REVIEWING THE CLIENT’S OPERATIONAL BACKGROUND WITH REGARD TO ITS FINANCIAL, LEGAL AND PERSONNEL SITUATIONS AND THE INDUSTRY ENVIRONMENT IN WHICH IT OPERATES

Auditors should have or obtain knowledge of the business of the entity to be
audited which is sufficient to enable them to identify and understand the events,
transactions and practices that may have a significant effect on the financial
statements or the audit thereof.
Knowledge of the business is used by auditors in:
(a) Assessing risks of error;
(b) Determining the nature, timing and extent of audit procedures; and
(c) Considering the consistency and reliability of the financial statements
as a whole when completing the audit.
The auditors’ level of knowledge for an engagement normally includes:
(a) General knowledge of the economy and the industry within which an
entity operates; and
(b) A more particular knowledge of how the entity operates. The level of
knowledge required by auditors is less than that possessed by the
directors.
The extent to which auditors need to formally document their knowledge of the
business depends:
(a) Upon its complexity and the number of persons who will be engaged on
the audit; and
(b) The need to cover possible departure, illness or incapacity of key
members of the audit team.
Auditors prepare such documentation to a level sufficient to facilitate proper
planning of the audit.

Matters to Consider in Relation to Knowledge of the Business

The auditor should consider the following matters in relation to knowledge of
the business:

General Economic Factors

(a) General level of economic activity (for example recession, growth);
(b) Interest rates and availability of financing;
(c) Inflation;
(d) Government policies:
(i) monetary policies,
(ii) fiscal policy,
(iii) taxation – corporate and others,
(iv) financial incentives (for example government aid programmes),
(v) tariffs, trade restrictions; and
(e) Foreign currency rates and controls.

The Industry – Conditions Affecting the Client’s Business

(a) The market and competition;
(b) Cyclical or seasonal activity;
(c) Changes in product technology;
(d) Business risk (for example high technology, high fashion, ease of entry
for competition);
(e) Declining or expanding operations;
(f) Adverse conditions (for example declining demand, excess capacity, and
serious price competition);
(g) Key ratios and operating statistics;
(h) Specific accounting practices and problems;
(i) Environmental requirements and problems;
(j) Regulatory framework; and
(k) Specific or unique practices (for example relating to labour contracts,
financing methods, accounting methods).

The Entity

Directors, management and ownership
(a) Corporate structure – private, public, government (including any recent
or planned changes);
(b) Beneficial owners, important stakeholders and related parties, local,
foreign, business reputation and experience) and any impact on the
entity’s transactions;
(c) The relationships between owners, directors and management;
(d) Attitudes and policies of owners;
(e) Capital structure (including any recent or planned changes); and
(f) Organisational structure.

Group Structure

(a) Subsidiaries’ audit arrangements;
(b) Directors’ objectives, philosophy, strategic plans;
(c) Acquisitions, mergers or disposals of business activities (planned or
recently executed);
(d) Sources and methods of financing (current, historical);
(e) Board of directors;
(f) Composition of board;
(g) Business reputation and experience of individuals independence from
and control over operating management;
(i) Frequency of meetings;
(j) Existence and membership of audit committee and scope of its activities;
(k) Existence of policy on corporate conduct; and
(l) Changes in professional advisors (for example lawyers).

Operating Management

(a) Experience and reputation;
(b) Turnover;
(c) Key financial personnel and their status in the organisation;
(d) Staffing of accounting department;
(e) Incentive or bonus plans as part of remuneration (for example based on
profit;
(f) Use of forecasts and budgets;
(g) Pressures on management (for example over-extended dominance by
one individual, support for share price, unreasonable deadlines for
announcing results);
(h) Management information systems;
(i) Internal audit function (existence, quality); and
(j) Attitude to internal control environment.
The entity’s business - products, markets, suppliers, expenses, operations
(a) Nature of business (for example, manufacturer, wholesaler, financial
services, import/ export);
(b) Location of production facilities, warehouses, offices;
(c) Employment (for example, by location, supply, wage levels, union
contracts, pension commitments, government regulation);
(d) Products or services and markets (for example, major customers and
contracts, terms of payment, profit margins, market share, competitors,
export, pricing policies,reputation of products, warranties, order books,
trends, marketing sategy and objectives manufacturing processes);
(e) Important suppliers of goods and services (for example, long-term
contracts, stability of supply, terms of payment, imports, methods of
delivery);
(f) Stocks (for example, locations, quantities);
(g) Franchise, licences, patents;
(h) Important expense categories;
(i) Research and development;
(j) Foreign current assets, liabilities and transactions by currency, hedging;
(k) Legislation and regulations that significantly affect the entity;
(l) Infomation systems – current, plan to change; and
(m) Debt structure, including covenants and restrictions.
Financial performance - factors concerning the entity’s financial condition and
profitability are as follows:
(a) Accounting policies;
(b) Earnings and cash flow trends and forecasts;
(c) Leasing and other financial commitments;
(d) Availability of lines of credit;
(e) Off balance sheet finance issues;
(f) Foreign exchange and interest rate exposures; and
(g) Comparison with industry trends.
Reporting environment: external influences which affect the directors in the
preparation of the financial statements are as follows:
(a) Legislation;
(b) Regulatory environment and requirements;
(c) Taxation;
(d) Accounting requirements;
(e) Measurement and disclosure issues peculiar to the business;
(f) Audit reporting requirements; and
(g) Users of the financial statements.
(Source: ACCA Auditing Handbook 2004/2005)

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