Audit Risk: Meaning, Characteristics, and Elements

What is Audit Risk? It refers to the risk that the auditor expresses an inappropriate audit opinion on the financial statements containing important errors. This article explains about Audit Risk with its Meaning, Characteristics, and Elements. In simple terms, it is the risk that an auditor will issue an unqualified opinion when the financial statements contain material misstatement. As well as, it 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.

Here are explain Audit Risk and its Meaning, Definition, Characteristics, and Elements.

One is that the certified public accountants believe that the fair financial statements are wrong, that is, the verified financial statements do not reflect the changes in the financial status, operating results and financial status of the audited unit by the requirements of accounting standards Or it may indicate that there are important errors in the audited unit or the scope of the review, which may not notice by the CPA;

The second is the wrong accounting statement that the certified public accountant thinks, but in fact, it is fair. It includes inherent risks, control risks, and inspection risks. Due to the increasingly complex environment of auditing, the tasks facing auditing are becoming more and more arduous; auditing also needs to support the principle of cost-effectiveness. The existence of these reasons determines the existence of audit risks in the audit process. This objectively requires certified public accountants to pay attention to the possibility of risks and take corresponding measures to avoid and control risks as much as possible.

ISA 200 states that auditors should plan and perform the audit to reduce audit risk to an acceptably low level that is consistent with the objective of an audit. (Auditing and Assurance Standard) AAS-6(Revised), “Risk Assessments and Internal Controls”, identifies the three components of audit risk i.e. inherent risk, control risk, and detection risk.

Definition of Audit Risk:

The following definition below are;

It is the risk that an auditor expresses an inappropriate opinion on financial statements.

According to Wikipedia;

“Audit risk (also referred to as residual risk) refers to the risk that an auditor may issue an unqualified report due to the auditor’s failure to detect material misstatement either due to error or fraud.”

As the definition explains It is the risk that auditors issued the incorrect audit opinion to the audited financial statements. For example, auditors issued an unqualified opinion to the audited financial statements even though the financial statements are materially misstated. In other words, the material misstatements of financial statements fail to identify or detect my auditors.

Characteristics of Audit Risk:

The nature of audit risk always shows certain characteristics or features. After discussing the connotation of audit risk; we should continue to elaborate on the characteristics of audit risk; and, explain the unique performance under our socialist market economy.

The details are as follows;

Universality:

Although the audit risk manifests by the deviation from the final audit conclusion and expectations; this deviation caused by many factors, and every link of the audit activity may lead to the generation of risk factors. Therefore, there are audit risks that are suitable for any kind of audit activity, and will ultimately affect the total audit risk.

Objectivity:

A significant feature of modern auditing is the method of sampling auditing, which is to infer the characteristics of the population based on the characteristics of a part of the sample in the population, and the characteristics of the sample are more or less in error from the characteristics of the population. But generally difficult to eliminate.

Therefore, whether it is statistical sampling or judgment sampling, if the population infers based on the sample review results, there will always be a certain degree of error, that is, the auditor must bear a certain degree of risk of making a wrong audit conclusion. Even in the case of detailed audits, due to the complexity of economic operations and the moral quality of managers, there are still cases where the audit results are inconsistent with objective reality.

Potential:

The existence of audit responsibility is a basic factor in the formation of audit risk. If the auditors are not subject to any constraints in practice and do not bear any responsibility for their work results, they will not form audit risk, which determines the audit risk for a certain period. Potential, If the auditor deviates from the objective facts, but does not cause undesirable consequences and does not cause the corresponding audit responsibility, then this risk only stays at the potential stage, and does not translate into real risk.

Contingency:

It is due to some objective reasons, or subjective reasons that the auditors are not aware of, that is, the auditors did not deliberately act; the auditors unintentionally accepted the audit risk, and inadvertently assumed the seriousness of the audit risk. As a result, It is very important to affirm that the audit risk is unintentional; because only under this premise, the auditors will try to avoid reducing the audit risk, and the control of the audit risk is meaningful.

Controllability:

Auditing has long been familiar with taking responsibility for the correctness of its reports. However, the guiding ideology of modern auditing has further evolved from system-based auditing to risk auditing. The audit profession has not been tied up by more and more audit risks. Instead of losing its vitality, it gradually develops in the direction of actively controlling audit risks. It is of great significance to correctly understand the controllability of audit risk.

On the one hand, we need not afraid of audit risk. Although the responsibility of auditors will lead to audit risk, once it occurs, its possible impact on the audit profession is also significant; but we can By identifying areas of risk and taking appropriate measures to avoid them; there is no need to dare to accept customers because of the existence of risks.

Audit Risk Model:

Audit Risk = Inherent Risk * Control Risk * Detection Risk

It may consider as the product of the various risks which may encounter in the performance of the audit. To keep the overall audit risk of engagements below the acceptable limit; the auditor must assess the level of risk about each component of audit risk. Above these risks of model define three elements or types of audit risks below you’ll understand.

Elements of Audit Risk:

The following detail of elements or types of audit risk below are;

Inherent risk:

What is Inherent risk? Inherent risk is generally considered to be higher where a high degree of judgment; and, estimation is involved or where transactions of the entity are highly complex. They refer to the possibility of a material misstatement in a certain statement on the financial statements without considering the internal control policies or procedures of the audited entity. It is the risk inherent in the business, whether or not internal control exists. It exists independently of the audit of accounting statements and is a risk that CPAs cannot change their actual level.

For example, the inherent risk in the audit of a newly formed financial institution that has significant trade and exposure in complex derivative instruments may be considered to be significantly higher as compared to the audit of a well-established manufacturing concern operating in a relatively stable competitive environment.

Characteristics of inherent risks:

The inherent risks have the following characteristics:

• The inherent risk level depends on the sensitivity of accounting statements to errors and frauds in business processing. The more false reports in the business process, the more false the report, the greater the inherent risk, and the lower the inherent risk. The greater the possibility of problems in economic business, the higher the inherent risk level; otherwise, the smaller. That is to say, for different businesses, the inherent risk level is also different;
• The generation of inherent risks related to the audited unit, but not to the certified public accountant. Accountants cannot reduce inherent risks through their work, but can only analyze and judge the inherent risk level through necessary audit procedures;
• The inherent risk level indirectly affects the external operating environment of the audited unit. Changes in the external operating environment of the audited unit will cause an increase in inherent risks. For example, due to the advancement of technology, some products of the audited unit will become obsolete; which brings the risk of whether the inventory valuation is correct;
• Inherent risks exist independently in the audit process and objectively exist in the audit process, and are relatively independent risks. The magnitude of this level of risk needs to certify by certified public accountants.

Control risk:

What is Control risk? Control Risk is the risk of a material misstatement in the financial statements arising due to absence or failure in the operation of relevant controls of the entity. It refers to the possibility that the internal control of the audited unit fails to prevent or discover a certain misstatement or omission in its accounting statements in time. As with inherent risks, auditors can only assess their level and cannot affect or reduce its size.

Control risk or internal control risk is the risk that current internal control could not detect or fail to protect significant error or misstatement in the financial statements. Assessment of control risk may be higher for example in case of a small-sized entity in which segregation of duties is not well defined; and, the financial statements are prepared by individuals who do not have the necessary technical knowledge of accounting and finance.

Characteristics of Control risk:

The control risk has the following characteristics:

• The level of control risk is related to the level of control of the audited unit. If the internal control system of the audited unit has important defects or cannot work effectively; then the mistakes will enter the financial reporting system of the audited unit, resulting in control risks;
• The control of risks has nothing to do with the work of certified public accountants. As with inherent risks, certified public accountants cannot reduce control risks; but certified public accountants can set a certain level of control risk based on the soundness and effectiveness of the internal control of the relevant part of the audited unit;
• Controlling risk is an independent risk in the audit process. Control risk exists independently in the audit process. This risk has nothing to do with the inherent risk. It is a function of the effectiveness of the internal control system or degree of the audited unit. Effective internal control will reduce control risk, while ineffective internal control will increase control risk. Since the internal control system cannot fully guarantee the prevention or discovery of all errors and deficiencies, the control risk cannot be zero; and, it will inevitably affect the final its risk.

Detection risk:

What is Detection risk or Inspection risk? Detection Risk is the risk that the auditors fail to detect a material misstatement in the financial statements. It refers to the possibility that a certified public accountant fails to discover a major misstatement or omission in the audited unit ’s accounting statements through a predetermined audit degree. Inspection risk is the only risk element that can control and manage by certified public accountants.

Well, detection risk is the risk that auditor fails to detect the material misstatement in the financial statements and then issued an incorrect opinion to the audited financial statements. Some detection risk is always present due to the inherent limitations of the audit; such as the use of sampling for the selection of transactions.

Characteristics of Detection risk:

The detection risk has the following characteristics are:

• It exists independently in the entire audit process. Not affected by inherent risks and control risks.
• The inspection risks are directly related to the work of certified public accountants. It is a function of the effectiveness of audit procedures and the effectiveness of certified public accountants in using audit procedures. Its actual level is related to the work of certified public accountants. It directly affects the final risk. In practice, certified public accountants reduce the inspection risk by collecting sufficient evidence to keep the total audit risk at an acceptable level. The level of inspection risk and the importance level together determine the nature, time, and scope of the substantive tests that the auditor needs to perform and the amount of evidence required to be collected.