One of the principles underlying auditing standards notes that the auditor obtains an understanding of the entity and its environment to provide a basis for identifying and assessing the risks of material misstatements in the financial statements. Auditors need an understanding of the client's business and industry because the nature of the business and industry affect business risk and the risk of material misstatements in the financial
statements. Auditors use the knowledge of these risks to determine the appropriate extent of further audit procedures. Show
1. Industry and External Environment - Read industry trade publications, AICPA Industry Audit Guides, and regulatory requirements. During the course of the plant tour, the CPA will obtain a perspective of the client's business, which will contribute to the auditor's understanding of the entity and its environment.
Remember that an important aspect of the audit will be an effective analysis of the inventory cost system. Therefore, the auditor will observe the nature of the company's products, the manufacturing facilities and processes, and the flow of materials so that the information obtained can later be related to the functions of the cost system. The three categories of client objectives are (1) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with laws and regulations. Each of these objectives affects the auditor's assessment of inherent risk and evidence accumulation as follows: 1. Reliability of financial reporting - The financial reporting framework selected by management may affect the reliability of financial reporting. For example, management's selection of the cash basis of accounting may affect the risks of material misstatement differently than the risks of material misstatement that might be present if management selects U.S. GAAP or IFRS as the framework for financial reporting. Furthermore, recent changes in those standards by the standards-setting bodies may impact the complexity of the underlying accounting for transactions, accounts, and disclosures, which increases inherent
risks. If management sees the reliability of financial reporting as an important objective, and if the auditor can determine that the financial reporting system is accurate and reliable, then the auditor can often reduce his or her assessment of inherent risk and planned evidence accumulation for material accounts. In contrast, if management has little regard for the reliability of management's financial reporting, the auditor must increase inherent risk assessments and gather more appropriate
evidence during the audit. Why is it essential to fully understand the clients industry business and organization?It enables us not only to tailor our work to meet the individual facts and circumstances of each client, but also to carry out that work and to evaluate our findings in an informed manner. Our knowledge of the client's business also helps us to develop and maintain a positive professional relationship with the client.
Why is it important to obtain an understanding of an entity and its business?Obtaining an understanding of the entity's performance measures assists the auditor in considering whether such pressures result in management actions that may have increased the risks of material misstatement.
Why do auditors need to be familiar with the organization business model?More specifically, the International Standards on Auditing requires that an auditor understand the company's objectives and strategies and those related business risks that might reasonably be expected to result in risks of material misstatement.
What knowledge does the auditor needs about the client's business in order to do the audit of historical financial statements?When auditing historical financial statements, an auditor must have a thorough understanding of the client and its environment. This knowledge should include the client's regulatory and operating environment, business strategies and processes, and measurement of indicators.
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