A3-M1-Understanding the Entity and Its Environment

The objective of performing AP during planning is to discover unusual transactions or events that may have an impact on the planning of the F/S audit.

The auditor should obtain an understanding of the entity and its environment sufficient to assess the RMM and to design and perform further audit procedures.

Leading indicators tend to predict economic activity. Orders for goods, building permits, and unfilled orders are all examples of leading indicators.

Reviewing F/S and disclosures for unusual transactions or unexpected balances —> this represents an AP that may be performed by an audit partner or audit manager during the OVERALL REVIEW stage (and not the planning phase) of an audit.

The planning process should include application of analytical procedures, such as comparison of the F/S with budgeted or anticipated results.

Analytical procedures involve comparison of recorded amounts to independent expectations developed by the auditor. During the planning stage, AP generally use financial data, such as unaudited information from internal quarterly reports.

A decrease in RE would be unreasonable b/c the auditor notice a significant increase in NI. NI closes to RE; therefore, absent an other information, the auditor would expect there would be an increase in RE.

During audit planning, an auditor is required to perform analytical procedures. These procedures are frequently done over the B/S and I/S. Therefore, it would be reasonable for an auditor to calculate gross profit percentage and the change in that percentage when compared to the prior period.

Risks relevant to financial reporting can arise due to rapid growth in the entity’s operations.

The auditor must obtain an understanding of the entity’s use of IT. This knowledge includes initiating, authorizing, recording, processing, and reporting of transactions. If an auditor does not have this understanding, it may impact their ability to properly assess risks and therefore plan and perform audit procedures to address those risks.

The trough of a business cycle is an economic low point with no positive indicators for the future. It is characterized by unused productive capacity and an unwillingness to risk new investments.

The peak of a business cycle marks the highest point of economic activity. At that point, firms are likely to face capacity constraints and labor shortages, which will put upward pressure on the overall price level.

In an expansionary phase, GDP increases, firms’ profits rise, and the demand for goods and services increases. To capitalize on this rising economic activity, businesses increase their capital investment and expand the size of their workforce.

Expansion > Peak > Contraction > Trough