Question

7-34 PCAOB (LO 2) AS 2110 provides the following guidance regarding the audi- tor's need to obtain an understanding of the company's selection and application of accounting principle: As part of obtaining an understanding of the company's selection and application of accounting principles, including related disclo- sures, the auditor should evaluate whether the company's selec tion and application of accounting principles are appropriate for its business and consistent with the applicable financial reporting framework and accounting principles used in the relevant industry. Also, to identify and assess risks of material misstatement related to omitted, incomplete, or inaccurate disclosures, the auditor should develop expectations about the disclosures that are neces- sary for the company's financial statements to be presented fairly in conformity with the applicable financial reporting framework. Read through AS 2110 (you can find it on the PCAOB website) and identify the specific issues that are relevant to the necessary under standing of the company's selection and application of accounting prin- ciples, including related disclosures.

Answer 1

Specific Issues that are relevant to necessary understanding of the Company’s selection and application of accounting principles are:-

1. Obtaining an Understanding of the Company and Its Environment:- The auditor should obtain an understanding of the company and its environment to understand the events, conditions, and company activities that might reasonably be expected to have a significant effect on the risks of material misstatement. Obtaining an understanding of the company includes understanding:

a. Relevant industry, regulatory, and other external factors;

b. The nature of the company;

c. The company's selection and application of accounting principles, including related disclosures;

d. The company's objectives and strategies and those related business risks that might reasonably be expected to result in risks of material misstatement; and

e. The company's measurement and analysis of its financial performance

2. Industry, Regulatory, and Other External Factors:- Obtaining an understanding of relevant industry, regulatory, and other external factors encompasses industry factors, including the competitive environment and technological developments; the regulatory environment, including the applicable financial reporting framework and the legal and political environment; and external factors, including general economic conditions.

3. Nature of the Company:- Obtaining an understanding of the nature of the company includes understanding:

The company's organizational structure and management personnel;

The sources of funding of the company's operations and investment activities,

including the company's capital structure, non capital funding (e.g., subordinated debt or dependencies on supplier financing), and other debt instruments;

The company's significant investments, including equity method investments, joint ventures, and variable interest entities;

The company's operating characteristics, including its size and complexity; Note: The size and complexity of a company might affect the risks of misstatement and how the company addresses those risks.

The sources of the company's earnings, including the relative profitability of key products and services; and Key supplier and customer relationships.

4. Company Objectives, Strategies, and Related Business Risks:- The purpose of obtaining an understanding of the company's objectives, strategies, and related business risks is to identify business risks that could reasonably be expected to result in material misstatement of the financial statements.

5. Obtaining an Understanding of Internal Control Over Financial:- The auditor should obtain a sufficient understanding of each component of internal control over financial reporting ("understanding of internal control") to

(a) identify the types of potential misstatements,

(b) assess the factors that affect the risks of material misstatement, and

(c) design further audit procedures.

The nature, timing, and extent of procedures that are necessary to obtain an understanding of internal control depend on the size and complexity of the company; the auditor's existing knowledge of the company's internal control over financial reporting; the nature of the company's controls, including the company's use of IT; the nature and extent of changes in systems and operations; and the nature of the company's documentation of its internal control over financial reporting.

6. Company’s Risk Assessment Process: - The auditor should obtain an understanding of management's process for:

a. Identifying risks relevant to financial reporting objectives, including risks of material misstatement due to fraud ("fraud risks");

b. Assessing the likelihood and significance of misstatements resulting from those risks; and

c. Deciding about actions to address those risks.

Obtaining an understanding of the company's risk assessment process includes obtaining an understanding of the risks of material misstatement identified and assessed by management and the actions taken to address those risks.

7. Control Activities: - The auditor should obtain an understanding of control activities that is sufficient to assess the factors that affect the risks of material misstatement and to design further audit procedures. As the auditor obtains an understanding of the other components of internal control over financial reporting, he or she is also likely to obtain knowledge about some control activities. The auditor should use his or her knowledge about the presence or absence of control activities obtained from the understanding of the other components of internal control over financial reporting in determining the extent to which it is necessary to devote additional attention to obtaining an understanding of control activities to assess the factors that affect the risks of material misstatement and to design further audit procedures.