Business understanding is important for auditors in the following way,
- Auditors will be able to assess the risk of material misstatement more precisely.
- It helps the auditor to identify potential business risks.
- It enables auditors to understand if they can cover the risk and issue a clean audit report.
- It enables auditors to understand market and competition.
Let’s understand the detailed aspects of the above.
1-Auditors will be able to assess risk of material misstatement more precisely.
The audit approach is dependent on risk identification, designing for audit procedures, obtaining sufficient and appropriate audit evidence, forming an opinion, and issuing the audit report.
It’s important to note that risk identification is the first step towards audit processing. In fact, auditors need to assess risk when accepting audit engagement. If the overall risk of the potential client is higher than the audit firm’s competence to cover the risk, they must withdraw from the engagement.
Further auditors identify risk from the following three main sources,
- Business/operations understanding
- Internal controls (operational and financial)
- Financial reporting
Business understanding is one of the most important sources for risk assessment. Some businesses have sensitive operations. For instance, banking operations are sensitive in terms of finance, authorization, regulations, approval etc. It means the industry is highly regulated and there is a higher risk while engaging.
On the other hand, a retail store has comparatively lower risk as their operations are not very sensitive. Hence, the risk brought by operations is lower. And even small audit firms can enter into audit engagement with them.
2-Business understanding helps the auditor to identify potential business risks.
The auditor needs to identify business risks. These risks can be identified by analyzing business operations, business model, production analysis, distribution network, supplier management, etc. Auditors need to cover identified business risks with sufficient and appropriate audit evidence. This enables them to form an opinion and issue an audit report.
3-Business understanding (BU) enables auditors to understand if they can cover the risk and issue a clean audit report.
It’s simple science that if auditors obtain sufficient and appropriate audit evidence to cover the risk, based on the audit evidence, they form an audit opinion that is not qualified and vice versa.
Sufficient audit evidence refers to the quantity of audit evidence. On the contrary, appropriateness refers to the quality of audit evidence.
4-BU will enable auditors to understand market and competition.
Business understanding enables an auditor to understand about products/services of an audit client. This further leads the auditor to research market competition and product performance.
Logical understanding of how business understanding increases audit quality
Business understanding enables an auditor to,
- Assess risk brought by business operations, products, services, marketing, distribution etc.
- Design audit procedures based on identified risk of material misstatement.
- Perform audit procedures and collect sufficient and appropriate audit evidence.
- Make an audit opinion and issue an audit report.