What Are Risk Assessment Procedures in an Audit?

Risk assessment procedures form the foundation of a financial statement audit. These are the initial activities an auditor performs to understand a company and its environment, including its internal operations and external pressures. This structured process allows the auditor to identify potential problem areas early. The information gathered directly informs the entire audit strategy, dictating the nature, timing, and extent of further work to ensure the audit is both efficient and effective.

The Objective of Risk Assessment Procedures

The primary objective of performing risk assessment procedures is to identify and evaluate the “risks of material misstatement.” A material misstatement is an error, omission, or misrepresentation in a company’s financial statements that is significant enough to influence the economic decisions of someone relying on those statements.

Auditors assess risks at two levels. The first is the financial statement level, which involves pervasive risks that could affect the statements as a whole. Examples include a weak control environment or significant “going concern” issues that raise doubts about the company’s ability to continue operating. These risks can create an environment where misstatements are more likely across many accounts.

The second level is the assertion level, which is more granular and tied to specific transactions, account balances, or disclosures. For instance, an auditor might identify a high risk of inventory being overvalued (valuation) or that a company has not recorded all its liabilities (completeness). Identifying these specific risks allows the auditor to design targeted tests for those areas.

Required Areas of Understanding

To identify risks, auditing standards from the Public Company Accounting Oversight Board (PCAOB) require auditors to understand several areas of the entity. This begins with the company’s industry, its regulatory landscape, and other external factors like economic conditions. For example, a company in a rapidly changing technological industry faces different risks than one in a stable, highly regulated utility sector.

PCAOB proposals are expanding these requirements, demanding auditors identify laws and regulations where noncompliance could materially impact financial statements. This includes rules with indirect effects, like environmental or anti-money laundering regulations. Auditors will need to assess the risk of noncompliance with the same diligence they apply to fraud risk.

The auditor must also understand the nature of the entity itself. This includes its operations, ownership structure, governance, and the types of investments it is making. This knowledge helps the auditor evaluate the company’s objectives and the related business risks that could impact financial reporting.

Another element is evaluating how the company measures and reviews its own financial performance. Auditors look at key performance indicators, financial ratios, and trends that management uses to run the business. Discrepancies or unusual trends in these metrics can signal potential misstatements.

An understanding of the entity’s system of internal control over financial reporting is also required. This is the set of policies and procedures the company implements to ensure the reliability of its financial reporting. An auditor needs to evaluate the design of these controls and determine if they have been implemented effectively to prevent or detect material misstatements.

Types of Risk Assessment Procedures

Auditors use several methods, often in combination, to gather information and assess risk. The primary procedures include:

• Inquiry, which involves seeking information from knowledgeable persons inside and outside the company. For instance, an auditor might inquire with the sales department about commission structures to understand pressures that could lead to aggressive revenue recognition.
• Analytical procedures, which involve the evaluation of financial information by analyzing plausible relationships among data. An auditor might compare a company’s gross margin percentage over time or to industry benchmarks, as a sudden change could indicate a misstatement.
• Observation, which consists of looking at a process or procedure being performed by others, such as watching employees take a physical inventory count.
• Inspection, which involves examining records, documents, or tangible assets. This could include reviewing significant contracts, inspecting board meeting minutes, or physically verifying the existence of equipment.

Documenting the Assessed Risks

The culmination of these procedures is the creation of comprehensive audit documentation. The auditor must document their understanding of the entity and its environment, including their evaluation of the company’s internal control system.

This documentation must clearly articulate the identified risks of material misstatement at both the financial statement and assertion levels, along with the rationale for these assessments. For example, if the auditor determines a high risk of overstated revenue, the documentation would explain the factors that led to this conclusion.

This detailed record provides the basis for designing further audit procedures, known as substantive tests and tests of controls. These subsequent procedures are specifically tailored to respond to the risks identified during the assessment phase, ensuring the audit team’s efforts are focused on the areas of highest risk.