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The auditor should obtain an understanding of the following five elements of the entity and its environment:

1 External factors, including:Industry factors, such as the competitive environment, supplier and customer relationships, and technological developments.The regulatory environment, which includes the applicable financial reporting framework, the legal and political environment, and environmental requirements that affect the industry.Other matters, such as general economic conditions.

2 Nature of the client, which includes its operations, its ownership, governance, the types of investments it makes and plans to make, how it is financed, and how it is structured.

3 Accounting policies, including the entity’s selection and application of accounting policies, the reasons for any changes, and 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.

4 Objectives and strategies and related business risks, which may result in material misstatement of the financial statements taken as a whole or as individual assertions.

5 Measurement and review of the client’s financial performance, which tell the auditor which aspects of the client’s performance management considers important.

(AU-C 315.12)

NOTE: The purpose of understanding the entity and its environment is to help identify and assess risk. For example:

 Information about the client’s industry may allow the auditor to identify characteristics of the industry that could give rise to specific misstatements.

 Information about the ownership of the client, how it is structured, and other elements of its nature will help identify related-party transactions that, if not properly accounted for and adequately disclosed, could lead to a material misstatement.

 The auditor’s identification and understanding of the business risks facing the entity increase the chance of identifying financial reporting risks.

 Information about the performance measures used by the entity may lead the auditor to identify pressures or incentives that could motivate entity personnel to misstate the financial statements.

 Information about the design and implementation of internal control may identify deficiencies in control design, which increase the risk of material misstatement.

NOTE: Obtaining an understanding of the entity and its environment also allows the auditor to make judgments about other audit matters, such as:

 Materiality

 Whether the entity’s selection and application of accounting policies are appropriate and financial statement disclosures are adequate

 Areas where special audit consideration may be necessary—for example, related-party transactions

 The expectation of recorded amounts used for performing analytical procedures

 The evaluation of audit evidence