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Understanding Audit Risk Components

Audit risk refers to the risk that a company's financial statements contain material misstatements, despite an audit opinion stating the statements are fairly presented. It has two components - the risk of material misstatement in the financials prior to the audit, and detection risk that the audit procedures fail to identify any material misstatements. Auditors perform procedures to reduce audit risk to an acceptable level and provide assurance to financial statement users. However, audit risk also carries potential legal liability for auditors, which is why auditing firms purchase malpractice insurance.

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10 views2 pages

Understanding Audit Risk Components

Audit risk refers to the risk that a company's financial statements contain material misstatements, despite an audit opinion stating the statements are fairly presented. It has two components - the risk of material misstatement in the financials prior to the audit, and detection risk that the audit procedures fail to identify any material misstatements. Auditors perform procedures to reduce audit risk to an acceptable level and provide assurance to financial statement users. However, audit risk also carries potential legal liability for auditors, which is why auditing firms purchase malpractice insurance.

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Niño Rey Lopez
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© All Rights Reserved
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Audit Risk

What Is Audit Risk?


Audit risk is the risk that financial statements are materially incorrect, even
though the audit opinion states that the financial reports are free of any material
misstatements.

KEY TAKEAWAYS

 Audit risk is the risk that financial statements are materially incorrect, even
though the audit opinion states that the financial reports are free of any
material misstatements.
 Audit risk may carry legal liability for a CPA firm performing audit work.
 Auditing firms carry malpractice insurance to manage audit risk and the
potential legal liability.
 The two components of audit risk are the 'risk of material misstatement'
and 'detection risk'.
Understanding Audit Risk
The purpose of an audit is to reduce the audit risk to an appropriately low level
through adequate testing and sufficient evidence. Because creditors, investors,
and other stakeholders rely on the financial statements, audit risk may carry legal
liability for a CPA firm performing audit work.

Over the course of an audit, an auditor makes inquiries and performs tests on the
general ledger and supporting documentation. If any errors are caught during the
testing, the auditor requests that management propose correcting journal entries.

At the conclusion of an audit, after any corrections are posted, an auditor


provides a written opinion as to whether the financial statements are free of
material misstatement. Auditing firms carry malpractice insurance to manage
audit risk and the potential legal liability.

The two components of audit risk are the risk of material misstatement and
detection risk. Assume, for example, that a large sporting goods store needs an
audit performed, and that a CPA firm is assessing the risk of auditing the
store's inventory.

1. Risk of Material Misstatement - The risk of material misstatement is the


risk that the financial reports are materially incorrect before the audit is
performed. In this case, the word "material" refers to a dollar amount that is
large enough to change the opinion of a financial statement reader, and
the percentage or dollar amount is subjective. If the sporting goods store's
inventory balance of $1 million is incorrect by $100,000, a stakeholder
reading the financial statements may consider that a material amount. The
risk of material misstatement is even higher if there is believed to be
insufficient internal controls, which is also a fraud risk.
2. Detection Risk - Detection risk is the risk that the auditor’s procedures do
not detect a material misstatement. For example, an auditor needs to
perform a physical count of inventory and compare the results to the
accounting records. This work is performed to prove the existence of
inventory. If the auditor's test sample for the inventory count is insufficient
to extrapolate out to the entire inventory, the detection risk is higher.

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