March 1, 2021

Audit Risk: Advance Guide for Finance

Compliance Risk
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Business processes and business entities face various types of risk. While an organisation can suffer from inaccurate data and its associated outcomes, an auditor also has their own set of risk involved in their audit procedures. Audit risk is a function of audits, and while it’s not possible to fully remove this type of risk, it is possible to control risk audit and minimise it to a tolerable level. 

We’ll cover what audit risk is, the types of audit risk, and ways to reduce audit risk with the aid of automation tools. 

What is Audit Risk? Definition 

Audit risk refers to the risk that an auditor will miss material misstatements when reviewing a client’s financial statements as part of their audit procedure. This means that the financial statements do include material misstatements or fraud, but it goes undetected by an auditor. 

Creditors, stakeholders and investors all rely on the accuracy of financial statements to make their decisions, so it’s important for auditors to perform their job correctly and reduce audit risk. After reviewing an organisation’s documentation, an auditor will provide their written opinion on whether or not the statements include material misstatements or are all clear. Since audit risk exists, many auditing firms will carry malpractice insurance to protect their interests against potential legal ramifications.  

What are the Types of Audit Risk? 

Audit risk is made up of two main components, namely the risk of material misstatement and its respective detection risk. Material misstatements refer to monetary discrepancies in an organisation’s financial statements.

Material misstatements come from the organisation providing the financial statements. Compounded by this type of risk, auditors face detection risk, which refers to the potential case of an auditor failing to recognise a misstatement. 

Risk of Material Misstatement:

Risk of material misstatement can be further broken down by its own two components, which include:

Inherent Risk: 

Inherent risk are risks that can’t be detected or managed by the organisation's internal controls. These are risks that are prevalent in business and may be due to the complexity of the nature of business or types of transactions. 

For example, the external environment can play a role in affecting business transactions at the hands of factors like politics or climate change. It’s up to an auditor to create an audit plan, approach and strategy that takes into account inherent risks that may impact an organisation’s financial statements. 

Control Risk: 

Control risk refers to the risk that an organisation’s internal controls are unable to detect or rectify a significant error or misstatement within its financial statements. It’s generally in the hands of management teams and key decision-makers to design stop gaps to avoid such types of problems from occurring. When there’s weak control, there’s a higher chance for material misstatements to happen, which in turn, will also lead to audit risk. 

It’s up to an auditor to test the internal control mechanisms to see if that’s the reason for misstatements or not. An auditor can assess the organisation’s internal control and is then able to conclude whether or not the controls are reliable or not. Control risk is not to be conflated by detection risk. Control risk is still something that happens on the organisational side. 

For example, a material misstatement may be the result of having unqualified professionals managing financial reporting and statements. Or, it could be that the organisation hasn’t clearly defined and allocated tasks to the right people. Many control risks can be easily minimised or even fully prevented with the addition of a finance automation software that can handle most tasks for your team automatically. 

Detection Risk:

On the other hand, when it comes to auditors, they may face detection risk. Detection risk is the possibility of an auditor failing to detect material misstatements. When this happens, they may issue the wrong opinion on the audited financial statements. 

Detection risk can stem from insufficient audit planning. Auditors can follow guidelines to help minimise these risks. Some best practices that can help an auditor minimise detection risk is: having a good understanding about the nature of the business that’s being audited, knowing about the complexity of the organisation’s financial statements, and deeply understanding the organisation’s internal controls. 

Data automation software can help maximise this detection with clearly defined processes setup in the system, and automatic alerts to specific stakeholders if there is anything unusual detected. There is also full audit trails to see exactly how and where the occurrence took place, and where the control weakness exists so that is can be corrected and resolved quickly

Why Do Auditors Need to Conduct a Risk Assessment?

A risk assessment is necessary so that auditors can set tolerable acceptance levels for detection risk accordingly. To make this possible, an auditor will need to take into account both inherent and control risks that pertain to the organisation and its environment. 

If the auditor deems there to be high control and inherent risk, it’ll translate into setting detection risk acceptance levels lower, so that the audit risk is at an acceptable level. Oppositely, if there’s a low level of expected control and inherent risks, then detection risk can be set higher. 

How to Calculate Audit Risks & Audit Risk Formula 

To calculate the audit risk, there’s an audit risk formula which comes from the combination of the types of audit risk. This translates to:

Audit risk = inherent risk x control risk x detection risk 

The “x” here signifies  the relationship between these three components of risk. So, the audit risk can be low if inherent and control risk are low, even though detection risk might be high. 

It’s also possible to think of the audit risk formula as the relationship between the risk of material misstatement and detection risk. 

This would look like:

Audit risk = risk of material misstatement x detection risk 

Audit Risk vs Fraud Risk vs Business Risk vs Acceptable Risk

When it comes to financial statements, there are many types of risks that are of serious impact. However, these risks can often be managed and minimised, especially with the help of finance automation software. 

But, to be able to adequately address, approach and potentially alter the risks your organisation or auditing firm may face, it’s first paramount to understand the differences. 

Let’s take a look at some definitions:

  • Audit risk: Up until now, we’ve focused on audit risk, what it means and how it is measured. To reiterate, audit risk refers to the chance that an auditor may miss material misstatements in financial statements when performing an audit. It’s impacted by three risks - control risk and inherent risk (which make up the risk of material misstatement on behalf of an organisation) and detection risk (which refers to the chance an auditor doesn’t detect material misstatements because of the applied audit procedure). 
  • Business risk: Business risks are exclusive to a company and its stakeholders. There’s a long list of business risks, and the largest type of risk to any organisation is its complete demise and failure. Some types of business risks include: financial risk, cash flow issues, legal issues, decline in demand, high customer turnover, over trading, economic instability, political instability, an increase in production costs, etc. 
  • Fraud risk: Fraud risk is the risk that there is a material misstatement present in the financial statement that goes undetected by both management and an auditor. If fraud is present, it’s up to management to rectify. It’s up to an auditor to assess whether or not fraud is likely to happen as well as the materiality of it, if it did occur. 
  • Acceptable audit risk: Acceptable audit risk is the auditor’s level of risk that they will take on and accept in releasing an unqualified audit opinion. An unqualified audit opinion means  that there has not been any material misstatements, so when an auditor is of this opinion, they have defined a level of acceptable audit risk. This is because there may be a possibility that there is, in fact, proof of material misstatement in the financial statements. 

Example of Audit Risk

Let’s consider an example of audit risk to understand how the audit risk formula works. 

Imagine Company A which operates in financial services, is a small firm that has an internal audit committee, but the individuals have no financial background, and the firm wants to keep the audit risk below 20%. 

We can assume that the inherent risk and control risk are relatively high, because the organisation operates in a highly regulated industry and there’s a low level of control because of the lack of financial expertise. If we assume that both inherent risk and control risk are at 60%, then we can figure out what detection risk must be set at to not assume more than 20% total audit risk. 

Audit risk = inherent risk x control risk x detection risk 

.20 = .60 x .60 x detection risk 

.20/.36 = detection risk -> .55 or 55% detection risk 

How an Auditor Can Reduce Audit Risk 

Neither a business nor an auditor will ever seek high levels of risk. In order to minimise audit risk, an auditor should spend time in the planning stage of an audit to fully understand the organisation and its environment. Auditors don’t impact the inherent and control risk directly, just the detection risk. 

Going deeper, auditors can leverage automation tools to help set up audit procedures that are standardised, repeatable, and supervisable. For tasks that require the recognition of patterns from data, robotic process automation can cut the time and increase the accuracy. 

Data automation software also helps by obtaining data from various sources automatically. This removes the need for any heavy lifting that would otherwise be required to standardise the data and structure records for review. 

The Bottom Line 

Many industries are required by law to conduct audits on a regular basis. The more internal control that your organisation is able to manage, the lower your audit risk will be. With the aid of finance automation tools, you can easily minimise risks because the software is able to safely collect, store and utilise data with little to zero margin of error, which translates into accurate financial statements. 

Organisations that are able to produce more accurate and timely financial statements because of automation immediately lessen the threat of material misstatements or fraud from occurring in the first place. In turn, audit risk becomes more manageable and predictable.

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