Understanding the entity and environment - Obtaining initial...

Learning Outcomes

After reading this article, you will be able to describe why auditors must obtain an initial understanding of the entity and its environment, outline the required areas of understanding, and explain key risk assessment procedures including inquiry, analytical review, observation, and inspection. You will also identify relevant information sources and link understanding to audit risk assessment for ACCA FAU.

ACCA Foundations in Audit (FAU) Syllabus

For ACCA Foundations in Audit (FAU), you are required to understand how an auditor gains initial knowledge about an entity and its environment to plan an effective audit. Focus your revision on:

• The importance of obtaining an initial understanding of the entity and environment
• Required areas of auditor understanding (e.g., industry, regulation, objectives, strategies, internal controls, financial reporting framework)
• Common sources and methods: enquiry, analytical procedures, observation, inspection
• Use of understanding to identify audit risks
• Evaluating the appropriateness of the entity's accounting policies and disclosure

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which methods are commonly used by auditors to gain initial understanding of a client's business?
   1. Legal advice only
   2. Inquiry, observation, inspection, analytical procedures
   3. Filing of annual returns
   4. Confirmation with tax authorities

2. True or false? Auditors are only required to understand the client’s accounting system and do not need to consider external factors such as industry trends or regulation.

3. Name two internal and two external sources an auditor might use to obtain knowledge about an entity before beginning the audit.

4. What is the purpose of performing preliminary analytical procedures during audit planning?

Introduction

At the outset of every audit, auditors need to gather information on the entity, its environment, and the financial reporting framework used. This understanding underpins risk assessment and is essential for designing appropriate and effective audit procedures. Failure to gather this knowledge increases the risk of missing significant misstatements.

Why Auditors Must Understand the Entity and Environment

An auditor cannot plan or perform effective procedures without first understanding the client's business operations, internal and external environment, industry conditions, legal/regulatory context, objectives and strategies, and applied financial reporting framework. This understanding helps highlight where material misstatements are most likely to occur.

Key Term: Entity and Environment
All factors, both internal (e.g., operations, internal controls, governance) and external (e.g., industry, regulation, economy) that influence financial reporting and business risks.

Key Term: Financial Reporting Framework
The set of accounting standards, laws, and regulations governing the preparation and presentation of the entity's financial statements.

Areas the Auditor Must Understand

When beginning an engagement, the following areas should be considered:

• Nature of the entity, including operations, ownership structure, and governance
• Industry, regulatory, and other external factors (laws, competition, market position)
• Entity objectives, strategies, and related business risks
• Measurement and review of financial performance (key performance indicators)
• Financial reporting processes and accounting policies, including applicable framework
• Internal control systems relating to financial reporting

This broad knowledge lets auditors anticipate the likely risks of material misstatement.

Methods for Gaining Initial Understanding

Auditors employ a combination of procedures to obtain the necessary understanding. The four primary methods are:

• Inquiry: Speak to management and relevant staff about business operations, objectives, recent changes, policies, and potential risk areas.
• Observation: Watch key processes, such as inventory counts or reconciliations, to see how controls operate in practice.
• Inspection: Review of documents and records, including board minutes, contracts, organizational charts, internal reports, and prior audit files.
• Analytical procedures: Compare financial data (current, past, budgets, industry benchmarks) to spot unusual trends or variances needing further investigation.

Key Term: Analytical Procedures
Evaluations of financial and non-financial data by studying plausible relationships and identifying variances or inconsistencies.

These procedures provide a solid overview of the entity and enable the auditor to focus audit work on more likely high-risk areas.

Worked Example 1.1

A new client operates several retail locations. During initial planning, what specific actions should an auditor take to understand the entity and environment?

Answer:
The auditor should:

• Review organization charts and key policies to understand structure and reporting lines.
• Hold meetings with store managers and head office staff to discuss business processes and major risks.
• Inspect board minutes for significant decisions or changes.
• Perform analytical procedures comparing sales and expenses between locations and prior years to spot anomalies.
• Review external sources (industry reports, competitor analysis, media articles) for market trends and regulatory developments affecting the retail sector.

Typical Sources of Information

Information comes from both internal and external sources. Examples include:

Internal:

• Management and staff interviews
• Board and committee minutes
• Management accounts, forecasts, budgets, policies and procedures manuals
• Previous audit working papers

External:

• Industry publications and benchmark data
• Regulatory bulletins and government reports
• Company website and public filings
• News and trade media

The auditor evaluates the reliability of these sources before placing reliance on them.

Role of Understanding in Risk Assessment

A thorough understanding of the entity and environment lets the auditor:

• Identify areas where material misstatements are more likely
• Assess inherent and control risks
• Design audit procedures directed towards significant risks

For instance, operating in a highly regulated industry may increase risk around compliance and disclosure.

Worked Example 1.2

The auditor notes the client expanded into a new line of business this year. Why does this require further attention during initial understanding?

Answer:
Expansion into a new business line often brings unfamiliar risks, possible gaps in internal controls, and the need for new accounting policies. The auditor must ask about objectives, anticipated risks, and whether the accounting team has the required competence. Analytical procedures may show unexpected results in the new business segment.

Exam Warning

It is a common error to assume understanding is only needed for current operations. Changes in management, business activities, or external environment in the current or prior periods may introduce new audit risks and must not be overlooked.

Summary

Obtaining an initial understanding of the entity and environment is fundamental for effective audit planning. Auditors use enquiry, observation, inspection, and analytical procedures to gather relevant information about both internal and external factors. This understanding is essential for identifying significant risks, assessing controls, and determining the nature, timing, and extent of audit procedures.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the purpose and importance of obtaining initial understanding of the entity and environment
• List key areas to be understood: nature of entity, external factors, objectives, financial reporting framework
• Outline main sources and procedures: enquiry, observation, inspection, and analytical procedures
• Describe how understanding feeds into risk assessment and audit planning
• Recognize the role of analytical procedures and the need to update understanding for any changes

Key Terms and Concepts

• Entity and Environment
• Financial Reporting Framework
• Analytical Procedures