Audit Risk

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Audit Risk

Key takeaways
* Audit risk is the risk that financial statements are materially incorrect even though the auditor issues an unqualified opinion.
* It creates potential legal liability for the audit firm; firms commonly carry malpractice insurance to manage that exposure.
* Audit risk has two main components: risk of material misstatement and detection risk.
* Auditors reduce audit risk by performing adequate tests and obtaining sufficient evidence.

What audit risk is

Audit risk is the possibility that financial statements contain material misstatements but the audit fails to detect them and issues an opinion that the statements are free of material misstatement. Because stakeholders—creditors, investors, regulators—rely on audited financials, audit risk can lead to legal and reputational consequences for the audit firm.

How an audit addresses risk

An audit reduces audit risk to an appropriately low level through a combination of risk assessment, inquiry, testing, and corroborating evidence. Typical audit activities include:
* Inquiries of management and staff.
* Tests of the general ledger and supporting documents.
* Physical verification procedures (for example, inventory counts).
* Requesting management to record correcting journal entries when errors are found.
* Issuing a written opinion after corrections and audit procedures are completed.

Components of audit risk

Audit risk is commonly viewed as comprising two components:

  1. Risk of material misstatement (RMM)
  2. The risk that the financial statements are materially incorrect before the audit begins.
  3. “Material” refers to an amount large enough to influence a user’s decisions; the threshold is subjective.
  4. RMM is higher when internal controls are weak or when fraud risk exists.

  5. Example: If a company reports $1,000,000 of inventory but it is understated or overstated by $100,000, many users may view that as material.

  6. Detection risk

  7. The risk that audit procedures fail to detect an existing material misstatement.
  8. Detection risk increases when audit procedures are inadequate—for example, when sample sizes are too small to support extrapolation to the whole population.
  9. Example: During an inventory audit, if the auditor’s sample of items for physical count is too limited, misstatements could go undetected.

Mitigating audit risk

Auditors manage and reduce audit risk by:
* Designing and performing sufficient and appropriate audit procedures based on assessed risks.
* Increasing substantive testing and sample sizes when risk is higher.
* Performing physical verification and confirmations where relevant.
* Evaluating and testing internal controls and adjusting substantive procedures if controls are weak.
* Documenting findings and obtaining management’s corrections before issuing the audit opinion.

Conclusion

Auditors cannot eliminate audit risk entirely, but through risk assessment, targeted testing, and sufficient evidence they aim to reduce it to an acceptably low level. Audit firms also manage residual legal exposure through professional liability insurance.