and where the
financial statements might be susceptible to material misstatement due to
fraud or error.
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Assists the engagement team members to gain a better understanding of
the potential for material misstatement of the financial statements in the
specific areas assigned to them, and to understand how the results of the
audit procedures that they perform may affect other aspects of the audit
including the decisions about the nature, timing, and extent of further audit
procedures.
Provides a basis upon which engagement team members communicate
and share new information obtained throughout the audit that may affect
the assessment of risks of material misstatement or the audit procedures
performed to address these risks.
SA 240 provides further requirements and guidance in relation to the discussion
among the engagement team about the risks of fraud.6
A21. It is not always necessary or practical for the discussion to include all
members in a single discussion (as, for example, in a multi-location audit), nor is
it necessary for all of the members of the engagement team to be informed of all
of the decisions reached in the discussion. The engagement partner may discuss
matters with key members of the engagement team including, if considered
appropriate, specialists and those responsible for the audits of components,
while delegating discussion with others, taking account of the extent of
communication considered necessary throughout the engagement team. A
communications plan, agreed by the engagement partner, may be useful.
Considerations Specific to Smaller Entities
A22. Many small audits are carried out entirely by the engagement partner (who
may be a sole practitioner). In such situations, it is the engagement partner who,
having personally conducted the planning of the audit, would be responsible for
considering the susceptibility of the entity’s financial statements to material
misstatement due to fraud or error.
The Required Understanding of the Entity and its Environment,
Including the Entity’s Internal Control
The Entity and its Environment
Industry, Regulatory and Other External Factors (Ref: Para. 11(a))
Industry factors
A23. Relevant industry factors include industry conditions such as the
competitive environment, supplier and customer relationships, and technological
developments. Examples of matters the auditor may consider include:
6 SA 240, paragraph 15.
SA 315 16
The market and competition, including demand, capacity, and price
competition.
Cyclical or seasonal activity.
Product technology relating to the entity’s products.
Energy supply and cost.
A24. The industry in which the entity operates may give rise to specific risks of
material misstatement arising from the nature of the business or the degree of
regulation. For example, long-term contracts may involve significant estimates of
revenues and expenses that give rise to risks of material misstatement. In such
cases, it is important that the engagement team include members with sufficient
relevant knowledge and experience7.
Regulatory factors
A25. Relevant regulatory factors include the regulatory environment. The
regulatory environment encompasses, among other matters, the applicable
financial reporting framework and the legal and political environment. Examples
of matters the auditor may consider include:
Accounting principles and industry specific practices.
Regulatory framework for a regulated industry.
Legislation and regulation that significantly affect the entity’s operations,
including direct supervisory activities.
Taxation (corporate and other).
Government policies currently affecting the conduct of the entity’s business,
such as monetary, including foreign exchange controls, fiscal, financial
incentives (for example, government aid programs), and tariffs or trade
restrictions policies.
Environmental requirements affecting the industry and the entity’s business.
A26. SA 2508, includes some specific requirements related to the legal and
regulatory framework applicable to the entity and the industry.
A27. In case of the audits of certain entities, in addition to legislation or
regulations, there may be government policy requirements and resolutions of the
legislature that affect the entity’s operations. Such elements are essential to
consider when obtaining an understanding of the entity and its environment.
7 SA 220, “Quality Control for an Audit of Financial Statements”, paragraph 14.
8 SA 250, “Consideration of Laws and Regulations in an Audit of Financial Statements”,
paragraph 10.
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Other external factors
A28. Examples of other external factors affecting the entity that the auditor may
consider include the general economic conditions, interest rates and availability
of financing, and inflation or currency revaluation.
Nature of the Entity (Ref: Para.11(b))
A29. An understanding of the nature of an entity enables the auditor to
understand such matters as:
Whether the entity has a complex structure, for example with subsidiaries
or other components in multiple locations. Complex structures often
introduce issues that may give rise to risks of material misstatement. Such
issues may include whether goodwill, joint ventures, investments, or
special-purpose entities are accounted for appropriately.
The ownership, and relations between owners and other people or entities.
This understanding assists in determining whether related party
transactions have been identified and accounted for appropriately. SA 5509,
establishes requirements and provides guidance on the auditor’s
considerations relevant to related parties.
A30. Examples of matters that the auditor may consider when obtaining an
understanding of the nature of the entity include:
Business operations – such as:
Nature of revenue sources, products or services, and markets,
including involvement in electronic commerce such as internet sales
and marketing activities.
Conduct of operations (for example, stages and methods of production,
or activities exposed to environmental risks).
Alliances, joint ventures, and outsourcing activities.
Geographic dispersion and industry segmentation.
Location of production facilities, warehouses, and offices, and location
and quantities of inventories.
Key customers and important suppliers of goods and services,
employment arrangements (including the existence of union contracts,
pension and other post employment benefits, stock option or incentive
9 SA 550, “Related Parties”. Reference may also be made to the Accounting Standard (AS) 18,
“Related Party Disclosures” for definition of related party and related party transactions.
SA 315 18
bonus arrangements, and government regulation related to
employment matters).
Research and development activities and expenditures.
Transactions with related parties.
Investments and investment activities – such as:
Planned or recently executed acquisitions or divestitures.
Investments and dispositions of securities and loans.
Capital investment activities.
Investments in non-consolidated entities, including partnerships, joint
ventures and special-purpose entities.
Financing and financing activities – such as:
Major subsidiaries and associated entities, including consolidated and
non-consolidated structures.
Debt structure and related terms, including off-balance-sheet financing
arrangements and leasing arrangements.
Beneficial owners (local, foreign, business reputation and experience)
and related parties.
Use of derivative financial instruments.
Financial reporting – such as:
Accounting principles and industry - specific practices, including
industry - specific significant categories (for example, loans and
investments for banks, or research and development for
pharmaceuticals).
Revenue recognition practices.
Accounting for fair values.
Foreign currency assets, liabilities and transactions.
Accounting for unusual or complex transactions including those in
controversial or emerging areas (for example, accounting for stock-
based compensation).
A31. Significant changes in the entity from prior periods may give rise to, or
change, risks of material misstatement.
Nature of Special-Purpose Entities
A32. A special-purpose entity (sometimes referred to as a special purpose
vehicle) is an entity that is generally established for a narrow and well-defined
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purpose, such as to effect a lease or a securitisation of financial assets, or to
carry out research and development activities. It may take the form of a
corporation, trust, partnership or unincorporated entity. The entity on behalf of
which the special-purpose entity has been created may often transfer assets to
the latter (e.g., as part of a de-recognition transaction involving financial assets),
obtain the right to use the latter’s assets, or perform services for the latter, while
other parties may provide the funding to the latter. As SA 550 indicates, in some
circumstances, a special-purpose entity may be a related party of the entity.10
A33. Financial reporting frameworks often specify detailed conditions that are
deemed to amount to control, or circumstances under which the special-purpose
entity should be considered for consolidation. The interpretation of the
requirements of such frameworks often demands a detailed knowledge of the
relevant agreements involving the special- purpose entity.
The Entity’s Selection and Application of Accounting Policies (Ref: Para.11(c))
A34. An understanding of the entity’s selection and application of accounting
policies may encompass such matters as:
The methods the entity uses to account for significant and unusual
transactions.
The effect of significant accounting policies in controversial or emerging
areas for which there is a lack of authoritative guidance or consensus.
Changes in the entity’s accounting policies.
Financial reporting standards and laws and regulations that are new to the
entity, and when and how the entity will adopt such requirements.
Objectives and Strategies and Related Business Risks (Ref. Para.11(d))
A35. The entity conducts its business in the context of industry, regulatory and
other internal and external factors. To respond to these factors, the entity’s
management or those charged with governance define objectives, which are the
overall plans for the entity. Strategies are the approaches by which management
intends to achieve its objectives. The entity’s objectives and strategies may
change over time.
A36. Business risk is broader than the risk of material misstatement of the
financial statements, though it includes the latter. Business risk may arise from
change or complexity. A failure to recognise the need for change may also give
rise to business risk. Business risk may arise, for example, from:
The development of new products or services that may fail;
10 SA 550, ‘Related Parties’, paragraph A7.
SA 315 20
A market which, even if successfully developed, is inadequate to support a
product or service; or
Flaws in a product or service that may result in liabilities and reputational
risk.
A37. An understanding of the business risks facing the entity increases the
likelihood of identifying risks of material misstatement, since most business risks
will eventually have financial consequences and, therefore, an effect on the
financial statements. However, the auditor does not have a responsibility to
identify or assess all business risks because not all business risks give rise to
risks of material misstatement.
A38. Examples of matters that the auditor may consider when obtaining an
understanding of the entity’s objectives, strategies and related business risks that
may result in a risk of material misstatement of the financial statements include:
Industry developments (a potential related business risk might be, for
example, that the entity does not have the personnel or expertise to deal
with the changes in the industry).
New products and services (a potential related business risk might be, for
example, that there is increased product liability).
Expansion of the business (a potential related business risk might be, for
example, that the demand has not been accurately estimated).
New accounting requirements (a potential related business risk might be,
for example, incomplete or improper implementation, or increased costs).
Regulatory requirements (a potential related business risk might be, for
example, that there is increased legal exposure).
Current and prospective financing requirements (a potential related
business risk might be, for example, the loss of financing due to the entity’s
inability to meet requirements).
Use of IT (a potential related business risk might be, for example, that
systems and processes are incompatible).
The effects of implementing a strategy, particularly any effects that will lead
to new accounting requirements (a potential related business risk might be,
for example, incomplete or improper implementation).
A39. A business risk may have an immediate consequence for the risk of
material misstatement for classes of transactions, account balances, and
disclosures at the assertion level or the financial statement level. For example,
the business risk arising from a contracting customer base may increase the risk
of material misstatement associated with the valuation of receivables. However,
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the same risk, particularly in combination with a contracting economy, may also
have a longer-term consequence, which the auditor considers when assessing
the appropriateness of the going concern assumption. Whether a business risk
may result in a risk of material misstatement is, therefore, considered in light of
the entity’s circumstances. Examples of conditions and events that may indicate
risks of material misstatement are indicated in the Appendix 2.
A40. Usually, management identifies business risks and develops approaches to
address them. Such a risk assessment process is part of internal control and is
discussed in paragraph 15 and paragraphs A86-A87.
A41. In case of audits of certain entities, “management objectives” may be
influenced by concerns regarding public accountability and may include
objectives which have their source in legislation, regulations, and government
directions.
Measurement and Review of the Entity’s Financial Performance (Ref: Para.
11(e))
A42. Management and others will measure and review those things they regard
as important. Performance measures, whether external or internal, create
pressures on the entity. These pressures, in turn, may motivate management to
take action to improve the business performance or to misstate the financial
statements. Accordingly, an understanding of the entity’s performance measures
assists the auditor in considering whether pressures to achieve performance
targets may result in management actions that increase the risks of material
misstatement, including those due to fraud – See SA 240 for requirements and
guidance in relation to the risks of fraud.
A43. The measurement and review of financial performance is not the same as
the monitoring of controls (discussed as a component of internal control in
paragraphs A105-A116), though their purposes may overlap:
The measurement and review of performance is directed at whether
business performance is meeting the objectives set by management (or
third parties).
Monitoring of controls is specifically concerned with the effective operation
of internal control.
In some cases, however, performance indicators also provide information that
enables management to identify deficiencies in internal control.
A44. Examples of internally-generated information used by management for
measuring and reviewing financial performance, and which the auditor may
consider, include:
SA 315 22
Key performance indicators (financial and non-financial) and key ratios,
trends and operating statistics.
Period-on-period financial performance analyses.
Budgets, forecasts, variance analyses, segment information and divisional,
departmental or other level performance reports.
Employee performance measures and incentive compensation policies.
Comparisons of an entity’s performance with that of competitors.
A45. External parties may also measure and review the entity’s financial
performance. For example, external information such as analysts’ reports and
credit rating agency reports may represent useful information for the auditor.
Such reports can often be obtained from the entity being audited.
A46. Internal measures may highlight unexpected results or trends requiring
management to determine their cause and take corrective action (including, in
some cases, the detection and correction of misstatements on a timely basis).
Performance measures may also indicate to the auditor that risks of
misstatement of related financial statement information do exist. For example,
performance measures may indicate that the entity has unusually rapid growth or
profitability when compared to that of other entities in the same industry. Such
information, particularly if combined with other factors such as performance-
based bonus or incentive remuneration, may indicate the potential risk of
management bias in the preparation of the financial statements.
Considerations specific to smaller entities
A47. Smaller entities often do not have processes to measure and review
financial performance. Inquiry of management may reveal that it relies on certain
key indicators for evaluating financial performance and taking appropriate action.
If such inquiry indicates an absence of performance measurement or review,
there may be an increased risk of misstatements not being detected and
corrected.
The Entity’s Internal Control (Ref: Para. 12)
A48. An understanding of internal control assists the auditor in identifying types
of potential misstatements and factors that affect the risks of material
misstatement, and in designing the nature, timing, and extent of further audit
procedures.
A49. The following application material on internal control is presented in four
sections, as follows:
General Nature and Characteristics of Internal Control.
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Controls Relevant to the Audit.
Nature and Extent of the Understanding of Relevant Controls.
Components of Internal Control.
General Nature and Characteristics of Internal Control (Ref: Para. 12)
Purpose of internal control
A50. Internal control is designed, implemented and maintained to address
identified business risks that threaten the achievement of any of the entity’s
objectives that concern:
The reliability of the entity’s financial reporting;
The effectiveness and efficiency of its operations;
Its compliance with applicable laws and regulations; and
Safeguarding of assets.
The way in which internal control is designed, implemented and maintained
varies with an entity’s size and complexity.
Considerations specific to smaller entities
A51. Smaller entities may use less structured means and simpler processes and
procedures to achieve their objectives.
Limitations of internal control
A52. Internal control, no matter how effective, can provide an entity with only
reasonable assurance about achieving the entity’s financial reporting objectives.
The likelihood of their achievement is affected by inherent limitations of internal
control. These include the realities that human judgment in decision-making can
be faulty and that breakdowns in internal control can occur because of human
error. For example, there may be an error in the design of, or in the change to, a
control. Equally, the operation of a control may not be effective, such as where
information produced for the purposes of internal control (for example, an
exception report) is not effectively used because the individual responsible for
reviewing the information does not understand its purpose or fails to take
appropriate action.
A53. Additionally, controls can be circumvented by the collusion of two or more
people or inappropriate management override of internal control. For example,
management may enter into side agreements with customers that alter the terms
and conditions of the entity’s standard sales contracts, which may result in
improper revenue recognition. Also, edit checks in a software program that are
designed to identify and report transactions that exceed specified credit limits
may be overridden or disabled.
SA 315 24
A54. Further, in designing and implementing controls, management may make
judgments on the nature and extent of the controls it chooses to implement, and
the nature and extent of the risks it chooses to assume.
Considerations specific to smaller entities
A55. Smaller entities often have fewer employees which may limit the extent to
which segregation of duties is practicable. However, in a small owner-managed
entity, the owner-manager11 may be able to exercise more effective oversight
than in a larger entity. This oversight may compensate for the generally more
limited opportunities for segregation of duties.
A56. On the other hand, the owner-manager may be more able to override
controls because the system of internal control is less structured. This is taken
into account by the auditor when identifying the risks of material misstatement
due to fraud.
Division of internal control into components
A57. The division of internal control into the following five components, for
purposes of the SAs, provides a useful framework for auditors to consider how
different aspects of an entity’s internal control may affect the audit:
(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
SA, provided all the components described in this SA are addressed.
A58. Application material relating to the five components of internal control as
they relate to a financial statement audit is set out in paragraphs A75-A116
below. Appendix 1 provides further explanation of these components of internal
control.
11 Owner-manager refers to the proprietor of an entity who is involved in running the entity on a
day-to-day basis.
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Characteristics of manual and automated elements of internal control relevant to
the auditor’s risk assessment
A59. 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.
A60. 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 financial statements, 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.
A61. 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.
SA 315 26
A62. 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.
A63. Manual elements in internal control may be more suitable where judgment
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.
A64. 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.
A65. 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
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Handbook of Auditing Pronouncements-I.A
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
A66. 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.
A67. Factors relevant to the auditor’s judgment 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.
A68. 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 procedures. For example, in
auditing revenue by applying standard prices to records of sales volume, the
auditor considers the accuracy of the price information and the completeness
and accuracy of the sales volume data. 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.
A69. 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. For
SA 315 28
example, use of access controls, such as passwords, that limit access to the
data and programs that process cash disbursements may be relevant to a
financial statement audit. Conversely, safeguarding controls relating to
operations objectives, such as controls to prevent the excessive use of materials
in production, generally are not relevant to a financial statement audit.
A70. 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.
A71. In certain circumstances, the statute or the regulation governing the entity
may require the auditor to report on compliance with certain specific aspects of
internal controls as a result, the auditor’s review of internal control may be
broader and more detailed.
Nature and Extent of the Understanding of Relevant Controls (Ref: Para. 13)
A72. 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.
A73. Risk assessment procedures to obtain audit evidence about the design and
implementation of relevant controls may include:
Inquiring of entity personnel.
Observing the application of specific controls.
Inspecting documents and reports.
Tracing transactions through the information system relevant to financial
reporting.
Inquiry alone, however, is not sufficient for such purposes.
A74. 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
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Handbook of Auditing Pronouncements-I.A
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 A61), 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 SA 330, “The Auditor’s
Responses to Assessed Risks”.
Components of Internal Control—Control Environment (Ref: Para. 14)
A75. 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
organization, influencing the control consciousness of its people.
A76. Elements of the control environment that may be relevant when obtaining
an understanding of the control environment include the following:
(a) Communication and enforcement of integrity and ethical values – These
are essential elements that influence the effectiveness of the design,
administration and monitoring of controls.
(b) Commitment to competence – Matters such as management’s
consideration of the competence levels for particular jobs and how those
levels translate into requisite skills and knowledge.
(c) Participation by those charged with governance – Attributes of those
charged with governance such as:
Their independence from management.
Their experience and stature.
The extent of their involvement and the information they receive, and
the scrutiny of activities.
The appropriateness of their actions, including the degree to which difficult
questions are raised and pursued with management, and their interaction
with internal and external auditors.
(d) Management’s philosophy and operating style – Characteristics such as
management’s:
Approach to taking and managing business risks.
Attitudes and actions toward financial reporting.
SA 315 30
Attitudes toward information processing and accounting functions and
personnel.
(e) Organisational structure – The framework within which an entity’s activities
for achieving its objectives are planned, executed, controlled, and reviewed.
(f) Assignment of authority and responsibility - Matters such as how authority
and responsibility for operating activities are assigned and how reporting
relationships and authorisation hierarchies are established.
(g) 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
A77. Relevant audit evidence may be obtained through a combination of
inquiries and other risk assessment procedures such as corroborating inquiries
through observation or inspection of documents. For example, through inquiries
of management and employees, the auditor may obtain an understanding of how
management communicates to employees its views on business practices and
ethical behavior. 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.
A78. 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
A79. 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.
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Whether they understand the entity’s business transactions.
The extent to which they evaluate whether the financial statements are
prepared in accordance with the applicable financial reporting framework.
A80. 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.
A81. 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 unauthorized transactions to be
processed. As explained in SA 330, the control environment also influences the
nature, timing, and extent of the auditor’s further procedures12.
A82. 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
A83. 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.
12 SA 330, paragraphs A2-A3.
SA 315 32
A84. 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 emphasizes the importance of integrity and
ethical behavior through oral communication and by management example.
A85. 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)
A86. 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 judgment.
Considerations specific to smaller entities (Ref: Para. 17)
A87. 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, inquiry 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)
A88. 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;
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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 statements.
Journal entries
A89. 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.
A90. 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 financial statements, 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
A91. 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.
SA 315 34
Considerations specific to smaller entities
A92. 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 inquiry than on review of documentation. The
need to obtain an understanding, however, remains important.
Communication (Ref: Para. 19)
A93. 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
A94. 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)
A95. 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:
Authorization.
Performance reviews.
Information processing.
Physical controls.
Segregation of duties.
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A96. 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 judgment of the auditor.
A97. The auditor’s judgment 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.
A98. 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.
A99. 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
A100. 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.
A101. 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)
A102. 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.
SA 315 36
A103. 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 center 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
A62 above.
A104. Application controls are manual or automated procedures that typically
operate at a business process level and apply to the processing of 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)
A105. 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.
A106. Management’s monitoring activities may 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
A107. Management’s monitoring of control is often accomplished by
management’s or the owner-manager’s close involvement in operations. This
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Handbook of Auditing Pronouncements-I.A
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)
A108. 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 inquiries
in paragraph 6(a) of this SA, may also provide information that is directly relevant
to the auditor’s identification and assessment of the risks of material
misstatement.
A109. 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 set out in an internal audit
charter or terms of reference.
A110. 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 focused 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.
A111. The auditor’s inquiries of appropriate individuals within the internal audit
function in accordance with paragraph 6(a) of this SA 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 the function.
A112. 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
SA 315 38
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.
A113. 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, SA 610 (Revised) applies.
A114. As is further discussed in SA 610 (Revised), 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.
A115. 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. SA 200 discusses the
importance of the auditor planning and performing the audit with professional
skepticism, including being alert to information that brings into question the
reliability of documents and responses to inquiries 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)
A116. 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.
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Identifying and Assessing the Risks of Material Misstatement
Assessment of Risks of Material Misstatement at the Financial Statement
Level (Ref: Para. 25 (a))
A117. Risks of material misstatement at the financial statement level refer to
risks that relate pervasively to the financial statements 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 statement level risks may be
especially relevant to the auditor’s consideration of the risks of material
misstatement arising from fraud.
A118. Risks at the financial statement level may derive in particular from
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 statements and may require an overall response by the auditor.
A119. The auditor’s understanding of internal control may raise doubts about the
auditability of an entity’s financial statements. 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 statements 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 statements.
A120. SA 705(Revised), “Modifications to the Opinion in the Independent
Auditor’s Report” establishes requirements and provides guidance in determining
whether there is a need for the auditor to consider a qualification or disclaimer of
opinion or, as may be required in some cases, to withdraw from the engagement
where this is legally possible.
Assessment of Risks of Material Misstatement at the Assertion Level (Ref:
Para. 25(b))
A121. 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
SA 315 40
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 statements as a whole and
potentially affect many assertions.
The Use of Assertions
A122. In representing that the financial statements are in accordance with the
applicable financial reporting framework, management implicitly or explicitly
makes assertions regarding the recognition, measurement, presentation and
disclosure of the various elements of financial statements and related
disclosures.
A123. 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 statements at appropriate amounts and any
resulting valuation or allocation adjustments are appropriately
recorded.
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(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 statements 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.
A124. 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.
A125. When making assertions about the financial statements of certain entities,
especially, for example, where the Government is a major stakeholder, in
addition to those assertions set out in paragraph A123, management may often
assert that transactions and events have been carried out in accordance with
legislation or proper authority. Such assertions may fall within the scope of the
financial statement audit.
Process of Identifying Risks of Material Misstatement (Ref: Para. 26(a))
A126. 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.
A127. Appendix 2 provides examples of conditions and events that may indicate
the existence of risks of material misstatement.
Relating Controls to Assertions (Ref: Para. 26(c))
A128. 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
SA 315 42
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.
A129. 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.
A130. 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)
A131. Significant risks often relate to significant non-routine transactions or
judgmental matters. Non-routine transactions are transactions that are unusual,
due to either size or nature, and that therefore occur infrequently. Judgmental
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.
A132. 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.
A133. Risks of material misstatement may be greater for significant judgmental
matters that require the development of accounting estimates, arising from
matters such as the following:
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Handbook of Auditing Pronouncements-I.A
Accounting principles for accounting estimates or revenue recognition may
be subject to differing interpretation.
Required judgment may be subjective or complex, or require assumptions
about the effects of future events, for example, judgment about fair value.
A134. SA 330 describes the consequences for further audit procedures of
identifying a risk as significant.13
Significant risks relating to the risks of material misstatement due to fraud
A135. SA 240 provides further requirements and guidance in relation to the
identification and assessment of the risks of material misstatement due to
fraud.14
Understanding Controls Related to Significant Risks (Ref: Para. 29)
A136. Although risks relating to significant non-routine or judgmental 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 judgmental 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.
A137. 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 statements.
A138. 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.15
13 SA 330, paragraphs 15 and 21.
14 SA 240, paragraph 25-27.
15 SA 265, “Communicating Deficiencies in Internal Control to Those Charged with Governance
and Management”, Paragraph A7.
SA 315 44
Risks for Which Substantive Procedures Alone Do Not Provide Sufficient
Appropriate Audit Evidence (Ref: Para. 30)
A139. Risks of material misstatement may relate directly to the recording of
routine classes of transactions or account balances, and the preparation of
reliable financial statements. 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.
A140. 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.
A141. The consequences for further audit procedures of identifying such
risks are described in SA 330.16
Revision of Risk Assessment (Ref: Para. 31)
A142. 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 SA 330 for further guidance.
Documentation (Ref: Para. 32)
A143. The manner in which the requirements of paragraph 32 are
documented is for the auditor to determine using professional judgment. For
16 SA 330, paragraph 8.
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Handbook of Auditing Pronouncements-I.A
example, in audits of small entities the documentation may be incorporated in the
auditor’s documentation of the overall strategy and audit plan that is required by
SA 300, “Planning an Audit of Financial Statements”17. 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 (see SA
330)18. 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.
A144. 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.
A145. The extent of documentation may also reflect the experience and
capabilities of the members of the audit engagement team. Provided the
requirements of SA 230, “Audit Documentation” 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.
A146. For recurring audits, certain documentation may be carried forward,
updated as necessary to reflect changes in the entity’s business or processes.
Material Modifications to ISA 315, Identifying and
Assessing the Risks of Material Misstatement Through
Understanding the Entity and Its Environment
Deletions
1. Paragraph A29 of the Application Section of ISA 315(A27 of SA 315) deals
with the application of the requirements of ISA 315 to the audits of public sector
entities regarding the effect of ministerial directives, government policy
requirements and resolutions of the legislature on the operations of the entity.
Since as mentioned in the “Preface to the Standards on Quality Control, Auditing,
Review, Other Assurance and Related Services”, the Standards issued by the
Auditing and Assurance Standards Board, apply equally to all entities,
irrespective of their form, nature and size, a specific reference to applicability of
the Standard to public sector entities has been deleted.
17 SA 300, paragraphs 7 and 9.
18 SA 330, paragraph 8.
SA 315 46
Further, it is also possible that even in case of non public sector entities, the
operation of the entity may be affected by government policy requirements and
resolutions of the legislature. Accordingly, the spirit of Paragraph A29 in ISA,
highlighting the fact that in some cases, the entity’s operations may be affected
by such requirements/resolutions, has been retained.
2. Paragraph A43 of the Application Section of ISA 315(A41 of SA 315) deals
with the application of the requirements of ISA 315 to the audits of public sector
entities regarding the influence of concerns relating to public accountability,
including objectives having source in legislation, regulations, government
ordinances, etc., on ‘management objectives’. Since as mentioned in the
“Preface to the Standards on Quality Control, Auditing, Review, Other Assurance
and Related Services”, the Standards issued by the Auditing and Assurance
Standards Board, apply equally to all entities, irrespective of their form, nature
and size, a specific reference to applicability of the Standard to public sector
entities has been deleted.
Further, it is also possible that even in case of non public sector entities, the
management’s objectives are influenced by such aspects. Accordingly, the spirit
of Paragraph A43 in ISA, highlighting the fact that in some cases, the
management objectives may be influenced by the concerns relating to public
accountability, including objectives having source in legislation, regulations,
government directions, has been retained.
3. Paragraph A73 of the Application Section of ISA 315(A71 of SA 315) deals
with the application of the requirements of ISA 315 to the audits of public sector
entities regarding the additional reporting responsibilities of the auditor with
respect to internal control because of any code of practice or compliance with
legislative authorities. Since as mentioned in the “Preface to the Standards on
Quality Control, Auditing, Review, Other Assurance and Related Services”, the
Standards issued by the Auditing and Assurance Standards Board, apply equally
to all entities, irrespective of their form, nature and size, a specific reference to
applicability of the Standard to public sector entities has been deleted.
Further, it is also possible that even in case of non public sector entities, the
statute or regulations may require the auditor to report on compliance with
certain specific aspects of internal control. Accordingly, the spirit of Paragraph
A73 in ISA 315, highlighting such additional reporting responsibilities of the
auditor, has been retained.
4. Paragraph A131 of the Application Section of ISA 315(A125 of SA 315)
deals with the application of the requirements of ISA 315 to the audits of public
sector entities regarding the relevance of management’s assertions that
transactions and events have been carried out in accordance with legislation or
proper authority, for the financial statement audit. Since as mentioned in the
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Handbook of Auditing Pronouncements-I.A
“Preface to the Standards on Quality Control, Auditing, Review, Other Assurance
and Related Services”, the Standards issued by the Auditing and Assurance
Standards Board, apply equally to all entities, irrespective of their form, nature
and size, a specific reference to applicability of the Standard to public sector
entities has been deleted.
Further, it is also possible that even in case of non public sector entities, there
may be similar assertions made by the management that may fall within the
scope of the financial statement audit. Accordingly, the spirit of Paragraph A131
in ISA 315, highlighting such fact, has been retained and an example has been
added.
SA 315 48
Appendix 1
(Ref: Paras. 4(c), 14-24 and A75-A116)
Internal Control Components
1. This appendix further explains the components of internal control, as set
out in paragraphs 4(c), 14-24 and A75-A116, as they relate to a financial
statement audit.
Control Environment
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 behavior
are the product of the entity’s ethical and behavioral 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
behavioral 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) Organizational structure. Establishing a relevant organisational structure
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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
behavior – 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 behavior. 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
financial statements 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 statements.
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 statements. 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:
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Changes in operating environment. Changes in the regulatory or operating
environment can result in changes in competitive pressures and
significantly different risks.
New personnel. New personnel may have a different focus on or
understanding of internal control.
New or revamped information systems. Significant and rapid changes in
information systems can change the risk relating to internal control.
Rapid growth. Significant and rapid expansion of operations can strain
controls and increase the risk of a breakdown in controls.
New technology. Incorporating new technologies into production processes
or information systems may change the risk associated with internal control.
New business models, products, or activities. Entering into business areas
or transactions with which an entity has little experience may introduce new
risks associated with internal control.
Corporate restructurings. Restructurings may be accompanied by staff
reductions and changes in supervision and segregation of duties that may
change the risk associated with internal control.
Expanded foreign operations. The expansion or acquisition of foreign
operations carries new and often unique risks that may affect internal
control, for example, additional or changed risks from foreign currency
transactions.
New accounting pronouncements. Adoption of new accounting principles or
changing accounting principles may affect risks in preparing financial
statements.
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:
Identify and record all valid transactions.
Describe on a timely basis the transactions in sufficient detail to permit
proper classification of transactions for financial reporting.
Measure the value of transactions in a manner that permits recording their
proper monetary value in the financial statements.
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Determine the time period in which transactions occurred to permit
recording of transactions in the proper accounting period.
Present properly the transactions and related disclosures in the financial
statements.
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:
Performance reviews. These control activities include reviews and analyses
of actual performance versus budgets, forecasts, and prior period
performance; relating different sets of data – operating or financial – to one
another, together with analyses of the relationships and investigative and
corrective actions; comparing internal data with external sources of
information; and review of functional or activity performance.
Information processing. The two broad groupings of information systems
control activities are application controls, which apply to the processing of
individual applications, and general IT-controls, which are policies and
procedures that relate to many applications and support the effective
functioning of application controls by helping to ensure the continued proper
operation of information systems. Examples of application controls include
checking the arithmetical accuracy of records, maintaining and reviewing
accounts and trial balances, automated controls such as edit checks of input
data and numerical sequence checks, and manual follow-up of exception
reports. Examples of general IT-controls are program change controls,
controls that restrict access to programs or data, controls over the
implementation of new releases of packaged software applications, and
controls over system software that restrict access to or monitor the use of
system utilities that could change financial data or records without leaving an
audit trail.
Physical controls. Controls that encompass:
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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 statement preparation, and therefore
the audit, depends on circumstances such as when assets are highly
susceptible to misappropriation.
Segregation of duties. Assigning different people the responsibilities of
authorising transactions, recording transactions, and maintaining custody of
assets. Segregation of duties is intended to reduce the opportunities to allow
any person to be in a position to both perpetrate and conceal errors or fraud
in the normal course of the person’s duties.
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 of 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
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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.
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Appendix 2
(Ref: Para. A39 and A127)
Conditions and Events that May Indicate Risks of Material
Misstatement
The following are examples of conditions and events that may indicate the
existence of risks of material misstatement. The examples provided cover a
broad range of conditions and events; however, not all conditions and events are
relevant to every audit engagement and the list of examples is not necessarily
complete.
Operations in regions that are economically unstable, for example, countries
with significant currency devaluation or highly inflationary economies.
Operations exposed to volatile markets, for example, futures trading.
Operations that are subject to a high degree of complex regulation.
Going concern and liquidity issues including loss of significant customers.
Constraints on the availability of capital and credit.
Changes in the industry in which the entity operates.
Changes in the supply chain.
Developing or offering new products or services, or moving into new lines of
business.
Expanding into new locations.
Changes in the entity such as large acquisitions or reorganisations or other
unusual events.
Entities or business segments likely to be sold.
The existence of complex alliances and joint ventures.
Use of off-balance-sheet finance, special-purpose entities, and other
complex financing arrangements.
Significant transactions with related parties.
Lack of personnel with appropriate accounting and financial reporting skills.
Changes in key personnel including departure of key executives.
Deficiencies in internal control, especially those not addressed by
management.
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Inconsistencies between the entity’s IT strategy and its business strategies.
Changes in the IT environment.
Installation of significant new IT systems related to financial reporting.
Inquiries into the entity’s operations or financial results by regulatory or
government bodies.
Past misstatements, history of errors or a significant amount of adjustments
at period end.
Significant amount of non-routine or non-systematic transactions including
intercompany transactions and large revenue transactions at period end.
Transactions that are recorded based on management’s intent, for example,
debt refinancing, assets to be sold and classification of marketable
securities.
Application of new accounting pronouncements.
Accounting measurements that involve complex processes.
Events or transactions that involve significant measurement uncertainty,
including accounting estimates.
Pending litigation and contingent liabilities, for example, sales warranties,
financial guarantees and environmental remediation.
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