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high, may enable the auditor to conduct a more efficient and effective audit.
Control Risk
.55 An understanding of the control environment is essential to the understanding of control risk. The auditor considers the overall influence of the owner-manager and other key personnel. For example, the auditor considers whether the owner-manager displays a positive control consciousness and considers the extent to which the owner-manager and other key personnel are actively involved in day-to-day operations.
.56 After obtaining an understanding of the accounting and internal control systems, the auditor makes a preliminary assessment of control risk, at the assertion level, for each material account balance or class of transactions. Substantive procedures may be reduced if reliance on these controls is warranted after investigation and testing. However, many internal controls relevant to large entities are not practical in the small entity, and as a result it may not be possible to rely on internal control to detect fraud or errors. For example, segregation of duties may be severely limited in small entities because accounting procedures may be performed by few persons who may have both operating and custodial responsibilities. Similarly, when there are few employees, it may not be possible to set up a system of independent checking of their work.
7 AUS 402, “Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement” and AUS 406, “The Auditor’s Procedures In Response to Assessed Risks” issued in February 2004 contain small entity audit considerations and are applicable for audits of a financial report for periods commencing on or after 15 December 2004. Paragraphs .54 to .65 of this AGS will be withdrawn when these new AUSs become effective .57 Inadequate segregation of duties and the risk of error may, in some cases, be offset by other control procedures such as the exercise of strong supervisory controls by the owner-manager means of direct personal knowledge of the entity and involvement in transactions. However this, in itself, may introduce other risks such as the potential for management override and fraud. Particular difficulties include the possible understatement of income by the non-recording or misrecording of sales. In circumstances where segregation of duties is limited and evidence of supervisory controls is lacking, the audit evidence necessary to support the auditor’s opinion on the financial report may have to be obtained entirely through the performance of substantive procedures.
.58 The auditor of a small entity may decide, based on the auditor’s understanding of the accounting system and control environment, to assume that control risk is high without planning or performing any detailed procedures (such as tests of controls) to support that assessment. Even where there appear to be effective controls it may be more efficient for the auditor to confine audit procedures to those of a substantive nature.
.59 The auditor makes management aware of material weaknesses in the design or operation of the accounting and internal control systems that have come to the auditor’s attention. Recommendations for improvement may also be made in this communication. Such recommendations are particularly valuable for the development of the small entity’s accounting and internal control systems.
Detection Risk
.60 The auditor uses the assessments of inherent and control risk to determ