Introduction
Auditing standards are a collection of criteria and concepts that auditors follow when performing an audit. These criteria promote uniformity, quality, and dependability in the audit process. They are created by professional accounting groups, such as the American Institute of Certified Public Accountants (AICPA), to protect the integrity and credibility of financial accounts. Auditing standards have developed to keep up with changes in company operations, regulatory needs, and technological advances (Gao & Zhang, 2019). These principles serve as the framework upon which auditors plan, carry out, and report on audit engagements.
SAS No. 145, titled ‘Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement,” is an auditing standard recently introduced by AICPA. It advises auditors to thoroughly understand the entity being audited and assess the risks of substantial misstatement. The standard highlights the need for auditors to be well-versed in the entity’s activities, industry, internal controls, and risk factors (Appelbaum et al., 2023). It also emphasizes the importance of assessing the risks of material misstatement, which assists auditors in determining the nature, time, and scope of audit procedures to be done. SAS No. 145 is a notable advancement in auditing standards since it focuses on improving audit effectiveness and efficiency by adopting a risk-based approach. Auditors can deliver more meaningful and relevant audit opinions if auditing methods are aligned with the SAS No. 145 outlines the essential principles and requirements (Appelbaum et al., 2023). Its goal is to provide a thorough understanding of the entity and its surroundings, as well as the process of assessing the risks of material misstatement.
The fundamental concepts, methodology, and practical implications of SAS No. 145 in the context of auditing practices will be examined in this study. It will go over the importance of understanding the entity and analyzing risks and auditors’ responsibility in efficiently executing these principles. Furthermore, the study paper will examine real-world examples and case studies to demonstrate how SAS No. 145 can be used. It will also assess the advantages and disadvantages of this auditing standard and potential future advances in the auditing industry.
The Entity
In auditing, the entity refers to the organization or business being audited. A corporation, partnership, government agency, or nonprofit organization could be involved. Raximova, Abdulxayeva & Pirimkulov (2020) explain that understanding the entity is essential during the audit process since it allows auditors to get insights into its operations, financial situation, and performance.
Importance of Understanding the Entity
Effective risk assessment: Auditors can detect and assess the risks of significant misstatement with a detailed understanding of the entity. It enables them to adjust audit procedures to the entity’s circumstances and manage resources effectively.
Planning the audit: Understanding the entity helps auditors design an effective audit strategy, determine the nature, timing, and scope of audit processes, and select the appropriate audit team (Raximova et al., 2020).
Evaluating internal controls: Understanding the entity’s internal control environment allows auditors to evaluate the design and efficacy of controls, identify control vulnerabilities, and determine how much reliance should be placed on those controls.
Assessing financial statement presentation: Understanding the entity assists auditors in evaluating the fairness and accuracy of financial statement presentation, including transaction and event recognition, measurement, and disclosure (Raximova et al., 2020).
Factors Considered When Understanding the Entity
Auditors must understand the industry in which the business operates, including its particular characteristics, risks, rules, and competitive landscape. This knowledge aids in analyzing industry-specific risks that may influence the entity’s financial statements.
Governance structure: The entity’s governance structure, which includes its board of directors, management team, and oversight processes, influences its control environment and financial reporting integrity (Raximova et al., 2020). Auditors should comprehend the entity’s organizational structure, including its subsidiaries, branches, and divisions. This knowledge aids in the identification of relevant reporting relationships, business lines, and geographic areas for the audit.
Business operations: Auditors must gather knowledge of the entity’s primary business activities, products, services, and income streams. Understanding business activities allows you to assess the completeness and accuracy of financial statement items.
Information systems: Auditors should be familiar with the entity’s information systems, which include the accounting system, internal financial reporting controls, and IT infrastructure (Raximova et al., 2020). This understanding aids in determining the dependability of financial data and the system’s integrity.
Procedures for Gaining an Understanding of the Entity
In order to understand the entity and its organizational and operational structures, auditors have to carry out certain procedures. First, they have to review the financial statements, footnotes and other relevant disclosures that can enable them to understand the entity’s financial position, results of operations and significant accounting policies. Moreover, auditors must research and analyze the entity’s industry, economic conditions and market trends to understand the external factors that may impact its financial statements (Raximova et al., 2020). In addition, auditors have to interact with managers and engage in discussions to gather much information about the entity’s operations, internal controls, accounting policies, and any pre-determined risks. Observation and inspection is also crucial process in the auditing procedure. In this process, auditors visit the entity’s premises, observe operations, inspect physical assets, and review supporting documentation to validate the information obtained and better understand the entity (Raximova et al., 2020). Finally, the auditor also reviews legal and regulatory compliance by assessing the entity’s compliance with applicable laws, regulations and contractual obligations, as noncompliance may have financial reporting implications.
Environment of the Entity
External Factors Affecting the Entity
Economic Conditions
Inflation, interest rates, currency rates, and overall economic stability or volatility are all examples of economic conditions. These elements can substantially impact a company’s financial performance, sales, profitability, and capacity to raise financing. Auditors must assess the current economic conditions and their possible impact on the entity’s financial statements and activities (Raximova et al., 2020). During an economic downturn, for example, a company may incur decreased consumer demand, lower revenues, and increased credit risk. Auditors must evaluate how such economic conditions affect the entity’s financial status and the appropriateness of management’s financial reporting decisions.
Regulations of the Industry
Various regulations are imposed on industries by government authorities or regulatory groups. These restrictions are intended to ensure ethical compliance, protect consumers, maintain market integrity, and promote fair competition. Auditors must grasp the applicable regulations affecting the entity’s industry, as noncompliance can have serious financial reporting consequences (Raximova et al., 2020). In the healthcare industry, for example, companies must follow severe rules regarding patient privacy (HIPAA), billing methods (Medicare/Medicaid), and quality standards (FDA). Auditors must assess the entity’s compliance with industry-specific regulations and their influence on financial reporting.
Competitive Landscape
The competitive landscape relates to an entity’s market dynamics, competitive factors, and industry structure. The quantity and strength of competitors, market share, pricing pressures, and technical improvements can all impact an entity’s financial performance. Auditors must comprehend the entity’s competitive environment to evaluate the risks associated with competitive pressures, market positioning, and the entity’s capacity to continue operations and profitability (Raximova et al., 2020). This understanding aids auditors in evaluating the entity’s financial statements for signs of aggressive pricing, market share erosion, or potential asset impairment.
Internal Factors Affecting the Entity
Structure of Governance
An entity’s governance structure includes the governing board, management staff, and internal control systems. It establishes the organization’s roles, responsibilities, and accountability. Auditors must assess the entity’s governance structure’s efficacy in supporting ethical behaviour, sound financial reporting, and effective risk management (Raximova et al., 2020). The independence of the board of directors, the presence of audit committees, and the entity’s dedication to compliance with laws and regulations all impact the control environment. Auditors evaluate the governance structure to comprehend the entity’s integrity and ethical ideals, as well as their impact on financial reporting.
Management Philosophy and Operating Style
The entity’s strategic objectives, management’s approach to decision-making, risk appetite, and communication techniques are all part of the management philosophy and operational style. It reflects how management establishes objectives, allocates resources, handles risks, and evaluates performance. Auditors must first grasp management’s ideology and operational style to examine the entity’s financial reporting and detect potential biases or dangers (Raximova et al., 2020). For example, if management is motivated by short-term profit, it may engage in aggressive accounting procedures or take undue risks to fulfil financial targets. Auditors assess management’s ideology and operational style to determine their impact on the entity’s financial statements and the accuracy of reported data.
Organizational Culture
Organizational culture is the common ideas, attitudes, and standards that drive employee behaviour inside an institution. It includes aspects such as the organization’s mission, values, work ethic, openness to feedback, and commitment to honesty. Auditors must understand the firm’s organizational culture since it substantially impacts financial reporting and the control environment (Raximova et al., 2020). A company with a strong ethical culture and a commitment to openness will have more reliable financial reporting and better internal controls. Auditors evaluate the entity’s culture by conducting interviews, observing employees, and studying applicable policies and procedures.
Assessing the Risks of Material Misstatement
Identifying and evaluating the risks that may result in major errors or omissions in the entity’s financial statements is part of assessing the risks of material misstatement. It is a critical phase in the audit process that allows auditors to focus on higher-risk areas, increasing the audit’s effectiveness and efficiency.
Importance of Assessing Risks
Assessing risks enables auditors to adjust their audit processes based on the entity’s specific risks, focusing on areas where misstatements are more likely to occur. This method ensures that audit resources are appropriately deployed and that the audit is responsive to the entity’s specific risk profile (Nehme et al., 2022). Audit quality is improved because auditors better understand the entity’s operations, procedures, and control environment through identifying risks. This understanding aids in spotting potential substantial misstatements and assuring the financial statements of the entity’s reliability and correctness.
Compliance with auditing standards
Risk assessment is a requirement of auditing standards such as SAS No. 145. Following these guidelines ensures that auditors meet professional obligations while maintaining consistency and quality in their audit engagements (Nehme et al., 2022).
Components of Risk Assessment
Inherent Risk
Inherent risk is the susceptibility of financial statements to major misstatements before the impact of internal controls is considered. It is caused by transaction complexity, judgment in accounting estimations, industry-specific hazards, and changes in the business environment (Rose et al., 2020). Auditors assess inherent risk to identify areas prone to misstatement, which assists them in determining the right audit processes.
Control Risk
The risk that substantial misstatements will not be prevented or detected promptly by the entity’s internal controls is called control risk. Auditors analyze control risk by evaluating the design and effectiveness of internal controls. Auditors may rely on strong and effective controls and minimize the scope of substantive processes if controls are strong and effective (Rose et al., 2020). However, auditors must conduct more vigorous testing if control risk is present.
Detection Risk
The detection risk is the possibility that auditors would fail to discover major misstatements in financial accounts. It is inversely proportional to the amount of assurance desired by auditors. Auditors consider detection risk when developing and carrying out audit procedures (Rose et al., 2020). Auditors attempt to provide a higher level of assurance that material misstatements, if present, will be recognized through lowering detection risk.
Application of SAS No. 145 in Auditing
Implementing SAS No. 145 entails implementing the standard’s requirements and guidelines into the audit strategy. The standard emphasizes knowing the entity and its surroundings, recognizing the risks of material misstatement, and devising and carrying out audit procedures to address those risks (Appelbaum et al., 2023). The following are the major phases in implementing SAS No. 145:
SAS No. 145 underlines the necessity of adequate audit planning. Auditors should evaluate the standard’s requirements while creating audit strategies, evaluating materiality levels, and identifying high-risk areas (Appelbaum et al., 2023). This includes considering the entity’s industry, external and internal elements, and an awareness of the entity’s processes and controls.
Risk assessment: According to the standard, auditors must examine the risks of substantial misstatement at both the financial statement and assertion levels. Auditors must identify inherent risks, assess control risks, and decide the appropriate detection risk level (Appelbaum et al., 2023). This entails acquiring adequate and relevant audit evidence to support the risk assessment process.
Audit procedures: Based on the risks identified, auditors should create and carry out audit procedures to address those risks. This may entail choosing and implementing substantive procedures such as detailed transaction testing, evaluating supporting documentation, and executing analytical operations. Appelbaum et al. (2023) further explain that when appropriate, it also entails reviewing internal controls’ design and operational effectiveness.
Documentation Requirements
Documentation is an important part of the audit process, and SAS No. 145 specifies criteria for documenting audit techniques and findings. Here are some important documentation considerations (AICPA, 2023):
Documentation of risk assessment: Auditors should document their understanding of the entity and its surroundings, including industry and external influences, governance structure, and internal controls (AICPA, 2023). They should also disclose their estimate of inherent risk, control risk, and detection risk and the reasoning behind their decisions.
Documentation of audit procedures: SAS No. 145 mandates documentation of the nature, timing, and scope of audit procedures executed. Auditors must document the procedures used to comprehend the entity, assess risks, and respond to those risks (AICPA, 2023). Documenting the particular methods carried out, the audit evidence acquired, and the conclusions made are all part of this.
Documentation of findings and conclusions: Auditors should document their findings, important issues detected, and conclusions reached during the audit. According to AICPA (2023), documenting any discovered substantial misstatements, flaws in internal controls, and the overall assessment of the financial statements’ fairness are all part of this.
Common Implications Experienced by Auditors in the Implementation of SAS No. 145
Entity complexity: Understanding and analyzing risks can be difficult when auditing complex businesses with intricate operations, several business lines, or global activities (AICPA, 2023). Auditors must use robust audit procedures, engage subject matter specialists as needed, and allocate adequate resources to address these challenges successfully.
Availability of trustworthy information: The availability and dependability of information might impact the audit process. Auditors may face difficulties when entities have insufficient systems, erroneous records, or insufficient documentation (AICPA, 2023). Auditors must apply professional scepticism in such circumstances, obtain further audit data, and analyze the impact on risk assessment and audit procedures.
Time and resource constraints: Conducting a successful audit when time and resources are limited can be difficult. Auditors should efficiently organize and manage audit engagements, utilizing technology and automation. According to AICPA (2023), to effectively address time and resource constraints, excellent communication and coordination within the audit team and with management and those responsible for governance are required.
Real-World Case Studies that Illustrate the Application of SAS No. 145
Case Study 1; XYZ Corporation
XYZ Corporation is a publicly traded manufacturing firm in a highly regulated industry. During the audit, the auditors used SAS No. 145, which focused on understanding the entity and analyzing risks. The auditors undertook extensive investigations and observations to understand better the entity’s business model, operations, and industry-specific hazards. They also evaluated the entity’s control environment, which included governance frameworks and internal controls relevant to industry compliance. Identifying inherent risks connected with sophisticated revenue recognition methods and potential noncompliance with industry-specific legislation was part of the risk assessment process. The effectiveness of internal controls over financial reporting was used to determine control risks.
Case Study 2; ABC Bank
ABC Bank is a financial organization that must adhere to strict regulatory guidelines. The auditors used SAS No. 145 to analyze risks and create appropriate audit processes. The auditors concentrated on comprehending the entity’s external elements, such as economic conditions, industry laws, and competitive landscape. They assessed the impact on the bank’s financial statements of changing interest rates, credit risk, and regulatory compliance requirements. The risk assessment method entailed evaluating inherent risks associated with the complexity of financial instruments, potential credit losses, and anti-money laundering rules compliance. The effectiveness of internal controls over financial reporting and risk management methods was used to measure control risks.
Analysis of the Outcomes with Reference to SAS No. 145
Risk assessment effectiveness
The risk assessment methods in both case studies by SAS No. 145 proved highly effective. The auditors identified significant risks unique to each organization and tailored the audit methods accordingly. The auditors could prioritize their audit efforts and spend resources effectively by identifying inherent hazards and control concerns (Financial). This resulted in a more robust audit strategy that targeted higher-risk areas, improving the entire audit process’s efficiency and effectiveness.
Financial reporting dependability
Using SAS No. 145 was critical in improving the trustworthiness of the financial statements in both case studies. The auditors better grasped the entities and processes by adhering to the standard’s standards. This comprehension, together with the rigorous risk assessment procedures, enabled the auditors to detect potential material misstatements and evaluate the efficacy of internal controls (Financial). As a result, the financial statements represented the entities’ financial conditions and performance more accurately and dependably.
Lessons learned and difficulties encountered.
The case studies highlighted numerous critical lessons gained and difficulties encountered by auditors when adopting SAS No. 145. Dealing with complex companies, such as those operating in regulated industries or with elaborate operations, was a regular challenge. Auditors must use rigorous audit procedures, engage subject matter experts, and allocate adequate resources to address the difficulties (Financial). Another issue was the lack of trustworthy information, particularly when entities lacked suitable systems or documentation. Auditors had to use professional scepticism and obtain additional audit evidence to overcome this issue. Time and resource restrictions were also key obstacles, necessitating auditors’ efficient planning and management of audit engagements and good communication with stakeholders (Financial).
Impact on audit quality and stakeholder confidence
In both case studies, the application of SAS No. 145 favoured audit quality and stakeholder confidence. Auditors could deliver a solid and credible audit opinion by adhering to the standard’s standards (Financial). The detailed risk assessment methods and the specialized audit techniques ensured that the audits were responsive to the entities’ hazards. This, in turn, improved the quality and accuracy of the audit work, giving stakeholders greater confidence in the financial statements.
Advantages and Disadvantages of SAS No. 145
Enhanced risk identification: By getting a thorough awareness of the company, its surroundings, and the industry in which it operates, auditors may more effectively identify and assess risks. This allows businesses to adjust their audit techniques to individual risks, resulting in a more focused and efficient audit.
Improved audit planning: Early in the audit process, understanding the entity and analyzing risks aids in developing a complete audit plan. According to the AICPA organization, auditors can better allocate resources, focus on high-risk areas, and prioritize their efforts, resulting in a more successful and efficient audit (Financial).
Increased financial statement reliability: By reviewing and testing the effectiveness of internal controls and estimating the risk of significant misstatement, auditors can provide greater certainty about the financial statements’ dependability (Financial).
Limitations of using SAS No. 145
Subjectivity in risk assessment: Risk assessment requires professional judgment and inherent subjectivity. Risk evaluations may differ depending on how auditors understand and evaluate risks (Financial). This subjectivity can affect the consistency and comparability of risk evaluations across audit engagements.
Understanding the entity is dependent on acquiring information and representations from management. The AICPA organization explains that management may intentionally or accidentally distort facts, resulting in erroneous risk assessments and potential audit failures (Financial). Auditors must maintain professional scepticism and confirm information gained from management from other sources.
Time and resource constraints: Understanding the entity and analyzing risks can take time and resources, especially for complex entities or those operating in fast-changing contexts.
Conclusion
SAS No. 145 has shown to be a critical standard in improving the audit process’s quality and effectiveness. The standard advocates a risk-based strategy that improves audit efficiency and financial reporting dependability by stressing entity understanding, risk assessment, and adjusting audit methods accordingly. It improves auditors’ capacity to detect serious misstatements, analyze internal controls, and offer credible audit opinions, increasing stakeholder trust. As the business landscape changes, auditing standards will evolve to handle new risks and problems. Future advancements could include adopting technology-driven audit approaches, improving the evaluation of emerging risks like cybersecurity and sustainability, and expanding the integration of risk assessment throughout the audit process.
References
AICPA. (2023). Recently issued auditing and attestation standards: Information and resources. https://us.aicpa.org/interestareas/frc/auditattest/auditing-standards-information-and-resources
Appelbaum, D., Duan, H. K., Hu, H., & Sun, T. (2023). The Double Materiality Audit: Assurance of ESG Disclosure. Available at SSRN 4367032.
Financial, S. www. aicpa. Org.
Gao, P., & Zhang, G. (2019). Auditing standards, professional judgment, and audit quality. The Accounting Review, 94(6), 201–225.
Nehme, R., Michael, A., & Haslam, J. (2022). The impact of time budget and deadline pressures on audit behaviour: UK evidence. Meditari Accountancy Research, 30(2), 245-266.
Raximova, G. M., Abdulxayeva, S., & Pirimkulov, O. M. (2020). FEATURES OF AUDIT OF SMALL AND MEDIUM-SIZED ENTERPRISES. Theoretical & Applied Science, (6), 101-105.
Rose, A. M., Rose, J. M., Suh, I., & Thibodeau, J. C. (2020). Analytical procedures: Are more good ideas always better for audit quality? Behavioral Research in Accounting, 32(1), 37-49.
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