Audit Risk

Meaning and definition of audit risk

Also referred as residual risk, the audit risk can be defined as the risk that the auditor will not discern errors or intentional miscalculations during the process of reviewing the financial statements of a company or an individual. The audit risk generally features two categories – risk regarding evaluation of financial materials and risk regarding the affirmations created by evaluation of financial documents.

An audit is requested by the companies so as to ensure the investors that their financial statements and reporting are fair and accurate. With the aim of insuring against future litigations arising from missed financial improprieties, like material misstatements, auditors will usually transmit malpractice insurance.

Types of audit risk

The different types of audit risk include:

• Inherent risk

Inherent risk is the risk that a financial statement is susceptible to a material misstatement. This statement could be related to a class of transactions, account balances or disclosures about important company dealings.

• Control risk

Control risk is the risk that one or more material misstatements might not be detected or prevented on a timely basis by the internal control systems of the company.

• Detection risk

Detection risk is the risk that an audit might not be capable of detecting a material misstatement.

Assessing the audit risk

The inherent risk and control risk is assessed by the auditor at three levels – high or maximum risk, medium or moderate risk, and low risk. High inherent and control risks call for a low detection risk so as to have an overall low audit risk. The auditor, therefore, needs to carry out more detection procedures to be convincingly assured about the financial statements being free from material misstatements.

Significance of audit risk

A low audit risk is significant as it is not possible for auditors to verify every transaction. The auditors generally focus on main risk areas, for example understated costs or overstated revenues, where it is possible that errors will lead to material misstatements on the financial statements. Moreover, auditing standards necessitate the auditors to plan and perform audits with professional skepticism as there is always a possibility for the financial statements being materially misstatement.