The audit risk is that auditors might issue an inappropriate audit report. It’s a prime business risk for audit firms that might bring reputational losses. So, auditors need to manage audit risk with a proactive approach.
To manage audit risk, auditors need to understand the components of audit risk and how things can be managed.
Components of audit risk
There are two parts of audit risk. These risks include the risk of material misstatement and the risk of detecting material misstatement during a performance of audit procedures.
Risk of material misstatement
Risk of material misstatement = control risk + inherent risk
Control risk depicts that the controls mechanism implemented by management is not adequate to execute financial operations efficiently. In other words, there may be significant gaps in the control processes leading to a higher risk of material misstatement.
If there is a higher control risk, there are higher chances of errors and fraud. For instance, the audit client does not have segregation of duties for cheques clearance, approval, and posting; there is a higher chance that staff with such massive power can conduct fraud.
Hence, if auditors find that controls are weak, it leads them to assess a higher risk of material misstatement and vice versa.
Further, it’s important to note that control risk can arise at the following two stages of an audit including.
- Bookkeeping level – At this level, control can be weak when verifying authorization, approval, and other checks related to accuracy. It’s an operational stage.
- Financial statement level – At this level, weak controls can lead to a material misstatement in the financial statement. For instance, using an inadequate financial reporting framework while preparing financial statements can lead to material misstatement.
Auditor’s understanding for the internal controls on financial reporting enables them to assess the control risk.
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Inherent risk is brought by the business operations of an audit client. Such risk is brought by multiple factors other than weak internal controls.
In simple words, if business operations are complex, inherent risk is expected to be higher and vice versa. Similarly, inherent risk is higher when the business needs to apply complex and judgmental accounting concepts. For instance, inventory valuation at oil and gas industries can be complex, leading to a somewhat higher risk of material misstatement in area of inventory.
There can be thousands of reasons and situations contributing to the inherent risk. Some of these are given below to clear your concept.
- Related party transactions carry an inherent risk.
- Application of complex accounting standards involving a higher degree of judgment.
- Lower integrity of management.
- The business has implemented performance-related pay for the management.
- There is a higher volume of transactions.
- There is a massive scale of judgment in business operations.
- There are new accounting pronouncements applicable to the business.
- Management is inefficient.
- There is a higher degree of misappropriation and susceptibility for the business.
- Inventory carried by the business is special in nature.
- The business operates under different regulations.
- Strict regulation applies to the business. For instance, banking, insurance, and leasing companies.
It’s important to note that extensive business understanding enables auditors to assess the inherent risk of material misstatement.
Detection risk is the risk that audit procedures may not detect material misstatement in the financial statement.
This is an area where the auditor can have significant influence, as auditors can manage detection risk by fluctuating samples. For instance, if auditors increase sample size, there are lower chances that misstatement will remain undetected. Hence, there is lower detection risk.
We can conclude that overall audit risk can be managed via adjusting detection risk. So, if the risk of material misstatement (control risk + inherent risk) is higher, sampling can be increased. This will lead to a decrease in sampling risk and overall adjustment for the audit risk.
This can be further understood as follows,
Audit risk = risk of material misstatement + detection risk
So, if the risk of material misstatement is higher, the auditor needs to lower detection risk. Hence, overall audit risk can be limited.
Further, it’s important to note that detection risk can be decreased by increasing sample size. To be conclusive, if the risk of material misstatement is higher, detection risk needs to be lower by increasing the sample.
Audit risk is the risk/probability that an auditor’s report may be inappropriate. It may be taken as an auditor may issue a clean audit report when there is a material misstatement in the financial statement.
There are two components of audit risk: risk of material misstatement and detection risk. The risk of material misstatement further includes control risk and inherent risk.
Control risk arises due to failure in the controls implemented by the business. While, inherent risk arises due to business nature, operations, complex transactions, and other related factors.