Audit risk is the risk that auditors may not be able to detect the risk of material misstatement in the accounting record of the business. When auditors accept a new audit client, they need to assess the risk of material misstatement to estimate if they can collect sufficient and appropriate audit evidence for the risk in the financing and operational business aspects.
Types of audit risk
Three types of audit risk include control risk, detection risk, and inherent risk. Let’s understand the nature of the risk and related aspects.
Control risk as audit risk
Control risk is the risk of failure in the controls implemented by the business. If the business has significant gaps in the internal controls, it’s exposed to the significant risk of misstatement and fraud. Even the business may observe loss/misappropriation of assets and resources if business operations are not conducted according to the appropriately designed workflow and processes.
The management of the business is primarily responsible for ensuring effective controls are installed in the business operations. Further, changes in the business’ operational and strategic activities should be reflected in the controls. In easy words, internal controls need to be updated if there is a change in the operational business areas.
The internal audit department of the business is expected to perform a crucial role in the area of internal controls. It’s their responsibility to test the controls, find weaknesses in the control, and implement changes leading to strength in the controls.
Detection risk refers to the risk of an auditor’s failure to detect material misstatement in the financial statement. In other words, the auditor may not design audit procedures that detect misstatement in the financial statement. So, the application of the appropriate TOCs and audit procedures helps to ensure detection risk is limited. It’s important to note that detection risk cannot be eliminated because the audit is done based on sampling, and there may be problems with the sampling and designing of the audit procedures.
Inherent risk is the natural risk of error and omissions in the financial statement. It arises due to financial and operational aspects of the business rather than a failure of internal controls. There is a higher inherence risk in the financial reporting processes where complex transactions involve more judgmental areas.
It’s also important to note that different businesses have different intensities of the inherent risk. For instance, a business with straightforward accounting is expected to have a lower level of inherent risk and vice versa.
How auditors assess the risk of material misstatement
Auditors assess the risk of a misstatement by performing the following audit procedures.
- Understanding of the business operations.
- Understanding of the internal controls.
- Understanding of the financial reporting processes.
- Performing preliminary audit procedures – PAR.
Auditing requires assessing the risk of material misstatement, designing the audit procedures, collecting audit evidence, and forming an opinion in a set of financial statements based on the work done. The process of risk assessment includes understanding business, financial reporting process, and performing preliminary audit procedures.
Further, three types of audit risk include control risk, detection risk, and inherent risk. Control risk is the risk of control failure. In other words, the business may not have strong internal controls that expose the business to the risk of material misstatement and fraud.
Detection risk is when designed audit procedures may not be adequate to limit the detection risk and lead to undetected errors and omissions.
Inherent risk arises due to the complexity of accounting and reporting functions. If the financial reporting process of the business is complex, it leads to higher inherent risk and vice versa.