Audit Risk
“Audit risk“ means the risk that the auditor gives an inappropriate audit opinion when
the financial statements are materially misstated.
Audit risk has 3 components:
I. Inherent Risk
II. Control Risk
III. Detection Risk
1 – Inherent Risks
Inherent risk is the risk which 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 risk than the transaction
involving high-value cheques.
2 – Control Risks
Control Risk is the risk of error or misstatement in financial statements due to the failure of internal
controls.
Example: Weaknesses of ICS
3 – Detection Risks
Detection risk is the risk of failure on part of Auditor to detect any errors or misstatements in financial
statements thereby giving an incorrect opinion about financial statements of the firm.
Example: Failure by Auditors to identify the continuous misreporting of financial statements by the
company.
Audit Risk Formula
Overall the Risk is calculated by combining all the above three types of audit risks. The audit risk formula
is as follows:
How to Minimize 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 proper and adequate sampling techniques.
Accurate assessment of clients internal control systems to know whether the control is
strong or weak.
Proper audit planning and selection of Audit procedure.
Audit Risk Assessment Procedures
Analytical procedures
Observation and inspection
Making Inquiries
Valuation Experts
Regulatory or financial publication
Conditions and Events That May Indicate Risks of Material Misstatement
The following are examples of conditions and events that may indicate the existence of
risks of material misstatement.
Going concern and liquidity issues.
Constraints on the availability of capital and credit.
Changes in the industry in which the entity operates.
Changes in the supply chain.
Expanding into new locations.
Lack of personnel with appropriate accounting and financial reporting skills.
Changes in the IT environment.
Where the audit risk is normal, then the auditor may approach his audit by
relying on
1. Test of controls
2. Substantive tests
3. Analytical review
Substantive audit procedures to verify Payroll
From the payroll record:
Select a sample of newly appointed staff and check their salaries with the appointment letter.
Select a sample of other staff (appointed in previous years) and check their salaries with the increment letter.
In both the above cases check that allowances and deductions are in accordance with the company’s policies or the relevant
legal requirements.
Select a sample of payroll summaries and:
Check that payroll summary has been approved by an appropriate authority.
Trace totals of payroll summaries to appropriate general ledger accounts.
Substantive Procedures for Raw material purchases:
Select a sample of transactions and carryout the following tests.
Check weather appropriate measures have been taken as per the company’s policy to ensure that purchases are made from
most competitive sources.
Check the relevant invoices.
Match invoices with goods receiving notes to ensure that goods have been received for all billings made by supplier.
Match supplier’s invoices with purchase orders to ensure that:
Purchases were duly authorized.
Rates and quantities mentioned on the invoice are same as those mentioned on the purchase order.
Check posting of supplier’s invoices to creditor’s accounts/ general ledger.
Perform cut-off procedures on purchases.
Perform analytical procedures on purchases made during the year by comparing current year purchases with the last year
and investigate significant differences, if any.
Difference between tests of controls and Substantive procedures &
analytical procedures
Test of control are checks performed to verify whether internal controls are
working using for example Enquiry, Observation etc.
Substantive procedures are checks of detail to verify different assertions in the
Financial statements for example Inspecting the existence of a fixed asset say
motor vehicle is a substantive procedure to ascertain existence.