What Are the Three Types of Audit Risk?

Auditing is the process of examining the financial statements of a company. Usually, external auditors conduct audits. External auditors are independent parties not related to the management of the auditee company. The process of auditing consists of many different procedures that auditors perform to form an opinion on whether the financial statements present a true and fair view and are prepared in conformity with the applicable financial reporting framework. Some companies may also have an internal audit department. In those cases, the internal auditors of the company may also audit its financial statements and also work on its internal controls.

The audit process requires auditors to examine not only the financial statements of a company but also the underlying evidence to ensure they present an appropriate opinion regarding those statements. During the process, auditors can apply different procedures to obtain audit evidence to form an opinion. However, before the audit process begins and auditors start to perform audit procedures, there are some other steps they must perform. These may include determining the risks. The International Standards on Auditing gives auditors some guidance related to those issues. Auditors must understand the risks involved in the auditing process and how to deal with them according to the standards.

What Are the Audit Risks?

According to ISA 200 – Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with ISAs’ defines audit risk as, “The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated”. It means audit risk is the risk that an auditor gives an unmodified audit opinion even if the financial statements of a company are materially misstated.

ISA 200 also states, “To obtain reasonable assurance, the auditor shall obtain sufficient appropriate audit evidence to reduce audit risk to an acceptably low level and thereby enable the auditor to draw reasonable conclusions on which to base the auditor’s opinion”. Therefore, the standard requires auditors to obtain audit evidence to ensure the audit risk related to an audit assignment is minimized.

Why Do We Need to Know the Audit Risks?

The reason why managing and understanding audit risk is crucial for auditors is that the stakeholders of a company rely on the auditors’ opinions to make decisions regarding their relationship with the company. In case of a misjudgment on the auditors’ part, they may end up making wrong decisions. While making wrong decisions does not directly affect auditors, stakeholders may end up taking legal action against the audit firm for their incorrect opinion.

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Identifying and assessing the audit risks of an audit assignment is also vital for auditors because the risk dictates the level of procedures auditors need to perform to obtain sufficient appropriate audit evidence. The audit risk at each client will be different due to different factors. Therefore, auditors must identify and assess the audit risk for each assignment to ensure they can reduce it to a minimum. It also helps auditors avoid any unnecessary audit procedures that may qualify as over-auditing.

3 Types of Audit Risks

Audit risk consists of three types. Knowing the different types of audit risks also helps auditors understand what to look for when determining the audit risk of an assignment. The three types of audit risk are inherent risk, control risk, and detection risk. Inherent risk and control risk combined is also known as the risk of material misstatement, which is the risk that the financial statements of a company are materially misstatement before the audit.

Inherent Risk

The inherent risk is one of the 3 types of audit risk. It is the risk that the financial statements of a company contain material misstatements before auditors can consider any related controls. It is the type of audit risk that arises in the audit process due to the nature of the auditee company and is not affected by the internal controls of the company, and audit procedures performed by the auditor. In simpler words, inherent risk is the susceptibility of an account balance or a transaction to misstatements. It usually exists due to the nature and environment of a company.

Inherent risk is the main type of audit risk as it comes before the other types. For example, a company that has complex business transactions involving financial instruments is more susceptible to inherent risk as compared to another company that has relatively simple transactions. Usually, the more complex and dynamic a company and its transactions are, the higher the inherent risks involved will be for the audit process.

Inherent risk is a type of audit risk that auditors cannot reduce as it is related to the nature of the company and, therefore, uncontrollable. The only way auditors can deal with inherent risk is to plan audit procedures according to their assessment of the risk. That means if the auditor considers the inherent risk of a company high, they can increase their audit procedures to minimize the overall audit risk of the company.

Control Risk

Control risk is another risk among the 3 types of audit risk. It is the type of audit risk that relates to the internal controls of a company. The control risk is when the internal controls, employed by the company fail to prevent or detect within its financial statements. After inherent risk, control risk is the next risk as companies put controls in place to minimize chances of fraud and error that may exist due to the nature of its operations and environment. Therefore, control risk is also outside the control of auditors.

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The control risk of an audit assignment depends on the auditors’ assessment of the internal controls of a company. They can achieve this through a test of control of the internal controls of the company. Assessing the internal controls of a company also requires auditors to have a strong understanding of its internal control policies and procedures. The goal of auditors when performing the assessment is to determine whether the controls in place can prevent or detect material misstatements related to relevant assertions.

Inherent risk and control risk are closely related and together make up the risk of material misstatement. When the inherent risk of an audit assignment is high, auditors must determine the level of control risk. As mentioned above, auditors cannot control the inherent or control risk of an audit assignment. Therefore, the only way the risk of material misstatement can be reduced is if the control risk of the audit assignment is low.

Detection Risk

While inherent and control risk depends on the nature and internal controls of the auditee company, detection risk is related to the auditing process. Detection risk is the risk that auditors fail to detect existing material misstatements in the financial statements of a company. This type of audit risk occurs when auditors cannot perform proper procedures to locate material misstatements.

Many factors contribute to a high detection risk. For example, improper audit planning, audit procedures or documentation, etc. can all cause the detection risk of an audit to go high. Unlike inherent and control risks,  auditors can directly control the detection risk. Usually, auditors decide the detection risk of an audit once they know the inherent and control risks.

Audit Risk Model

An audit risk model is a tool that auditors can apply to quantify the audit risk involved in an assignment. It allows auditors to manage the overall audit risk of an audit assignment better. According to this model, the overall audit risk of an audit assignment is the product of the 3 types of audit risk namely inherent, control, and detection risks. Therefore, the formula for the model is as below.

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Audit Risk Model

As mentioned above, inherent and control risks are also known as the risk of material misstatement. Therefore, we can rewrite the formula of the audit risk as follows.

Audit Risk Model with combined Inherent and Control Risks

While the tool allows auditors to assess the audit risk of an engagement, it still requires some judgment from auditors. That is because the values of each type of risk are not easily quantifiable. Often, auditors need to use professional judgment to assess each type of risk and assign value to it.

How Does Audit Risk Affect the Audit Strategy?

There are many ways in which the audit risk of an assignment can affect the audit strategy used by auditors. As mentioned above, auditors use the audit risk of an audit assignment as a basis to determine the level of audit procedures they need to perform to form an opinion. Similarly, audit risk also plays a crucial role in the determination of the materiality of an assignment. Performance materiality can also dictate the procedures that auditors must undertake to ensure they give a proper opinion.

The rule for audit risk affecting the audit strategy is simple. The higher the audit risk of an assignment is, the more procedures and testing auditors will perform. Therefore, it also affects the time taken by auditors to complete the audit.

How to Minimize Audit Risk?

While auditors cannot control the inherent and control risk of an audit assignment, they can control detection risk. Therefore, through minimizing detection risk, auditors can reduce the overall audit risk. There are different ways in which auditors can minimize detection risk. These include the following.

  • Using proper audit planning.
  • Applying appropriate audit procedures.
  • Monitoring and supervising their work.
  • Ensuring proper documentation is made.
  • Having a robust review process.
  • Using professional and competent staff for audit assignments.
  • By allocating staff depending on their skills and experience.
  • Using professional skepticism during audits.

While the above is not an exhaustive list, it should give auditors a decent idea of how to minimize audit risks.

Conclusion

Audit risk is the risk that an auditor expresses an unmodified opinion despite material misstatements in the financial statements. There are three main types of audit risks, inherent, control, and detection risks. Auditors can also use the audit risk model to quantify the risk of an assignment. Assessing the audit risk of an audit assignment is crucial as it dictates the audit strategy that auditors undertake. To minimize audit risks, auditors must focus on reducing detection risks.

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