What is Audit Risk?
Audit risk is the probability that the financial statements of the company contain the error which is material to the company even though the same has been verified and audited by the auditor of the company without any qualification with respect to it.
In simple terms, Audit risk is defined as the risk of financial statements not being truly representative of an actual financial position of the organization or a deliberate attempt to conceal the facts even though audit opinion confirms that statements are free from any material misstatement. This risk can have a bearing on shareholders, creditors, and prospective investors.
- This risk may arise due to any one or both of the two – Clients or Auditors.
- This risk may be due to two reasons – mistakes/errors or a deliberate misstatement.
Top 3 Types of Audit Risks
Following are the Top 3 Types:
#1 – Inherent Risks
Inherent risk is the risk that could not be prevented due to uncontrollable factors, and it is also not found in Audit.
Example: transactions involving high-value cash amount carry more inherent riskInherent RiskInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization. than the transaction involving high-value cheques.
Sources of Inherent Risk:
- Complex business transactionsBusiness TransactionsA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements. involving derivative instruments;
- Transactions requiring a high level of judgment which may lead to the risk of not being identified;
- Industry having frequent technological developments may expose the firms to technology obsolescence risk.
- A company that has already misreported certain figures in the past may be more likely to misreport it again.
#2 – Control Risks
Control Risk is the risk of error or misstatement in financial statements due to the failure of internal controls.
Example: Failure on the part of management to control and prevent transaction carried out by staff who is not authorized to carry out those transactions in the first place.
Sources of Control Risk:
- Failure of management to instill proper and effective internal controlInternal ControlInternal control in accounting refers to the process by which a company implements various rules, policies, or procedures to ensure the accuracy of accounting and finance information, safeguard the various assets of the business, promote accountability in the business, and prevent the occurrence of frauds in the company. for financial reporting.
- Failure to ensure proper segregation of duties among people responsible for financial reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. ;
- The non-existence of the culture of proper documentation and filing;
#3 – Detection Risks
Detection risk is the risk of failure on the part of the Auditor to detect any errors or misstatements in financial statements, thereby giving an incorrect opinion about the financial statements of the firm.
Example: Failure by Auditors to identify the continuous misreporting of financial statements by the company.
Sources of Detection Risk:
- Poor audit planning, selection of wrong audit procedures on the part of the auditor;
- Poor interaction and engagement with audit management by Auditor;
- Poor understanding of the client’s business and complexity of financial statements;
- Wrong selection of sample size.
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Audit Risk Formula
Overall the Risk is calculated by combining all the above three types of audit risks. The formula is as follows:
Based on the above risk factors, AuditorsAuditorsAn auditor is a professional appointed by an enterprise for an independent analysis of their accounting records and financial statements. An auditor issues a report about the accuracy and reliability of financial statements based on the country's local operating laws. can arrive at the level of risk and decide on the strategy to deal with it.
How to Minimise Audit Risk?
- Having a strong Audit team that has sufficient knowledge of the business and transactions involved;
- Sufficient time is provided to the team to analyze financials;
- Ensuring strong engagement with the management of the client firm to understand business philosophy and practices;
- Ensuring proper and adequate sampling techniques;
- Accurate assessment of the client’s internal control systems to know whether the control is strong or weak;
- Proper audit planning and selection of Audit procedure;
This has been a guide to Audit risk. Here we discuss the Audit risk Formula, its top 3 types including the inherent risk, control risk, and detection risk and how to reduce the same. You may learn more about Accounting basics from the following articles –