What is 'Audit Risk'

Audit risk is the risk that the financial statements are materially incorrect, even though the audit opinion states that the financial reports are free of any material misstatements. The two components of audit risk are the risk of material misstatement and detection risk. Because creditors, investors and other stakeholders rely on the financial statements, audit risk may carry legal liability for a CPA firm performing audit work.

!--break--An auditor provides a written opinion as to whether the financial statements are free of material misstatement. An audit requires a CPA firm to make inquiries and perform testwork on the financial statements. Auditing firms carry malpractice insurance to manage audit risk and the potential legal liability.

Factoring in CPA Firms

Large public companies typically engage one of the Big Four accounting firms – PricewaterhouseCoopers, KPMG, Ernst & Young or Deloitte Touche Tohmatsu – to perform an audit. Many companies hire staff to perform internal audits, and external audit firms may rely on some of the internal work performed. The Big Four was previously the Big Five, but Arthur Andersen lost the ability to perform audit work after being indicted on counts of obstruction of justice for its role in the Enron scandal. According to a 2008 Government Accountability Office (GAO) report, the Big Four firms audit 98% of U.S. companies with annual revenues over $1 billion. Smaller companies are more likely to engage a mid-range firm, such as Grant Thornton.

The Differences Between Risks

Assume, for example, that a large sporting goods store needs an audit performed, and that a CPA firm is assessing the risk of auditing the store's inventory. The risk of material misstatement is the risk that the financial reports are materially incorrect before the audit is performed. In this case, the word "material" refers to a dollar amount that is large enough to change the opinion of a financial statement reader, and the percentage or dollar amount is subjective. If the sporting goods store's inventory balance of $1 million is incorrect by $100,000, a stakeholder reading the financial statements may consider that a material amount.

Detection risk is the risk that the auditor’s procedures do not detect a material misstatement. For example, an auditor needs to perform a physical count of inventory and compare the results to the accounting records, and this work is performed to prove the existence of inventory. If the auditor's inventory count procedures are weak, the detection risk is higher.

BREAKING DOWN 'Audit Risk'

RELATED TERMS
  1. Continuous Audit

    An auditing process that examines accounting practices continuously ...
  2. Auditability

    The ability to achieve accurate results in the examination of ...
  3. Certified Internal Auditor - CIA

    A certification offered to accountants who conduct internal audits. ...
  4. Field Audit

    An audit is an investigation conducted by the Internal Revenue ...
  5. Auditing Standards Board - ASB

    The American Institute of Certified Public Accountants' (AICPA) ...
  6. Auditor's Opinion

    A certification that accompanies financial statements and is ...
Related Articles
  1. Taxes

    What To Do If You Get Audited

    If you're in the minority of those that get audited, find out how to prepare and how to handle the process.
  2. Investing

    What is Inherent Risk?

    Inherent risk is the possibility of inaccurate information appearing in a financial statement due to factors such as error or omission.
  3. Personal Finance

    A Day In The Life Of An Auditor

    If you like the idea of examining and attesting to a company's financial performance for a living, a career in auditing might be right for you.
  4. Managing Wealth

    Make $1 Million? Expect an Audit

    If you make $1 million or more, the IRS has its eyes on you. Here's what you can do about it.
  5. Investing

    Audit the Fed: Is Trump Right? (JPM)

    Find out why Donald Trump has a point when he claims it is vitally important to audit the Federal Reserve, the central banking authority in the United States.
  6. Insights

    Internal Auditor: Career Path & Qualifications

    Find out what kind of work internal auditors do in large organizations, and learn more about how to get started working in the field.
  7. Insights

    Financial Auditor: Career Path & Qualifications

    Learn more about what it takes to become an internal or external financial auditor, and determine whether the profession is right for you.
  8. Personal Finance

    Career Advice: Accounting Vs. Auditing

    Understand the subtle distinctions between accounting and auditing, and learn what each offers a new graduate in terms of salary, job security and daily life.
  9. Managing Wealth

    Internal Auditor: Job Description & Average Salary

    Learn about what the job of internal auditor entails, as well as the median salary, education and certifications required and future career path.
  10. Insights

    How The IRS Works: Functions & Audits

    Even the most enlightened citizen curses taxes, possibly while simultaneously acknowledging that they're the price of a civilized society.
RELATED FAQS
  1. What should I do to prepare for an IRS audit?

    Find out how to prepare for an IRS audit, what kinds of audits you might face and what kinds of habits you should develop ... Read Answer >>
  2. How is inherent risk assessed by an auditor?

    Learn how CPA auditors assess the levels of inherent risk of different audit areas that they use to design the procedures ... Read Answer >>
  3. Can the IRS audit you after a refund?

    Learn how the U.S. Internal Revenue Service (IRS) can conduct a tax audit even after a taxpayer was issued a tax refund in ... Read Answer >>
  4. What's the average salary of an audit clerk?

    Learn how much audit clerks earn per year on average, and review what these finance professionals and others in similar fields ... Read Answer >>
  5. How important are contingent liabilities in an audit?

    Read about the importance of contingent liabilities during an audit, why audits are necessary and how contingent liabilities ... Read Answer >>
  6. Are IRS audits random?

    Learn about how the U.S. Internal Revenue Service (IRS) conducts its tax audits based on random selection, document matching ... Read Answer >>
Hot Definitions
  1. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
  2. Pro Forma

    A Latin term meaning "for the sake of form". In the investing world, it describes a method of calculating financial results ...
  3. Trumpcare

    The American Health Care Act, also known as Trumpcare and Ryancare, is the Republican proposal to replace Obamacare.
  4. Free Carrier - FCA

    A trade term requiring the seller to deliver goods to a named airport, terminal, or other place where the carrier operates. ...
  5. Portable Alpha

    A strategy in which portfolio managers separate alpha from beta by investing in securities that differ from the market index ...
  6. Run Rate

    1. How the financial performance of a company would look if you were to extrapolate current results out over a certain period ...
Trading Center