MANAGEMENT CHARACTERISTICS AND INTEGRITY

3.28 The personal characteristics, philosophy, and operating style of the individuals who
comprise an entity’s management have a significant influence on the entity as a whole.
3.29 The integrity of management is fundamental to our ability to perform an audit
engagement and is a key consideration in our assessment of engagement risk. If management
does not meet an acceptable standard of integrity, we ordinarily do not wish to be associated
with the entity.
3.30 We consider whether we have reason to question the characteristics or integrity of one
or more members of management or otherwise question our ability to rely on management’s
representations. Engagement risk may be increased by the existence of one or more of the
following conditions:
 Management is involved with illegal activities.
 Management is involved with questionable activities.
 Management has frequently changed banks, attorneys, or auditors.
 Management has failed to engage reputable professional third parties.
 Significant personal difficulties in the lives of management have occurred.
 Management appears willing to accept unusually high levels of risk.
 Management is dominated by one strong personality.
 An individual with no ownership interest exercises substantial influence.
 Significant or unexpected changes in management have recently occurred.
 Management is inexperienced.
3.31 We consider whether we have reason to be concerned about management’s overall
commitment to reliable financial reporting. Engagement risk may be increased by the
existence of one or more of the following conditions:
 The company adopts controversial accounting policies.
 Management tends to interpret accounting standards aggressively.
 Management is reluctant to record adjustments proposed by the auditors.
 Transactions without substantial economic justification exist.
 A significant number of related-party transactions exist.
 Management places undue emphasis on achieving planned results.
 The entity is planning or negotiating significant new financing.
3.32 We consider our accumulated experience with management and their dealings with us
and with others to assess management’s characteristics and integrity together with their
overall commitment to reliable financial reporting.

ORGANIZATION AND MANAGEMENT STRUCTURE

3.33 The overall organization and management structure should provide an effective
framework for planning, directing, and controlling the entity’s financial operations and
reporting functions. The nature of the entity’s organization and its management structure may
indicate increased engagement risk.
3.34 Some of the following conditions may, in combination with other factors, increase the
likelihood of material misstatement; others affect engagement risk by increasing our exposure
to third parties.
3.35 We consider whether the organizational structure is appropriate in relation to the size
and nature of the business. Engagement risk may be increased by the existence of one or
more of the following conditions:
 The organizational structure is unduly complex.
 The client has undergone rapid expansion.
 The client has recently acquired other entities.
 There are a large number of decentralized operating entities.
  The reporting structure is unduly complex.
3.36 We consider whether the management structure and internal control are appropriate to
the size and nature of the business. Engagement risk may be increased by the existence of
one or more of the following conditions:
 A defined management structure is lacking, and there is a poorly defined
allocation of responsibility and accountability.
 Management’s capability or style is inconsistent with the size and growth of
the business.
 There is inadequate supervision and review of decentralized operations.
 There is inadequate supervision and review of multinational operations.
 There is insufficient supervision and review of data processing operations.
3.37 Some of the organization and management structure conditions that may indicate
increased engagement risk also affect our understanding of the control environment, as
discussed in Chapter 7 (refer to paragraphs 7.05-7.06).

NATURE OF THE BUSINESS

3.38 The nature of the business sometimes indicates increased engagement risk.
Engagement risk may be increased if the entity: B
 Has a long-term operating cycle
 Uses complex or innovative financing techniques
 Operates in a volatile industry or market
 Makes significant accounting estimates that involve greater than normal
subjectivity, complexity, or uncertainty
 Operates in an industry frequently associated with questionable or illegal
activities
 Has made a significant acquisition in the past year of an entity that operates
in an industry in which management has little or no prior experience.

BUSINESS ENVIRONMENT
3.39 Engagement risk may also be increased if the entity is particularly vulnerable to
external influences in the business environment that affect its operations and its viability as a
going concern. These external influences arise from one or more of the following conditions:
B
 The entity issues securities to the public or has broad public accountability.
 Unusual significance will be attached to the financial statements.
 The financial performance of the company is significantly better or worse
than others in the industry.
 There are pressures from regulatory authorities that may influence
management to distort financial results.
 The company is involved in a transfer of interest or a contest for control.
 Compliance with debt covenants is marginal related to financial results.
 There is pending or previous litigation against the entity.
 There are factors that indicate a deteriorating relationship with regulators.
3.40 The entity may also be vulnerable to: [Revised March 31, 1998]
 Economic events (e.g., sharp fluctuations in interest rates, commodity
prices, or foreign currency exchange rates)
 Industry conditions (e.g., overcapacity, technological change, or product
obsolescence)
 Change in government (e.g., if the business is a government contractor)
 Change in regulations (e.g., expanded reporting requirements)
 Consumer or social issues (e.g., compliance with environmental control
 standards, product liability issues)

NATURE OF THE AUDIT ENGAGEMENT

3.41 The nature of the audit engagement and our prior experience may significantly affect
our assessment of engagement risk. We also need to have a clear understanding of any
significant accounting or reporting issues.
3.42 We consider whether there are reasons to be concerned about the conditions
surrounding the audit engagement. Engagement risk may be increased by the existence of one
or more of the following conditions:
 Management has failed to give auditors full cooperation in the past.
 Management places unreasonable demands on our personnel or
unreasonable time constraints on the issuance of our reports.
 Formal or informal restrictions have been placed on us that limit our ability
to communicate effectively with senior management, board of directors, or
audit committee.
 Management has failed to volunteer information regarding significant or
unusual transactions.
 This is a first-time audit engagement.
 There were unusual or controversial circumstances associated with the
client’s decision to change auditors.
3.43 We consider whether we have reason to believe that the compliance of our audit with
generally accepted auditing standards may be questioned. Engagement risk may be increased
by the existence of one or more of the following conditions:
 Matters exist that could cause third parties to question our independence.
 Matters, such as significant litigation between this entity and another client
of the firm, exist that could cause us to be perceived as having a conflict of
interest.
 The entity, or a major segment of the entity, is likely to be sold.
 The results of our audit will be relied on by other auditors.
 Other auditors will be relied on for material portions of the work to be
performed on consolidated subsidiaries.
 Significant affiliated entities or other related parties exist that we will not
audit and with whom significant transactions might have occurred.
 We will not be able to render an unqualified report because of scope
limitations, accounting and disclosure issues, or “going concern” problems.
3.44 We consider whether there are significant accounting issues that may present greater
than normal engagement risk. Engagement risk may be increased by the existence of one or
more of the following conditions:
 The entity engages in unique, highly complex, and material transactions that
pose difficult “substance over form” questions.
 There are accounting estimates that are unusually significant because of the
nature of the industry or the relative importance in the financial statements.
 There are significant transactions with related parties.
 The entity has recently changed to a less preferable accounting method, or
such a change is under consideration.
 There are significant nonmonetary transactions.
 The financial statements include assets that have been written up in value in
connection with a purchase from a related party.
 There are unusual problems relating to a possible restatement of financial
statements, including those for interim periods.
 FINANCIAL RESULTS
3.45 Engagement risk may be increased if management is under significant pressure to
report certain financial results. Management may be under significant pressure if one or more
of the following conditions exist: B
 It is likely that the entity, or a major segment of the entity, will be sold.
 There is a perceived need to support the entity’s share price.
 A significant portion of management’s compensation is based on financial
results.
 Owners or management desire low taxable income.
 Optimistic financial forecasts have been issued, or there are high
expectations in the markets based on past earnings and share price.
 The entity is growing and is near the limit of its financial resources.
 The entity’s performance is declining sharply.
 There is doubt whether the entity will have sufficient distributable profit or
cash flow to continue making distributions at the current level.
3.46 Management may also be under pressure to manipulate earnings or financial position
if there are factors indicating that the entity may not be able to continue as a going concern for
the foreseeable future. Such factors may include:
 Insufficient working capital or credit lines to enable the business to operate
at a profitable capacity
 Requirements for new capital in excess of its availability
 Substantial debt from unusual sources (e.g., related parties) or on unusual
terms
 Violations, or apparent violations, of debt restrictions (e.g., maintenance of
working capital) or of other terms of a trust deed
 Violations, or apparent violations, of capital structure regulations
 Inability to make debt payments as scheduled or to pay other creditors
 Projections of significant cash-flow difficulties
 Loss or possible loss of a major customer or group of customers
 Existence of off-balance-sheet financing or contingent liabilities.
3.47 An increased engagement risk resulting from the possible inability of the client to
continue as a going concern should be responded to in the nature, timing, and extent of the
planned audit procedures.

BUSINESS RELATIONSHIPS AND RELATED PARTIES

3.48 Engagement risk may be increased if we do not have a clear understanding of the
nature of significant transactions and business relationships between the entity and other
entities, particularly if the other entities are presented as third parties when in fact they are
related parties. This could also affect our conclusions about management’s integrity.
For example, our ability to have a clear understanding of significant
transactions and relationships may be hindered if the organizational
structure of a group of related entities is complex, especially if we do
not audit a significant proportion of the related entities.
3.49 The existence of related parties, and transactions between such parties, in itself is not
an indication of increased engagement risk. However, we need to be aware of the possibility
that related party transactions may have been motivated by a desire to improve reported
earnings or financial position, or by fraud. We need to recognize the difficulties in detecting
fraud when there is collusion between related parties.
3.50 The existence of related parties and related party transactions may also have an effect
on the financial statements or on the application of relevant taxation laws.
3.51 In considering the existence of possible related party transactions, we focus on the
underlying and economic substance of such relationships and not merely on their legal form.

OUR PRIOR KNOWLEDGE AND EXPERIENCE

3.52 Engagement risk is typically higher in the early years of our service as auditors
because of our lack of accumulated experience with and knowledge of the client. There is
evidence that a high proportion of alleged audit failures occurs in the early years of an audit
engagement. B
3.53 Such alleged failures are due partly to the fact that unfamiliarity with the client makes
it difficult to identify many of the other factors that affect the assessment of engagement risk.
This difficulty may also arise if there are significant changes in the business, whether caused
by acquisitions or otherwise.
3.54 The quality of our services is dependent upon the professional competence of our
personnel and the availability of those personnel to perform the services. Consequently,
before accepting or continuing a client relationship or undertaking an audit engagement, we
determine that a sufficient number of competent personnel (including those having industry
expertise or, where necessary, expertise in foreign professional standards or laws) will be
available.
3.55 In those rare situations in which personnel having appropriate industry or other
expertise are not available, consultation concerning our acceptance or continuance of the audit
engagement and assistance from another office or member firm needs to be considered.

LIKELIHOOD OF INTENTIONAL MISREPRESENTATION

3.56 We need to be alert to situations that may indicate intentional misrepresentation. We
need to maintain an appropriate level of professional skepticism throughout the audit
engagement and during all contacts with the client.
3.57 Intentional misrepresentation by management of the financial statements that results in
damages to third parties and/or investors is usually described as management fraud. This is
distinguished from employee fraud, which generally refers to the defrauding of the entity by
management or employees.
3.58 Situations that are susceptible to intentional misrepresentation seldom occur in
isolation. Research and experience have shown that the likelihood of management fraud
increases when a combination or sequence of specific circumstances exist.
3.59 Common factors that are cause for concern include the following:
 Management attempts to restrict our access to people and information.
 There is a lack of supporting information for payments.
 The identity of who controls the entity is not readily determinable.
 There is rapid turnover of senior management, especially in financial areas.