What is Detection Risk
Detection risk is the chance that an auditor will fail to find material misstatements that exist in an entity's financial statements. These misstatements may be due to either fraud or error. Auditors make use of audit procedures to detect these misstatements, but because of the nature of these procedures, some detection risk will always exist. For example, sometimes auditors take a sample of a certain type of company transaction because examining every transaction is impractical. Increasing the sample size can reduce detection risk, but some risk will always remain. Detection risk is one of the three elements that comprise audit risk, the other two being inherent risk and control risk.
BREAKING DOWN Detection Risk
A common mistake that auditors make is to conclude that a detected misstatement is trivial. Sometimes a misstatement that is trivial in one unit of a company may become material when aggregated over multiple business units, making a significant impact on the company's financial statements. Detection risk may be higher in regions where regulatory bodies are relatively ineffective.
Audit procedures used to minimize detection risk include:
- Classification testing: Used to determine whether transactions were classified correctly.
- Completeness testing: Used to examine if any transactions are missing from the accounting records. An auditor may review a client's bank statements, for example, to determine if payments to suppliers were not recorded.
- Valuation testing: Used to test whether the value of the assets and liabilities on the company's books are accurate.
- Occurrence testing: Used to determine whether recorded transactions have actually occurred. This test could involve examining specific invoices listed on the sales ledger as well as customer order and shipping documentation.