Understanding the client entity and its environment in selected Maltese audit firms : an evaluation

Abstract

Understanding the client entity and its environment is one of the most fundamental stages in the audit process. It entails auditors to perform audit procedures so as to understand internal and external matters about their clients. Such process has lately gained significant importance owing to the fact that it is a major contributor to reducing audit risk, enhancing the quality of audits and augmenting the confidence in the auditing profession; objectives which the profession has been striving to achieve since the occurrence of the recent worldwide scandals. Principally through personal in-depth semi-structured interviews, this dissertation aims at evaluating the approach of different-sized local audit firms to the understanding of the entity and its environment. The study seeks to identify the perceived significance of understanding the entity and its environment, to examine the matters which auditors consider and the audit procedures and sources of information which they use for understanding the entity and its environment, and to identify other considerations pertinent to such process. Barriers for a more effective process are also analysed. The study concludes that the primary aim of understanding the entity and its environment is that of identifying and assessing the risks of material misstatement of the financial statements whether due to fraud or error. Gaining knowledge about the client is also vital for designing and performing further audit procedures effectively and efficiently as well as for providing a better service to clients. The matters mostly considered in understanding clients are legislation and regulation, taxation, general level of economic activity, and the nature of revenue sources. The most frequently used audit procedures and sources of information for understanding the entity and its environment are discussions with management and other key personnel, auditors’ previous experience and preliminary analytical procedures. The study also concludes that the effectiveness of the process is hampered by lack of communication and interviewing skills, by the lack of documentation and disorganization present in the local small and family businesses as well as by the lack of availability of industry information and business statistics. ‘The local businesses’ reluctance to divulge information and culture that resists collaboration with auditors are other barriers for a more effective process. The familiarity which Maltese auditors enjoy with their clients is another perceived hindrance by many audit firms. KEY WORDS: Understanding the entity and its environment; matters; audit procedures and sources of information, barriers; local audit firms.