A preliminary knowledge of the client's business is needed in order to determine whether or not to accept the audit of the financial statements of a prospective client or to continue with the audit of the financial statements of an existing client. The knowledge is preliminary because in many instances, particularly in the case of prospective clients, a more detailed knowledge of the business may not be possible as the auditor may not have access to the potential client's records and staff.
This preliminary knowledge includes a general knowledge of the ownership, operations, the the control environment, and management of the client, a general knowledge of the economy and industry within which the entity operates, its financial performance and reporting framework, and a more particular knowledge of how the entity operates, including knowledge of the financial results of prior years. During this audit stage, auditors also obtain an understanding of the entity's accounting policies and whether or not these policies are appropriate and relevant to the business of the entity. The knowledge should be sufficient to identify and assess both the acceptable and achievable audit risk at the financial statement level (AR*1 and AR1).
The auditor obtains this knowledge by performing various activities including observation, inspection, inquiry and analytical procedures such as ratio analysis and common size analysis.
ISA315 suggests a number of sources for obtaining this knowledge, such as through previous audit or consulting experience, a visit to the premises, inquiry of other auditors/advisers with industry/client experience, inspection of industry publications, inquiry of client personnel, inspection of published financial information, inspection of internal documents, and the performance of analytical procedures. Some of this information may be included in charts and tables to facilitate understanding. (See the Journal of Accountancy article Charts in Real Time.)
In the case of a prospective client, access to some of the above information may not be made available, in which case the auditor may have difficulty in assessing whether or not to accept the entity as a client. For continuing engagements, auditors update and re-evaluate information previously gathered, including information contained in prior year's working papers.
Ratio analysis is a type of analytical procedure that is used to obtain a better understanding of an entity’s business. Ratio analysis used for this purpose involves a comparison of the actual value of a ratio (e.g. gross profit ratio, debt to equity ratio) with the expected value. The expected value may be based on, for example, prior period values, values in other divisions of the company and/or industry averages. (A useful source of industry information, particularly for auditors in the USA, is BizStats.com, which provides access to financial ratios, business statistics and benchmarks for a wide variety of businesses and industries.)
Common size analysis is a type of cross-sectional analysis used for comparing the percentage of components of balance sheets and profit and loss statements of one entity with comparable data from one or more other entities. This analysis is used particularly for the comparison of a client's results with the industry average and/or an industry competitor.
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