Even if the audit opinion states that there are no material misstatements, audit risk is the possibility that financial statements are materially incorrect. Different types of audit risks may expose a certified public accounting (CPA) firm to legal liability. When the financial statements are materially incorrect, the auditor faces audit risk. Audit risk is proportional to the risk of material misstatement and detection.
Audit risk is comprised of two components: the risk of material misstatement and the risk of risk identification. For example, a large sporting goods store requires an audit, and a CPA firm assesses the risk of auditing the store’s inventory. When an auditor examines a client’s financial statements, errors or fraud may be overlooked. Auditors can reduce auditing risk by increasing the number of audit procedures used.
Types of Audit Risks
Because users of financial statements rely on auditors’ assurances when they read an organization’s financial statements, reducing audit risk to a manageable level is an essential part of the audit function. These risks can be classified into three types by auditors. These are their names:
- Inherent risk,
- Detection Risk,
- Control Risk.
What is Inherent Risk?
Inherent risk is the risk presented by a company’s financial error or omission of documents or statements caused by a factor other than a failure of internal control. Auditors and researchers must watch for inherent risk when evaluating financial statements. The inherent risk is greatest when management must use significant judgment and approximation in recording a transaction or when complex financial instruments are involved.
Origin
This risk is likely to occur in a financial audit when transactions are complicated, or financial assumptions require a high degree of judgment. Inherent risk, control risk, and detection risk constitute one of the risks auditors and researchers must look for when evaluating financial statements. Because of complicated regulatory requirements and the utilization of difficult-to-assess financial tools, it is usually in the finance industry.
Examples for the Types of Audit Risks
When multiple activities or the same action are performed multiple times, some activities are likely prone to error. For example, purchase transactions from a vendor with multiple transactions may not be recorded or are recorded with the incorrect amount.
Non-routine accounts or transactions may be dangerous. For example, accounting for fire damage or acquiring another company is unusual enough that auditors risk focusing on it too much or too little.
The level of risk present to achieve a corporation’s objectives before taking actions to reduce the risk’s impact or likelihood is typically defined as an inherent risk. After the organism’s feedback has been formulated and implemented, the degree of risk is referred to as the residual risk.
How To Reduce Inherent Risk?
Even when an auditor determines that the inherent and control risks are high, they can reduce the overall audit risk by lowering the detection risk. This can be accomplished by conducting targeted audits or using larger sample sizes. Implementing or strengthening internal controls is one of the most effective ways for organizations to minimize their inherent risk level. External auditors frequently audit corporate financial statements and internal controls. In either case, auditors are responsible for identifying any errors or inconsistencies. The danger posed by these errors is known as an inherent risk.
What is Detection Risk?
In a financial statement audit, detection risk refers to the possibility that the auditor’s processes will fail to detect an existing and potentially material misstatement, alone or combined with other misstatements.
Origin
When an auditor does not recognize a material misstatement in a firm’s financial statements, there is a risk of detection. Audit risk is classified into three types: detection risk, inherent risk, and control risk.
To reduce the risk of detection, auditors must adhere to proper audit procedures. There will always be some detection risk, but the auditor’s goal is to reduce it enough to keep the overall audit risk at an acceptable level.
Examples
When an organization offers non-assurance offerings to an audit client that have a tangible impact on their financial statements, the detection risk is high. This is because of the decrease in the firm’s ability to detect misstatements. Auditors can reduce detection risk by reorganizing the audit team so that those who worked on non-assurance engagements no longer work on the audit team and have the work reviewed by a highly competent independent auditor.
When more intensive testing is carried out on transaction data just before, and after the end of the fiscal year, detection risk in the areas of inventory and cost of sales is reduced. When the auditor’s assessment of the risk of material misstatement near the end of the year is high but low for the rest of the year, the auditor focuses on cut-off testing.
How To Reduce Risk?
Auditor detection risk can be reduced by performing additional substantive tests and assigning the most experienced staff to an audit. Some of the tests that can be performed are classification testing, completeness testing, occurrence testing, and valuation testing. The nature, timing, and scope of the auditor’s substantive procedures reduce detection risk. The auditor should obtain more evidence from substantive procedures as the appropriate level of detection risk decreases.
What is Control Risk?
Control risk is the risk that internal management arrangements will fail to detect and correct material deviations promptly. Control risk is a misstatement caused by error or fraud in an assertion that could be material, either alone or in combination with other misstatements, and that will not be prevented or detected promptly by the company’s internal control.
Origin
Control risks arise due to a company’s internal control system’s limitations. Internal control systems reviewed regularly are more likely to retain their effectiveness over time. Management should review and update the internal control system on an annual basis.
Control risks arise due to a company’s internal control system’s limitations. Internal control systems reviewed regularly are more likely to retain their effectiveness over time. Management should review and update the internal control system on an annual basis.
Examples
For example, internal control may be in place that requires monthly bank statement reconciliation. There is a risk that bank reconciliations for any month must be adequately prepared or reviewed, resulting in an incorrect bank balance. Control risks include, among other things, cybersecurity risks, integrity and moral risks, fraud risks, and poor business system designs.
Control risk monitoring is an essential function of a company’s accounting department. Controllable risk factors are those that you can change or influence. Uncontrollable risk factors are those over which you have no control. While having multiple risk factors increases your chances of developing cardiovascular disease, having just one does not.
How To Reduce Control Risk?
There is a distinct method for lowering control risk. The following are the appropriate steps for assessing control risk:
- Consider knowledge gained in advance procedures to gain an understanding
- Determine any potential errors.
- Determine the controls that are required.
- Control tests should be carried out.
- Assess the scientific proof and make a decision
References
- TUOVILA. (2022, July 28). Inherent Risk: Definition, Examples, and 3 Types of Audit Risks. Investopedia.
- Types of Audit Risks and Their Sources. (2020, August 17). Back Office Partners | Accounting Firm Johor Bahru.
- Sinra. (2017, January 5). 3 Types of Audit Risk: Definition | Model | Example | Explanation. Wikiaccounting.
- Bragg, S. (2022, December 26). Audit risk definition — AccountingTools.
- TUOVILA. (2021, February 27). Detection Risk: Definition, Main Components, Analysis, and Example. Investopedia.
- Jan. (2020, February 15). Detection Risk. Detection Risk (Audit) | Factors | Examples.
- Control Risk In Auditing: Steps of Assessing Control Risk. (2019, October 29). iEduNote.
- Bragg, S. (2022, May 24). Detection risk definition — AccountingTools.
- Auditing Standard No. 8. (2022). Default.
- Control risk. (2022). Control Risk.
- Diaz. (April 6, 2022). Inherent risk vs control risk overview differences examples.
- Wing, J. (2016, January 7). Risk Factors and Common Types of Cardiovascular Disease. Florida Medical Clinic.
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