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.
The five major aspects of understanding the client's business and industry, along with potential sources of information that auditors commonly use for each of the five areas, are as follows:
1. Industry and External Environment - Read industry trade publications, AICPA Industry Audit Guides, and regulatory requirements.
2. Business Operations and Processes - Tour the plant and offices, identify related parties, and inquire of management.
3. Management and Governance - Read the corporate charter and bylaws, read minutes of board of directors and stockholders meetings, and inquire of management.
4. Client Objectives and Strategies - Inquire of management regarding their objectives for the reliability of financial reporting, effectiveness and efficiency of operations, and compliance with laws and regulations; read contracts and other legal documents, such as those for notes and
bonds payable, stock options, and pension plans
5. Measurement and Performance - Read financial statements, perform ratio analysis, and inquire of management about key performance indicators that management uses to measure progress toward its objectives.
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 nature of the company's products and the manufacturing facilities and processes will reveal the features of the cost system that will require close audit
attention. For example, the audit of a company engaged in the custom-manufacture of costly products such as yachts would require attention to the correct charging of material and labor to specific jobs, whereas the allocation of material and labor charges in the audit of a beverage-bottling plant would not be verified on the same basis. The CPA will note the stages at which finished products emerge and
where additional materials must be added. He or she will also be alert for points at which scrap is generated or spoilage occurs. The auditor may find it advisable,
after viewing the operations, to refer to auditing literature for problems encountered and solved by other CPAs in similar audits. The auditor's observation of the manufacturing processes will reveal whether there is idle plant or machinery that may require disclosure in the financial statements. Should the machinery appear to be old or poorly maintained, the CPA might expect to find heavy expenditures in the accounts for repairs and maintenance. On the other hand, if the auditor determines that the company has recently installed new equipment or constructed a new building, he or she will expect to find these new assets on the books.In studying the flow of materials, the auditor will be alert for possible problems that may arise in connection with the observation of the physical inventory, and he or she may make preliminary estimates of audit staff requirements. In this regard, the auditor will notice the various storage areas and how the materials are stored. The auditor may also keep in mind for further investigation any apparently obsolete inventory. The auditor's study of the flow of materials will disclose the points at which
various documents such as material requisitions arise. He or she will also meet some of the key manufacturing personnel who may give the auditor an insight into production problems and other matters such as excess or obsolete materials, and scrap and spoilage. The auditor will be alert for the attitude of the manufacturing personnel toward internal controls. The CPA may make some inquiries about the methods of production scheduling, timekeeping procedures, and whether work standards are employed. As a result of these observations, the internal documents
that relate to the flow of materials will be more meaningful as accounting evidence The CPA's tour of the plant will give him or her an understanding of the plant terminology that will enable the CPA to communicate fluently with the
client's personnel. The measures taken by the client to safeguard assets, such as protection of inventory from fire or theft, will be an indication of the client's attention to internal control measures. The location of the receiving and shipping
departments and the procedures in effect will bear upon the CPA's evaluation of internal control. The auditor's overall impression of the client's plant will suggest the accuracy and adequacy of the accounting records that will be audited.
three categories of client objectives are
(1) reliability of financial reporting
(2) effectiveness and efficiency of operations
(3) compliance with laws and regulations.
Each of these objectives affects the auditor's assessment
of the risk of material misstatement 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 risk of material misstatement that might be present if management selects U.S. GAAP or IFRS as the framework for financial reporting. Furthermore, 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 the risk of material misstatement 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 evidenceduring the audit.
2. Effectiveness and efficiency of operations - This area is of primary concern to most clients. Auditors need knowledge about the effectiveness and efficiency of a client's operations in order to assess client business risk and the risk of material misstatement in the financial statements. For example, if a client is experiencing inventory management problems, this would most likely increase the auditor's assessment of risk for the planned evidence accumulation
3. Compliance with laws and regulations - It is important for the auditor to understand the laws and regulations that affect an audit client, including significant contracts signed by the client. For example, the provisions in a pension plan document would significantly affect the auditor's assessment of risk and evidence accumulation in the audit of the unfunded liability for pensions. If the client were in violation of the provisions of the pension plan document, risk and planned evidence for pension-related accounts would increase.
Because materiality is relative rather than absolute, it is necessary to have benchmarks for establishing whether misstatements are material.
For example, in the audit of a manufacturing company, the auditor might use as benchmarks: net income before taxes, total assets, current assets, and working capital.
For a governmental unit, such as a school district, there is no net income before taxes, and therefore that would not be an available benchmark. Instead, the primary benchmarks would likely be fund balances, total assets, and perhaps total revenue.