How does the auditor obtains an understanding of the client and its environment?

Risk Assessment Procedures

To obtain the understanding of the entity and its environment, auditors perform risk assessment procedures, which include:

These risk assessment procedures are supplemented by further audit procedures in the form of tests of controls and substantive procedures to obtain sufficient audit evidence to express an opinion on the financial statements.

Information on the Client's Business and Its Environment

When should a health club recognize its revenue from the sale of lifetime memberships? Is a company organized to produce a single motion picture a going concern? What basis should be used to record a barter of goods over the Internet?An international network of independently owned computers that operates as a giant computing network. Data on the Internet are stored on “Web servers,” which are computers scattered throughout the world. What is a reasonable depreciable life for today's most advanced information systems? We will not attempt to answer these questions in this textbook; we raise them simply to demonstrate that the auditors must obtain a good working knowledge of an audit client's business and its environment if they are to design effective audit procedures. An understanding of the client and its environment encompasses:

   Performing procedures to obtain an understanding of the entity and its environment is an essential part of planning and performing an audit. Specifically, the understanding establishes a frame of reference for the auditors to use in (1) considering the appropriateness of the accounting policies applied by the client, (2) identifying areas where special audit consideration may be necessary (specialized risks), (3) establishing appropriate materiality, (4) developing expectations for analytical procedures, (5) designing and performing audit procedures, and (6) evaluating audit evidence.

The Nature of the Client

What is the client's business model? Who are its major customers and suppliers? What types of transactions does the client engage in? How are they accounted for? These are the types of questions that the auditors attempt to answer to obtain an understanding of the nature of the client. The auditors' understanding of the nature of the client will include the client's competitive position, organizational structure, governance processes, accounting policies and procedures, ownership, capital structure, and product lines. Then the auditors turn their attention to the client's critical business processes and obtain an understanding of how these processes create value for the client's customers. Using a manufacturing company as an example, the auditors will obtain an understanding of:

Industry, Regulatory, and Other External Factors

The factors envisioned here include industry conditions, such as the competitive environment, supplier and customer relationships, and technological developments. They also include the regulatory, legal, and political environment and general economic conditions. These factors may subject the client to specialized risks that may in turn affect the audit. Many firms—including the Big 4 firms to varying degrees—have adopted a financial model to evaluate the client's industry that considers the attractiveness and other characteristics of the industry. Concerning the overall attractiveness of the industry, auditors consider such factors as:

The other characteristics of the client's industry that auditors consider include factors such as economic conditions and financial trends, governmental regulations, changes in technology, and widely used accounting methods.

Objectives and Strategies and Related Business Risks

The client's objectives are the overall plans of the entity as defined by management. Management attempts to achieve these objectives by developing strategies, or operational actions. However, achieving management's objectives is always subject to business risks. As described in the previous section, these are the conditions that threaten management's ability to execute strategies and achieve objectives. The auditors obtain an understanding of the client's operating and financing strategies and attempt to identify significant business risks faced by the client. Significant risks that may be identified for a particular client might include risks related to competition, changes in government regulations, changes in technology, volatility of raw materials prices, interruption of supplies of critical raw materials, changes in major markets, or increases in interest rates. In obtaining their understanding of these matters, the auditors are particularly interested in management's risk assessment process. Well-operated companies use formal processes for identifying business risks and devising ways to mitigate them. An understanding of this process can assist the auditors in identifying significant business risks and evaluating their audit significance. Many of these business risks may create risks of material misstatement of the financial statements.

Methods of Measuring and Reviewing Performance

Management may use a variety of techniques to measure and review performance, such as budgets, key performance indicators, variance analysis, and segment performance reports. Many firms have developed a balanced scorecard that uses a combination of financial and nonfinancial performance measures to assess the financial, customer, internal business process, and learning and growth perspectives of the organization. These measurement systems assist management in gauging progress toward meeting its objectives. External parties also may measure and review the client's performance. Examples include bond rating agencies, credit agencies, and financial analysts. The methods of measuring and reviewing performance are important to the auditors in determining the incentives of management and other employees because their compensation is often tied to the measures. These incentives may create pressure on management or employees to misstate the financial statements or otherwise engage in fraud. In addition, the auditors may use these measures in designing analytical procedures to provide evidence about the fairness of the financial statements.

Internal Control

Internal control is designed to provide reasonable assurance of achieving objectives related to reliable financial reporting, efficiency and effectiveness of operations, and compliance with applicable laws and regulations. The nature and extent of the audit work to be performed on a particular engagement depend largely upon the effectiveness of the client's internal control in preventing or detecting material misstatements in the financial statements. Before auditors can evaluate the effectiveness of internal control, they need a knowledge and understanding of how it works: what controls exist and who performs them, how various types of transactions are processed and recorded, and what accounting records and supporting documentation exist. The auditors must have a sufficient under-standing of the design and implementation of internal control to plan the audit. Chapter 7 focuses on the auditors' consideration of internal control.

Sources of Information

Much information about the nature of the client may be obtained through inquiries of management and other personnel. For example, the auditors may use inquiry to determine the major types of sales transactions and the nature of the client's customers. The auditors may combine inquiry and inspection to determine the content of sales contracts and the accounting policies used for recognizing revenues under the contracts. They also make inquiries of other personnel within the organization. As an example, production personnel can provide the auditors with a more detailed understanding of production processes. In addition, informal discussions between the auditors and key officers of the client can provide information about the history, size, operations, accounting records, and internal control of the enterprise. Finally, the auditors may make numerous inquiries to identify and assess fraud risks as described later in this chapter.

   Many other sources of information on clients are available to the auditors. AICPA Audit and Accounting Guides and Industry Risk Alerts, trade publications, and governmental agency publications are useful in obtaining an orientation to the client's industry. Previous audit reports, annual reports to stockholders, SEC filings, and prior years' tax returns are excellent sources of financial background information.

Electronic Research

A number of computerized research tools are available to allow the auditors to efficiently obtain information for use in their audits. Some examples include:

Tour of Plant and Offices

Another useful preliminary step for the auditors is to arrange an inspection tour of the plant and offices of a prospective client. This tour will give the auditors some understanding of the plant layout, manufacturing process, principal products, and physical safeguards surrounding inventories. During the tour, the auditors should be alert for signs of potential problems. Rust on equipment may indicate that plant assets have been idle; excessive dust on raw materials or finished goods may indicate a problem of obsolescence. A knowledge of the physical facilities will assist the auditors in planning how many audit staff members will be needed to participate in observing the physical inventory.

   The tour affords the auditors an opportunity to observe firsthand what types of information technology and internal documentation are used to record such activities as receiving raw materials, transferring materials into production, and shipping finished goods to customers. An understanding of these computer applications and documentation is essential to the auditors' consideration of internal control. Inquiries of personnel in various departments may provide the auditors with critical information about the client's operations and may serve to confirm information obtained from financial management.

   In visiting the offices, the auditors will learn the location of various facilities and accounting records. The auditors can ascertain the practical extent of segregation of duties within the client organization by observing the number of office employees. In addition, the tour will afford an opportunity to meet the key personnel whose names appear on the organization chart. The auditors will record the background information about the client in a permanent file available for reference in future engagements.

Analytical Procedures

As described in Chapter 5, analytical proceduresTests that involve comparisons of financial data for the current year to that of prior years, budgets, nonfinancial data, or industry averages. From a planning standpoint, analytical procedures help the auditors obtain an understanding of the client’s business, identify financial statement amounts that appear to be aff ected by errors or fraud, or identify other potential problems. involve comparisons of financial statement balances and ratios for the period under audit with auditor expectations developed from sources such as the client's prior years' financial statements, published industry statistics, and budgets. When used for risk assessment purposes, analytical procedures assist the auditors in planning the nature, timing, and extent of audit procedures that will be used for the specific accounts. The approach used is one of obtaining an understanding of the client's business and transactions and identifying areas that may represent higher risks. The auditors will then plan a more thorough investigation of these potential problem areas. Auditors perform analytical procedures as a part of the risk assessment process for every audit.

   An example of the use of an analytical procedure for risk assessment purposes is the comparison of the client's inventory turnover for the current year with comparable statistics from prior years. A significant decrease in inventory turnover might lead the auditors to consider the possibility that the client has excessive amounts of inventory. As a result, the auditors would plan more extensive procedures to search for inventory items that may be obsolete.

The Statement of Cash Flow and Obtaining an Understanding of the Client

The auditors may use the statement of cash flows to analyze cash flows while obtaining an understanding of the client, particularly as a part of risk assessment analytical procedures. For a profitable, growing company, one ordinarily expects positive operating cash flows, perhaps slightly higher than net income due to the addition of depreciation and amortization items back to income. Cash flows from investing are often negative for such a company as it makes capital expenditures and investments. The direction of cash flows from financing is expected to vary among years depending upon issuance and redemption of stock and debt.

   Continuing with the example of a profitable, growing company, when the auditors find that cash from operations is significantly less than net income, investigation of the reason or reasons is appropriate. Possible reasons include large increases in current assets (e.g., accounts receivable and inventory) and decreases in liabilities (e.g., accounts payable), and recognition of large amounts of revenues for which no cash has been received. While such conditions may or may not indicate a misstatement, they are worthy of follow-up and explanation.

Determining Materiality

The concept of materiality recognizes that some matters are important to the fair presentation of financial statements, while others are not. The materiality concept is basic to the audit, because the audit report states that an audit is performed to obtain reasonable assurance about whether the financial statements are free of material misstatement.

   Materiality judgments depend both upon the financial reporting framework being used and on the auditors' professional judgment. U.S. generally accepted accounting principles refer to FASB Statement of Financial Accounting Concepts No. 2, “Qualitative Characteristics of Accounting Information,” which defines materiality as

Alternatively, PCAOB Auditing Standard No. 11, “Consideration of Materiality in Planning and Performing an Audit,” points out that in interpreting the federal securities laws the Supreme Court of the United States has held that a fact is material if there is:

   Although one may question whether these two descriptions differ significantly from one another, it is important to realize that they both involve a consideration of quantitative and qualitative factors—particularly when evaluating a misstatement that has been identified. Under certain circumstances, a misstatement that would ordinarily be considered immaterial in quantitative terms may be material because of its nature. As an example, an illegal payment of an otherwise immaterial amount could be material if there is a reasonable possibility that it could lead to a material contingent liability or a material loss of revenue.

   Auditors consider materiality both in planning the audit and in evaluating audit findings. In planning the audit, auditors use materiality in determining the proper scope of audit procedures. The audit must be planned to obtain reasonable assurance of detecting material misstatements of the financial statements. In evaluating audit findings, the auditors use materiality to evaluate whether actual or likely misstatements that have been found are material to the financial statements. This is a critical decision because a material misstatement should result in audit opinion modification, while an immaterial misstatement should not. Because this chapter emphasizes planning, we will emphasize the planning concept of materiality, but we also will provide a brief discussion of materiality for evaluation purposes. Materiality for evaluation purposes is also addressed in Chapter 16.

Planning Materiality

The auditors' purpose in considering materiality at the planning stage of the audit is to determine the appropriate scope of their audit procedures. Audit procedures should be designed to detect material misstatements, so that the auditors do not waste time searching for immaterial misstatements that cannot affect the auditors' report. As described in Chapter 5, the scope of the auditors' procedures for an account is directly related to the risk of material misstatement of that account. The auditors will perform extensive procedures on an account with a high risk of material misstatement. No audit procedures will be performed on an account that is quantitatively immaterial unless, based on qualitative considerations, the account is significant. For example, an Accounts Receivable from Officers account might be considered material regardless of its size.

   While planning the audit, the auditors also may become aware of a number of accounting expediencies followed by the client that may result in immaterial misstatements. The concept of materiality often allows auditors to “pass over” certain conceptual accounting errors, such as charging low-cost items like small tools or business machines directly to expense accounts. But even in these situations, the auditors need to carefully consider the possibility that the effect of such accounting expediencies may differ materially from results obtained following generally accepted accounting principles. Accounting expediencies are not acceptable simply because the client's management says the amounts involved are immaterial or because the amounts involved were considered immaterial in the past.

Quantifying Planning Materiality at the Overall Financial Statement Level  Auditing standards require that auditors determine materiality levels for the overall financial statements. As an example, the auditors may conclude that a $100,000 misstatement of net income before taxes is material for purposes of the income statement, and $200,000 for the balance sheet. Many possible misstatements affect both the balance sheet and the income statement; for example, an overstatement of ending inventory both overstates assets on the balance sheet and net income on the income statement. Because of such possible misstatements, the auditors will design their audit to detect the smallest misstatement that would be material to any one of the financial statements, in this case $100,000.

   Auditors may use rules of thumb related to a financial statement base, such as net income, total revenues, or total assets, to develop these estimates of overall materiality. Rules of thumb that are commonly used in practice include:

   The appropriate financial statement base for computing materiality will vary based on the nature of the client's business. For example, total revenues for a financial institution are often too small to use as the base in conjunction with the percentages presented above. In addition, if a company is in a near break-even position, net income for the year will be much too small to be used as the financial statement base. In that situation, the auditors will often choose another financial statement base or use an average of net income over a number of prior years.

   Auditors often use a “sliding scale” for calculating overall materiality. For example, they might use 1 percent of total sales for materiality on the audit of a small business and ½ percent of total sales on the audit of a large corporation. This is because the absolute amount of materiality is also important. Consider a small business with $2,000,000 in revenue. If ½ percent of total revenue was used as a rule of thumb, $10,000 would be calculated as overall materiality. However, it is unlikely that $10,000 would affect a user's decision about the financial position and results of operations of any such company. In addition, it would be impractical to audit the company to that level of precision.

Allocating Overall Materiality to Individual Accounts  Once the auditors have determined planning materiality for the overall financial statements, they may allocate materiality to individual financial statement accounts. Such an allocation is most frequently made to help establish the scope of substantive procedures when audit sampling is being used for one or more accounts. When materiality is allocated to a particular account, Statements on Auditing Standards and the International Auditing Standards refer to this amount as performance materialityThe amount set by the auditors at less than materiality for accounts (or individual financial statements) to reduce to an appropriately low level the probability that the for the account. At the individual audit test level, the amount may be further adjusted to arrive at tolerable misstatement. For example, assume that auditors are using statistical sampling for several tests relating to the accounts receivable account. Also assume that planning materiality is set at $1,000,000 for the overall financial statements. To facilitate audit testing, the auditors may decide that $750,000 is the appropriate amount for performance materiality for accounts receivable, and $600,000 is the appropriate amount for tolerable misstatement for the individual tests of accounts receivable.1

One of the Big 4 CPA firms developed the following table to assist its audit staff in determining planning materiality based on the greater of total assets or total sales.

To illustrate application of the table, assume that a company has $12,670,000 of total assets and $20,520,000 of total revenue. Planning materiality would be calculated as described below:

$85,500 + .00460 ($20,520,000 – $10,000,000) = $133,892

   When considering the allocation of materiality to individual accounts, it is important to understand that simply allocating planning materiality to all accounts dollar for dollar, so that the total amount of all the performance materiality or tolerable misstatement disaggregation is equal to overall planning materiality, is far too conservative. The reason is that misstatements of various accounts often counterbalance each other. That is, the overstatement of one asset may be offset by the understatement of another. Another reason that materiality should not be allocated dollar for dollar is the double-entry bookkeeping system, which allows detection of misstatements in an account by auditing a related account. For example, if at year-end a purchase of inventory on credit is recorded at an improper amount, the misstatement may be detected by the tests of inventories, accounts payable, or cost of goods sold.

   A number of techniques are used to allocate materiality to individual accounts in practice—we will describe two. In using the first technique, the auditors multiply the amount of overall planning materiality by some factor, usually from 1.5 to 2. This amount is then allocated to the various balance sheet accounts.

   The second technique involves allocating materiality only to those accounts that are to be tested with audit sampling. In using this approach, the auditors typically determine performance materiality by reducing overall planning materiality by an estimate of the aggregate amount of misstatement that will go undetected. Some amount of undetected misstatement is expected in every audit because the auditors design their tests to detect only material misstatement—smaller amounts often go undetected. Finally, the auditors determine tolerable misstatement for the particular audit test based on the amount of performance materiality for the account. Tolerable misstatement may be the same amount or lower than performance materiality for the account depending on the audit sampling technique being used. Chapter 9 illustrates how tolerable misstatement is used in conjunction with substantive procedures using various audit sampling techniques.

Evaluation Materiality

As indicated previously, the use of evaluation materiality typically involves circumstances in which one or more misstatements have been identified and the auditors must evaluate whether the amounts involved are material. The auditors' approach is to first consider whether the misstatements identified are quantitatively material. Here the auditors must consider not only the known amount of misstatement but also any likely or projected misstatement. As an example, if the auditors test 10 percent of a population and find a $10,000 misstatement, they would estimate that the entire population is misstated by about $100,000 ($10,000 ÷ 10%).2 Rules-of-thumb materiality amounts applied for planning purposes are often used in this quantitative analysis. If the auditors believe that the estimated amount of misstatement is not quantitatively material, they must still consider whether qualitative factors make the item material.

Qualitative Considerations of Materiality  Qualitative factors are particularly significant to evaluation materiality. As an example, related party transactions of relatively small amounts might be considered material to the company's financial statements. Examples of other factors that may make an item qualitatively material include the following:

Evaluation materiality and the overall process of evaluating audit procedures are described in greater detail in Chapter 16.

Why it is important for auditors to understand a client's control environment?

How understanding the entity and its environment helps auditor in risk assessment?