What Is Audit Risk?
Audit risk is the risk that financial statements are materially incorrect, even though the audit opinion states that the financial reports are free of any material misstatements. The purpose of an audit is to reduce the audit risk to an appropriately low level through adequate testing and sufficient evidence. Because creditors, investors, and other stakeholders rely on the financial statements, audit risk may carry legal liability for a CPA firm performing audit work.
Over the course of an audit, an auditor makes inquiries and performs tests on the general ledger and supporting documentation. If any errors are caught during the testing, the auditor requests that management propose correcting journal entries. At the conclusion of an audit, after any corrections are posted, an auditor provides a written opinion as to whether the financial statements are free of material misstatement. Auditing firms carry malpractice insurance to manage audit risk and the potential legal liability.
Types of Audit Risks
The two components of audit risk are the risk of material misstatement and detection risk. 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.
Risk of Material Misstatement
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. The risk of material misstatement is even higher if there is believed to be insufficient internal controls, which is also a fraud risk.
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. This work is performed to prove the existence of inventory. If the auditor's test sample for the inventory count is insufficient to extrapolate out to the entire inventory, the detection risk is higher.