Auditors hold a lot of responsibility when providing their professional audit opinion on a report. Given the different types of audit risk that exists, an audit risk model can be useful in determining the likelihood of submitting an incorrect report.
To help manage audit risk, we will define what it is, the various components of an audit risk model and how automation can help to reduce audit risk.
Audit risk is the risk that an auditor may issue an incorrect opinion on a company’s financial statements.
There are various ways by which this could happen, including:
Audit risk exists no matter who conducts an audit report or the type of company providing the financial statements. However, there are ways to help manage and reduce audit risk.
One of the best ways to limit audit risk is to utilise the audit risk model. In order to help organisations identify the problems that may arise in their audits, the model divides the types of audit risks into categories.
Once divided and understood, organisations and auditors can apply the audit risk formula to try to keep the components of the audit risk model below an acceptable limit.
The audit risk formula is:
Audit Risk = Inherent Risk x Control Risk x Detection Risk
Audit risk models are made up of three types of risk. Some risks are easier to mitigate than others. While some types of risk are left to the onus of the auditor, others like control risk are to be managed by the entity itself.
To be able to apply the aforementioned formula, let’s uncover what each type of risk involves.
Arguably the most difficult component to manage is inherent risk. Inherent risk is the risk of material misstatement in financial statements. This could happen because of errors or missing information (omission). Inherent risks exist because the nature of business and their respective environments can be complex and unruly.
Also, the changing environment of businesses could make it such that an opinion issued was correct at the time of the audit, but once the audit is published, something has changed which is no longer accurately reflected in the report.
Inherent risk is higher when there’s estimation or transactions have layers of complexity. To illustrate, the inherent risk of a newly formed startup that operates in a fast-paced and risky market environment is more likely to be higher than that of an established big box retailer that operates in a consistent, predictable environment.
Detection risk is the risk that an auditor fails to identify a material misstatement. This means that the organisation may have evidence of fraud or mistakes, but the auditor doesn’t take notice. Even if the auditor misses this critical fact unintentionally, they will still be considered to be at fault. That being said, detection risk is present even if an auditor is very thorough in their audit process.
For example, an auditor takes a sample of transactions that display no foul play. However, if the auditor is able to expand their sample size, they may decrease detection risk. The expected level of control risk and inherent risk will help an auditor be able to gauge the acceptable level of detection risk, which thereby will impact their audit strategy.
Control risk is a type of risk that falls more on the hands of the organisation than the auditor. It refers to the potential failure or lack of control that an organisation has over its operations. Since an auditor receives the information and documentation to audit from the company itself, there could be data issues.
An auditor will carry out their process believing that the provided information is accurate and well-maintained. However, this could be entirely false. In order to prevent fraud, correct mistakes and ensure accurate data in a timely manner, organisations must have solid processes in place that can do so.
One way that an organisation can enhance their internal controls is to implement financial automation software to help manage and secure data and carry out processes automatically (which naturally helps to prevent errors, improve visibility and standardise processes).
Every auditor has the goal to provide a correct audit opinion. While it’s impossible to fully remove every type of risk that exists, auditors can use the audit risk model to better manage risk to an acceptable level.
First, they’ll review the estimated level of each type of risk. Although the formula is written like a mathematical equation, it’s not able to be objectively assessed. Instead, auditors use their professional judgement, experience and research to determine the levels of each type of risk. They can then better understand the relationship of each category of risk to make sure that the overall audit risk is within a tolerable limit.
The only risk that auditors can actually act directly upon is detection risk. This means that if control risk and inherent risk are high, they’ll have to adjust their process to focus on lowering detection risk. We’ll touch more on this shortly as we will see how audit risk affects overall audit strategy.
For an auditor to gain a sense of the entity’s risk environment, they’ll likely consider the following:
A business can have some control over its risk environment, but there are many aspects that are beyond anyone’s control. However, the same cannot be said about internal controls. It’s up to business leaders to design strategies, review processes and implement solutions to maximise internal control and standardise processes.
It’s worthwhile to review how an organisation is handling its controls by reviewing its financial reporting processes, control activities, communication and monitoring abilities. Auditors will consider how much emphasis a business places on accurate financial reporting, the ways by which information is monitored and its day-to-day activities.
Audit risk is the building block of an audit strategy. From the start, an auditor will look to assess an organisation’s control risk and inherent risk to get a sense of the risks of material misstatements (RMM). To do this, an auditor will look at the client’s business, operations and financial activities. They’ll consider external factors, financial performance and the organisation’s internal strategies.
With this information, an auditor can then apply the risk model to see how much emphasis must be placed on detection risk. This key piece will determine their strategy. For example, given a high control and inherent risk, then an auditor will need to perform more substantive tests to lessen detection risk. If the opposite is true, then detection risk could be relatively low and so the auditor’s process will be less intensive.
To reiterate, not all risk is avoidable, but most aspects of risk can be managed. Automation software can help finance lessen their inherent risk and control risk. With automation tools, an organisation benefits from streamlined and standardised processes which can be accurately managed, measured, monitored and improved upon.
Furthermore, by utilising data analytics and reporting capabilities, an organisation can have a better understanding of its business environment and make the right decisions that can improve its operations. Automation software allows for utmost transparency and security of data. The software inherently reduces the risk of human error, especially when it comes to financial processes that require immense attention to detail given the high volume or data and figures.
Lastly, businesses can choose to use an automation software that stores transaction history and can provide audit trails. This way, an auditor can receive documentation of everything that occurred up to the point of their audit. If there are any mistakes or misstatements, it’ll be easier for both the organisation and auditor to pinpoint anything that’s not right and correct it by reviewing the data’s past.
All businesses hope to receive an unqualified opinion, which happens when an auditor determines that financial records are clean and free of any misrepresentations. With automation software, businesses can reduce their inherent risk and control risk, making the audit risk model easier to manage when it comes time for an auditor to perform their job.
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