There are three types of audit risk. These types of audit risk include inherent risk, control risk, and detection risk.
The nature of the business brings inherent risk. The business cannot bypass inherent risk if they need to operate. For instance, the business operates in a highly regulated industry, there is a risk of non-compliance with the applicable rules. So, this risk is brought by the operations of the business. Hence, it’s inherent in the business and needs to be managed.
It’s important to note that the company’s management is responsible for installing safeguards against risk. It’s not the responsibility of the auditor.
Control risk is when a financial statement may contain errors because of a deficiency in the internal control system. This deficiency of internal controls can lead to undocumented transactions and erroneous accounting treatment for the revenue, expenses, assets, liabilities, profit/loss etc.
Further, it’s important to note that the company’s management is responsible for implementing a system of internal controls that lead to strong financial reporting and a strong control environment.
However, if the control risk is higher, the auditor must extend their sample and audit procedures.
Detection risk means that the auditor may not be able to detect material misstatement due to sampling during an audit. As we know the accounting ledger contains thousands of accounting entries and it’s impossible to check each transaction in the ledger and perform tracing or vouching. So, sampling is used to select transactions. However, the risk is that the auditor may not select transactions that contain material misstatement. So, these transactions remain unchecked and full of error.
The auditor can manage this risk by changing the size of a sample. For instance, the auditor can increase sample size to reduce detection risk. On the other hand, auditor can decrease sample size if the overall risk is lower.
Components of audit risk
There are two components of audit risk. These components include the following.
- Risk of material misstatement – Inherent risk and control risk combine to make the risk of material misstatement. This is the risk of the financial statement before an audit is conducted.
- Detection risk is the risk that auditors may not be able to detect transactions that contain errors.
So, overall audit risk is composed of risk of material misstatement and detection risk. The auditor can significantly impact the detection risk to manage overall risk. So, if the risk of material misstatement is higher, an auditor needs to lower the detection risk by increasing the sample size. In simple words, if inherent risk and control risk is higher, an auditor needs to lower detection risk by increasing the sample size.
Conclusion on types of audit risk
There are three types of audit risk. These risks include inherent risk, control risk, and detection risk. Business operations bring inherent risk. For instance, the business needs to comply with applicable regulations. This risk is born with the birth of a business.
Control risk is due to a deficiency in the internal control systems. Lack of controls on the accounting transaction/documentation leads to errors.
Detection risk is about sampling. If the sample size is larger, the detection is risk is lower and vice versa.