AUDITING THEORY

Understanding the Entity and Its Environment

LECTURE NOTES
Importance of Understanding the Entity and its information, or a different perspective in identifying risks
Environment including Internal Control of material misstatement, through inquiries of others
within the entity. Inquiries directed towards with others
The auditor’s understanding of the entity and its
within the entity are summarized below:
environment, including internal control (this will be
discussed next topic, ‘AT.1510B-Understanding the Entity’s Those May help the auditor understand the
Internal Control’), is the foundation of the conduct of an charged with environment in which the financial
effective audit. It establishes a frame of reference within governance statements are prepared.
which the auditor plans the audit and exercises Internal audit May provide information about internal
professional judgment throughout the audit, for example, personnel audit procedures performed during the
when: year relating to the design and
 Assessing ROMM of the financial statements; effectiveness of the entity’s internal
 Establishing materiality; control and whether management has
 Considering the appropriateness of the selection and satisfactorily responded to findings from
application of accounting policies, and the adequacy of those procedures.

m
financial statement disclosures; Employees May help the auditor to evaluate the

er as
 Identifying areas where special audit consideration involved in appropriateness of the selection and

co
 Developing expectations for use when performing initiating, application of certain accounting policies.


analytical procedures;
Responding to the assessed ROMM and
eH w processing or
recording

o.
 Evaluating the sufficiency and appropriateness of audit complex or
rs e
evidence obtained. unusual
transactions
ou urc

The auditor uses professional judgment to determine the In-house legal May provide information about such
extent of the understanding required sufficiently enough to counsel matters as litigation, compliance with laws
be able to identify and assess risks of material and regulations, knowledge of fraud or
o

misstatements, which is ordinarily less than that possessed suspected fraud affecting the entity,
by management in managing the entity. warranties, post- sales obligations,
aC s

arrangements (such as joint ventures)

vi re

Procedures to Obtain an Understanding with business partners and the meaning

of contract terms.
The procedures that the auditor should follow in order to
Marketing or May provide information about changes in
obtain an understanding sufficient to assess the risks and
y

sales the entity’s marketing strategies, sales

consider these risks in designing the audit plans include
personnel trends, or contractual arrangements with
ed d

the following:
its customers.
a. performing risk assessment procedures;
ar stu

b. considering the use of information obtain in prior

Analytical Procedures
period audits; and
c. having discussion among audit engagement team. Analytical procedures mean evaluations of financial
information through analysis of plausible relationships
is

Risk Assessment Procedures (RAP) among both financial and non-financial data. Analytical
procedures also encompass such investigation as is
Th

Risk assessment procedures are the audit procedures

necessary of identified fluctuations or relationships that are
performed to obtain an understanding of the entity and its
inconsistent with other relevant information or that differ
environment, including the entity’s internal control, to
from expected values by a significant amount.
identify and assess the risks of material misstatement,
whether due to fraud or error, at the financial statement
sh

It involves comparisons between the auditor’s expectations

and assertion levels, thereby providing a basis for
and the recorded (reported) amounts. Examples of
designing and implementing responses to the assessed
auditor’s expectations are:
risks of material misstatement.
 Financial information:
o Comparable information for prior periods
The risk assessment procedures shall include the following:
o Anticipated results (budgets or forecasts)
a. Inquiries of management, and of others within the
o Industry information
entity.
 Relationships:
b. Analytical procedures.
o Elements of financial information expected to have
c. Observation and inspection.
a predictable pattern (gross margin)
o Between financial and non-financial information,
However, risk assessment procedures by themselves do
(payroll costs to number of employees)
not provide sufficient appropriate audit evidence on which
to base the audit opinion.
The auditor should apply analytical procedures at the
Inquiries of Management, and of Others within the Entity planning and overall review stages of the audit. Analytical
procedures may help identify the existence of unusual
Much of the information obtained by the auditor’s inquiries transactions or events, and amounts, ratios, and trends
is obtained from management and those responsible for that might indicate matters that have audit implications.
financial reporting. However, the auditor may also obtain Unusual or unexpected relationships that are identified
https://www.coursehero.com/file/14402588/AT1810-Understanding-the-Entity-and-Its-Environment/
Page 1 of 7
may assist the auditor in identifying risks of material
misstatement, especially risks of material misstatement
due to fraud.
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.
Types of Analytical Procedures
The following are the types of typical analytical procedures
applied in an audit:
 Trend analysis – this type is based on the assumption
that performance will continue in line with previous
performance or industry trends unless something
unusual is happening in the company.
 Ratio analysis – this type similar to financial statement
analysis, and is highly effective technique to highlight
account balances that are out of line and may signal
the potential for fraud.
 Test of reasonableness – this type tests whether a
recorded amount is reasonable with regards to the
auditor’s expectation.
 Regression analysis – this type involves time-series
analysis by examining trends in relationship with
previous results.
Investigating Results of Analytical Procedures
If analytical procedures identified fluctuations or
inconsistent relationships that differ significantly from
expected values, investigate differences by:
 Inquiring of management and obtaining appropriate
audit evidence relevant to management’s responses;
and
 Performing other audit procedures as necessary in the
circumstances.

m
In summary, analytical procedures are performed in the following areas of audit:

er as
Stage Planning and Risk Assessment Testing (Fieldwork) Completion

co
Procedure Preliminary analytical Substantive analytical Concluding (Final or overall)

Objective
eH w
procedures (As part of RAP)
To obtain understanding the
procedures
To detect material
analytical procedures
To form an overall conclusion that

o.
entity and its environment in misstatements, about an the financial statements are
rs e
order to identify and assess assertion, as part of responses to consistent with the auditor’s
ou urc

ROMMs ROMMs understanding of the entity

Attention Yes No Yes
directing?
Is it required? Yes No Yes
o

Results Identification and assessment Obtain reasonable assurance Conclusion that FSs are consistent
of ROMMs about the fairness of an with the auditor’s understanding or
aC s

assertion the auditor may identify previously

vi re

unrecognized ROMM
Observation and Inspection relevance of such information, the auditor may make
y

inquiries and perform other appropriate audit procedures,

Observation and inspection may support inquiries of
such as walk-throughs of relevant systems.
ed d

management and others, and may also provide

information about the entity and its environment.
ar stu

Discussion Among the Engagement Team (‘Brainstorming’)

Examples of such audit procedures include observation or
inspection of the following: The engagement partner and other key engagement team
 The entity’s operations. members shall discuss the susceptibility of the entity’s
 Documents (such as business plans and strategies), financial statements to material misstatement, and the
is

records, and internal control manuals. application of the applicable financial reporting framework
 Reports prepared by management (such as quarterly to the entity’s facts and circumstances. The engagement
Th

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 (tour).
 Books, periodicals and other publications related to the
sh
partner shall determine which matters are to be
communicated to engagement team members not involved
in the discussion.
Understanding The Entity and Its Environment

entity and its environment.

Information Obtained in Prior Periods
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.
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
The auditor shall obtain an understanding of the following:
 Relevant industry, regulatory, and other external
factors including the applicable financial reporting
framework
 Nature of the entity
o Its operations;
o Its ownership and governance structures;
o The types of investments that the entity is making
and plans to make; and
o The way that the entity is structured and how it is
financed.
 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.

https://www.coursehero.com/file/14402588/AT1810-Understanding-the-Entity-and-Its-Environment/
Page 2 of 7
 The entity’s objectives and strategies, and those
related business risks that may result in risks of
material misstatement.
 The measurement and review of the entity’s financial
performance
Industry, Regulatory and Other External Factors
Industry Factors
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:
 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.
The industry in which the entity operates may give rise to
specific risks of material misstatement. Hence, it is
important that the engagement team include members
with sufficient relevant knowledge and experience.
 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
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.
Business risk is 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. Business risk is

m
broader than the risk of material misstatement of the

er as
Regulatory Factors
financial statements, though it includes the latter.

co
Relevant regulatory factors include the regulatory
eH w
environment. The regulatory environment encompasses,
among other matters, the applicable financial reporting
Business risk may arise from change or complexity. A
failure to recognize the need for change may also give rise

o.
framework and the legal and political environment. to business risk. Business risk may arise, for example,
rs e
Examples of matters the auditor may consider include: from:
 Accounting principles and industry specific practices.  The development of new products or services that may
ou urc

 Regulatory framework for a regulated industry. fail;

 Legislation and regulation.  A market which, even if successfully developed, is
 Taxation (corporate and other). inadequate to support a
 product or service; or
o

 Government policies currently affecting the conduct of

the entity’s business.  Flaws in a product or service that may result in
aC s

 Environmental requirements affecting the industry and liabilities and reputational risk.
vi re

the entity’s business.

An understanding of the business risks facing the entity
Other External Factors increases the likelihood of identifying risks of material
y

misstatement, since most business risks will eventually

Examples of other external factors affecting the entity that have financial consequences and, therefore, an effect on
ed d

the auditor may consider include the general economic the financial statements. However, the auditor does not
conditions, interest rates and availability of financing, and
ar stu

have a responsibility to identify or assess all business risks

inflation or currency revaluation. because not all business risks give rise to risks of material
misstatement.
Nature of the Entity
Examples of matters that the auditor may consider when
is

An understanding of the nature of an entity enables the

auditor to understand such matters as: obtaining an understanding of the entity’s objectives,
 Whether the entity has a complex structure. strategies and related business risks that may result in a
Th

 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.
sh
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

Examples of matters that the auditor may consider when
obtaining an understanding of the nature of the entity
include:
 Business operations
 Investments and investment activities
 Financing and financing activities
 Financial reporting
Significant changes in the entity from prior periods may
give rise to, or change, risks of material misstatement.
The Entity’s Selection and Application of Accounting
Policies
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.
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).

https://www.coursehero.com/file/14402588/AT1810-Understanding-the-Entity-and-Its-Environment/
Page 3 of 7
 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).
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, 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.
m
er as
Usually, management identifies business risks and
develops approaches to address them as an entity’s risk
co
assessment process, which is part of the entity’s internal
eH w
control.
o.
Measurement and Review of the Entity’s Financial
rs e
Performance
ou urc
MULTIPLE CHOICE
o
aC s
Risk Assessment Procedures
vi re
1. The main purpose of risk assessment procedures is to
a. Obtain an understanding of the entity and its
environment, including its internal control, to
assess the risks of material misstatement at the
y
financial statement and assertion levels.
ed d
b. Test the operating effectiveness of controls in
preventing, or detecting and correcting, material
ar stu
misstatement at the assertion level.
c. Detect material misstatements at the assertion
level.
d. All of the above
is
2. Which of the following is least likely to be considered a
Th
risk assessment procedure?
a. Analytical procedures.
b. Confirmation of ending accounts receivable.
c. Inspection of documents.
d. Observation of the performance of certain
sh
accounting procedures.
3. Inquiries directed towards internal audit personnel may
most likely
a. Relate to their activities concerning the design and
effectiveness of the entity’s internal control and
whether management has satisfactorily responded
to any findings from those activities
a. Help the auditor in understanding the environment
in which the financial statements are prepared
b. Relate to changes in the entity’s marketing
strategies, sales trends or contractual
arrangements with its customers
c. Help the auditor in evaluating the appropriateness
of the selection and application of accounting
policies
https://www.coursehero.com/file/14402588/AT1810-Understanding-the-Entity-and-Its-Environment/
Page 4 of 7
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.
Documentation
The auditor shall document:
 The risk assessment procedures performed, as part of
detailed audit plan.
 The discussion among the engagement team, and the
significant decisions reached (normally in a
memorandum or minutes of meeting)
 Key elements of the understanding obtained regarding
each of the aspects of the entity and its environment
including the sources of information from which the
understanding was obtained (normally in a
‘understanding the business template’)
For recurring audits, certain documentation may be carried
forward, updated as necessary to reflect changes in the
entity’s business or processes.
- done -
4. Which of the following procedures would an auditor
least likely perform while obtaining an understanding
of a client in a financial statement audit?
a. Coordinating the assistance of entity personnel in
data preparation.
b. Discussing matters that may affect the audit with
firm personnel responsible for non-audit services
to the entity.
c. Selecting a sample of vendors' invoices for
comparison to receiving reports.
d. Reading the current year's interim financial
statements.
5. Which one of the following is a valid source of
information about the client's processes?
a. Management inquiry
b. Review of the client's budget
c. Tour of client’s plant and operations
d. All are valid sources.
6. Each of the following may be relevant to an auditor
when obtaining knowledge about the client’s business
and industry, except
a. Performing a walkthrough tests
b. Publications related to the industry
c. Visits the entity’s premises
d. Discussion with people within or outside the entity
7. An understanding of a client’s business and industry
and knowledge about operations are essential for
performing an adequate audit. For a new client, most
of this information is obtained:
a. from the predecessor auditor.
b. from the Securities and Exchange Commission.
c. from the permanent file.
d. at the client’s premises.
8. To obtain an understanding of a continuing client's c. Study of the relationships of financial data with
business, an auditor most likely would relevant nonfinancial data.
a. Perform tests of details of transactions and d. Tracing transactions through the system to
balances. determine whether procedures are being applied as
b. Review prior year working papers and the prescribed.
permanent file for the client.
14. In performing an audit, which one of the following
c. Read current issues of specialized industry
procedures would be considered an analytical
journals.
procedure?
d. Reevaluate the client's internal control
a. Comparing last year’s interest expense with this
environment.
year’s interest expense.
9. Which of the following statements is correct, when b. Comparing signatures on checks with the
obtaining understanding about the client’s business? signatures of authorized check signers.
a. For continuing engagements, the auditor may no c. Reviewing initials on received documents
longer obtain knowledge about the client’s d. Reviewing procedures followed in receiving,
business. depositing, and disbursing cash.
b. The level of knowledge required of the auditor is
15. Which of the following is not an example of analytical
ordinarily more than the level of knowledge
evidence?
possessed by management.
a. Compared inventory turnover by major class with
c. Preliminary knowledge about the entity’s industry
the prior year on a monthly and quarterly basis.
must be obtained after accepting the engagement
b. Compared gross profit percentages by major
to determine whether the auditor has the
product classes with the prior year.
necessary knowledge to perform the audit.
c. Examined invoices for plant asset additions to
d. Following the acceptance of the engagement, the
determine whether the client had erroneously

m
auditor should obtain detailed knowledge about the

er as
recorded ordinary repairs as plant assets.
client’s business preferably at the start of the
d. Examined monthly performance reports and

co
engagement.
eH w investigated significant variations from budgeted
10. The auditor’s understanding of the entity and its amounts.
environment assists the auditor in

o.
16. An auditor compares year-to-year account balances in
a. Assessing the risks and identifying potential
rs e
order to perform analytical procedures. This is an
problems.
example of:
ou urc

b. Planning and performing the audit effectively and

a. Ratio analysis
efficiently.
b. Trend analysis
c. Evaluating the audit evidence, determining
c. Internal control analysis
materiality and in developing expectations for use
o

d. Vertical analysis
when performing analytical procedures.
d. All of the above.
aC s

17. What analysis best considers the economic

relationships among account balances?
vi re

Analytical procedures a. Altman "Z" Analysis

11. Evaluations of financial information made by a study of b. Ratio analysis.
plausible relationships among both financial and non- c. Vertical analysis.
y

financial data. It also encompasses the investigation of d. Horizontal analysis.

ed d

identified fluctuations and relationships that are

inconsistent with other relevant information or that 18. For all audits of financial statements made in
ar stu

differ from expected values by a significant amount. accordance with PSAs, the use of analytical procedures
a. Audit planning is required to some extent
b. Audit evidence In the As a As an overall in
c. Analytical procedures assessment of substantive the completion
is

d. Inspection Risk of MM test stage

a. Yes No Yes
12. Analytical procedures are used in an audit because it is b. No Yes No
Th

assumed of financial statements that c. No Yes Yes

a. management fraud can be discovered using such d. Yes No No
procedures.
b. it is plausible that no relationship among data 19. Analytical procedures used in planning an audit should
sh

exists.
c. analytical procedures are used as tests of controls.
d. plausible relationships among data may reasonably
be expected to exist and continue in the absence of
known conditions to the contrary.
13. Analytical procedures enable the auditor to predict the
balance or quantity of an item under audit.
Information to develop this estimate can be obtained
from all of the following, except
a. Comparison of financial data with data for
comparable prior periods, anticipated results (e.g.,
budgets and forecasts), and similar data for the
industry in which the entity operates.
b. Study of the relationships of elements of financial
data that would be expected to conform to a
predictable pattern based upon the entity’s
experience.
focus on
a. Reducing the scope of tests of controls and
substantive tests.
b. Providing assurance that potential material
misstatements will be identified.
c. Enhancing the auditor’s understanding of the
client’ s business required to identify areas of
heightened risk.
d. Assessing the adequacy of the available evidence.
20. The auditor notices significant fluctuations in key
elements of the company's financial statements. If
management is unable to provide an acceptable
explanation, the auditor should
a. Consider the matter a scope limitation.
b. Perform additional audit procedures to investigate
the matter further.
c. Intensify the examination with the expectation of
detecting management fraud.

https://www.coursehero.com/file/14402588/AT1810-Understanding-the-Entity-and-Its-Environment/
Page 5 of 7
 d. Withdraw from the engagement. III. Objectives and strategies and the related business
risks that may result in a material misstatement of
21. Which of the following statements is not correct with
the financial statements
respect to analytical procedures?
IV. Measurement and review of the entity’s financial
a. Auditing standards emphasize the need for
performance.
auditors to develop and use expectations.
V. Internal control
b. Analytical procedures must be performed
a. All of the above
throughout the audit.
b. I, II and III only
c. Analytical procedures may be performed at any
c. I and II, III and IV only
time during the audit.
d. I and III only
d. Analytical procedures use comparisons and
relationships to assess whether account balances 26. Nature of the entity refers to
appear reasonable. a. The entity’s operations, its ownership and
governance, the types of investments that it is
The Entity and Its Environment
making and plans to make, the way that the entity
22. The audit team gathers information about a new
is structured and how it is financed
client's business and industry in order to obtain:
b. The overall plans for the entity
a. an understanding of the clients internal control
c. The operational approaches by which management
system for financial reporting.
intends to achieve its objectives
b. an understanding of how economic events and
d. The result of significant conditions, events and
transactions have an effect on the company's
circumstances, actions or inactions that could
financial statements.
adversely affects the entity’s ability to achieve its
c. information about engagement risk.
objectives and execute the strategies or the setting
d. information regarding whether the company is
of inappropriate objectives and strategies
engaging in financial statement fraud.

m
er as
27. The result of significant conditions, events and
23. Which statement is incorrect regarding obtaining an
circumstances, actions or inactions that could

co
understanding of the entity and its environment?
eH w adversely affects the entity’s ability to achieve its
a. Obtaining an understanding of the entity and its
objectives and execute the strategies or the setting of
environment is an essential aspect of performing
inappropriate objectives and strategies

o.
an audit in accordance with PSAs.
a. Audit risk c. Significant risk
rs e
b. That understanding establishes a frame of
b. Business risk d. Sampling risk
reference within which the auditor plans the audit
ou urc

and exercises professional judgment about 28. Which statement is correct regarding business risk?
assessing risks of material misstatement of the a. The risk of material misstatement of the financial
financial statements and responding to those risks statements is broader than business risk, though it
o

throughout the audit. includes the latter

c. The auditor’s primary consideration is whether the b. The auditor should identify or assess all business
aC s

understanding that has been obtained is sufficient risks

vi re

to assess the risks of material misstatement of the c. All business risks give rise to risks of material
financial statements and to design and perform misstatements
further audit procedures. d. A business risk may have an immediate
y

d. The depth of the overall understanding that is consequence for the risk of misstatement for
required by the auditor in performing the audit is classes of transactions, account balances, and
ed d

equal to that possessed by management in disclosures in the assertion level or the financial
ar stu

managing the entity. statements as a whole

24. An initial audit requires more audit time to complete 29. A potential business risk created by industry
than a recurring audit. One of the reasons for this is developments may most likely include
that a. Increased product liability
is

a. new auditors are usually assigned to an initial b. Increased legal exposure

audit. c. The entity does not have the personnel or
Th

b. predecessor auditors need to be consumed.
c. the client's business, industry and internal control
are unfamiliar to the auditor and need to be
carefully studied.
d. a larger proportion of customer accounts
sh
expertise to deal with the changes in the industry.
d. Loss of financing due to the entity’s inability to
meet financing requirements.
30. A potential business risk created by new products may

receivable need to be confirmed on an initial audit. most likely include

a. Increased product liability
25. The auditors’ understanding of the entity and the b. Increased legal exposure
environment consists of the following aspects c. The entity does not have the personnel or
I. Industry, regulatory, and other external factors, expertise to deal with the changes in the industry.
including the applicable financial reporting d. Loss of financing due to the entity’s inability to
framework meet financing requirements.
II. Nature of the entity, including the entity’s selection
and application of accounting policies - now do the DIY drill -

DO-IT-YOURSELF (DIY) DRILL

1. The objective of performing analytical procedures in c. Related-party transactions.
planning an audit is to identify the existence of d. Recorded transactions that were not properly
a. Unusual transactions and events. authorized.
b. Illegal acts that went undetected because of
internal control weaknesses.
https://www.coursehero.com/file/14402588/AT1810-Understanding-the-Entity-and-Its-Environment/
Page 6 of 7
 2. Which of the following is not an information source for a. Relate to their activities concerning the design and
developing analytical procedures used in the audit? effectiveness of the entity’s internal control and
a. Relationships among financial statement elements whether management has satisfactorily responded
b. Relationships between financial and relevant to any findings from those activities
nonfinancial data b. Help the auditor in understanding the environment
c. Comparison of financial data with anticipated in which the financial statements are prepared
results (e.g., budgets and forecasts) c. Relate to changes in the entity’s marketing
d. Comparison of current year financial data with strategies, sales trends or contractual
projections for next year's financial results arrangements with its customers
d. Help the auditor in evaluating the appropriateness
3. What type of analytical procedure would an auditor
of the selection and application of certain
most likely use in developing relationships among
accounting policies
balance sheet accounts when reviewing the financial
statements of a nonpublic entity? 11. Analytical procedures are used for the following
a. Trend analysis. purposes except
b. Regression analysis. a. To assist the auditor in planning the nature, timing
c. Ratio analysis. and extent of other auditing procedures.
d. Risk analysis. b. As a substantive test to obtain evidential matter
about a particular assertion related to account
4. Analytical procedures are used for the following
balances or classes of transactions.
purposes:
c. As an overall review of financial information in the
a. To assist the auditor in assessing the risk of
final review stage of the audit.
material misstatements of the FS
d. To evaluate the effectiveness of the client’s
b. As a substantive test to obtain evidential matter
internal control.
about particular assertion related to account

m
er as
balances or classes of transaction. 12. Which of the following is not a typical analytical review
c. As an overall review of financial information in the procedure?

co
final review stage of the audit. eH w a. Study of relationships of the financial information
d. All of the above. with relevant non-financial information.
b. Comparison of the financial information with

o.
5. The preliminary use of analytical review procedures by
similar information regarding the industry in which
rs e
the auditor is
the entity operates.
a. required to identify areas of heightened risk
ou urc

c. Comparisons of recorded amounts of major

b. optional in accordance with auditor judgment.
disbursements with appropriate invoices.
c. only used when other planning procedures cannot
d. Comparisons of the financial information with
be applied.
budgeted amounts.
o

d. used to assist the auditor in documenting internal

control. 13. As a result of analytical procedures conducted during
aC s

the planning phase, the independent auditor

6. Which of the following are the most common
vi re

determines that the gross profit percentage has

techniques used in obtaining knowledge of a client in
declined from 30% in the preceding year to 20% in the
the planning phase of an audit engagement?
current year. The auditor should
a. Confirmation, enquiry, analysis, reperformance
y

a. Express an opinion which is qualified due to the

b. Enquiry, analysis, observation, inspection
inability of the client company to continue as a
ed d

c. Enquiry, analysis, observation, reperformance

going concern
d. Vouching, tracing, discussion, analysis
ar stu

b. Evaluate management's performance in causing

7. The purpose of risk assessment procedures is to this decline
a. Obtain an understanding of the entity and its c. Require footnote disclosure
environment d. Consider the possibility of an error in the financial
statements
is

b. Reduce detection risk

c. Evaluate management ability
14. Jennings and Company has repositioned the firm's
d. Determine the operating effectiveness of controls
Th

business strategy from the basis of competing on costs

8. The auditor uses knowledge gained from the to competing on product differentiation. All the
understanding of the client's business and industry to following will increase, except:
assess: a. Audit risk.
b. Business Risk.
sh

a. Client business risk

b. Control risk
c. Inherent risk
d. Audit risk
9. An auditor has accessed client business risk and the
risk to material misstatements to the clients financial
statements. These are done in order to:
a. apply the audit risk model in determining the
appropriate audit procedures to perform.
b. determine the reliance on the company's internal
control systems for financial reporting.
c. determine the test of balances to be performed by
the audit team.
d. assure the CPA firm that they can perform the
audit effectively and efficiently,
10. Inquiries directed towards those charged
governance may most likely
c. Financial risk.
d. Risk of Material Misstatements.
15. An auditor who accepts an audit engagement and does
not possess the industry expertise of the business
entity should:
a. engage financial experts familiar with the nature of
the business entity.
b. obtain a knowledge of matters that relate to the
nature of the entity’s business.
c. refer a substantial portion of the audit to another
CPA who will act as the principal auditor.
d. first inform management that an unqualified
opinion cannot be issued.
 - end of AT.1510A - 
with

https://www.coursehero.com/file/14402588/AT1810-Understanding-the-Entity-and-Its-Environment/
Page 7 of 7

Powered by TCPDF (www.tcpdf.org)