It is important that an auditor gain a detailed knowledge of their client. Knowledge about the entity is gained through interviewing client personnel, including those charged with governance. The auditor will ask questions about what the client does, where it does it, how it functions, how its ownership is structured, and what its sources of financing are. For new clients, this process is very detailed and time-consuming. For a continuing client, this process is less onerous and involves updating the knowledge gained on previous audits. By gaining an understanding of the client, the auditor is in a stronger position to assess entity-level risks and the financial statement accounts that require closer examination. The auditor is looking to identify business risks that will ultimately affect the financial statements. The following paragraphs outline some of the information that may be gathered by the auditor to gain an understanding of their client at the entity level. Major customers are identified so that the auditor may consider whether those customers have a good reputation, are on good terms with the client (that is, they are likely to remain a customer in future), and are likely to pay the client on a timely basis. Dissatisfied customers may withhold payment, which affects the allowance for doubtful accounts and the client's cash flow, or may decide not to purchase from the client in the future, which can affect the going concern assumption. If a client has only one or a few customers, this risk is increased. The auditor also considers the terms of any long-term contracts between their client and their client's customers. In gathering information about a client's customers, the auditor gains an understanding about the markets the client serves and how it competes in these markets. Major suppliers are identified to determine whether they are reputable and supply quality goods on a timely basis. Consideration is given to whether significant levels of goods are returned to suppliers as faulty, and what the terms of any contracts with suppliers and the terms of payment to suppliers include. The auditor also assesses whether the client pays its suppliers on a timely basis. If the client is having trouble paying its suppliers, it may have trouble sourcing goods because suppliers may refuse to transact with a company that does not pay on time. Whether the client is an importer or exporter of goods is identified. If the client trades internationally, the auditor considers the stability of the country (or countries) the client trades with, the stability of the foreign currency (or currencies) the client trades in, and the effectiveness of any risk management policies the client uses to limit exposure to currency fluctuations (such as hedging policies). The client's capacity to adapt to changes in technology and other trends is assessed. If the client is not well positioned to adjust to such changes, it risks falling behind competitors and losing market share, which in the longer term can affect the going concern assumption. If the client operates in an industry subject to frequent change, it risks significant losses if it doesn't keep abreast of such changes and "move with the times." For example, if a client sells laser printers, the auditor will need to assess whether the client is up to date with changes in technology and customer demands for environmentally friendly printers. The nature of any warranties provided to customers is assessed. If the client provides warranties on products sold, the auditor needs to assess the likelihood that goods will be returned and the risk that the client has underprovided for that rate of return (adequacy of the warranty provision). The auditor will pay particular attention to goods being returned for the same problem, indicating that there may be a systemic fault. For example, say a client sells quality pens and the auditor notices that a number of pens are being returned because the mechanism to twist the pen open is faulty. In this case, the auditor will assess the likelihood that other pens will be returned for the same reason, the steps being taken by the client to rectify the problem, and whether the provision for warranty is adequate in light of this issue. The terms of discounts given by the client to its customers and received by the client from its suppliers are reviewed. An assessment is made of the client's bargaining power with its customers and suppliers to determine whether discounting policies are putting profit margins at risk, which may place the future viability of the client at risk. An assessment is made of the client's reputation with its customers, suppliers, employees, shareholders, and the wider community. A company with a poor reputation places future profits at risk. It is also not in the best interests of the auditor to be associated with a client that has a poor reputation. An understanding is gained of client operations. The auditor will note where the client operates, the number of locations it operates in, and the dispersion of these locations. The more spread out the client's operations are, the harder it is for the client to effectively control and coordinate its operations, increasing the risk of errors in the financial statements. The auditor will need to visit locations where the risk of material misstatement is greatest to assess the processes and procedures at each site. If the client has operations in other provinces or overseas, the auditor may plan for a visit to those sites by staff from affiliated offices at those locations where risk is greatest. For example, an auditor is more likely to visit client operations if the client opens a new, large site, or if the business is located in a country where there is a high rate of inflation or where there is a high risk of theft. An understanding is gained of the nature of employment contracts and the client's relations with its employees. The auditor will consider the way employees are paid, the mix of wages and bonuses, the level of unionization among the workforce, and the attitude of staff to their employer. The more complex a payroll system is, the more likely it is that errors can occur. When staff are unhappy, there is greater risk of industrial action, such as strikes, which disrupt client operations. The auditor will also consider whether the client will be able to attract and retain the skilled employees needed to ensure its business success. The client's sources of financing are reviewed. An assessment is made of a client's debt sources, the reliability of future sources of financing, the structure of debt, and the reliance on debt versus equity financing. An auditor assesses whether the client is meeting interest payments on funds borrowed and repaying funds raised when they are due. If a client has a covenant with a debt provider, the auditor will need to understand the terms of that covenant and the nature of the restrictions it places on the client. Debt covenants vary. A company may, for example, agree to limit further borrowings. It may agree to maintain a certain debt to equity ratio. If the client does not meet the conditions of a debt covenant, the borrower may recall the debt, placing the client's liquidity position at risk and increasing the risk that the client may not be able to continue as a going concern. The client's ownership structure is assessed. A complex ownership structure may lead to more complex accounting issues, such as when an entity's financial statements include goodwill, joint ventures, special purpose entities, and investments. The auditor is also interested in the amount of debt funding relative to equity, the use of different forms of shares, and the differing rights of shareholder groups. The client's dividend policy and its ability to meet dividend payments out of operating cash flow are also of interest. Table 3.1 provides a summary of the entity-level considerations of the auditor.

TABLE 3.1 Knowledge of the businessentity-level considerations

Knowledge of the businessentity-level considerations

Who are the client's major customers? Who are the client's major suppliers?

Is the client an importer or exporter?

Is the client able to adapt to technological changes?

Does the client offer warranties with its products?

Does the client offer discounts to its customers? Is it offered discounts by its suppliers?

Does the entity have a positive reputation overall?

Where does the entity operate? Does it have one or many locations? Is it geographically dispersed?

What are the characteristics of the entity's work force? Is the payroll system complex?

What are the entity's sources of financing? What is the client's ownership structure?