What Is Audit Risk and Its Core Components?
Understand how auditors balance a company's potential for financial error with their own testing to provide a credible opinion on its financial health.
An independent audit provides an opinion on whether a company’s financial statements are presented fairly. However, there is always a chance that an auditor could issue a clean opinion on financial statements that are, in fact, significantly flawed. This possibility is known as audit risk. It is the risk that material misstatements, whether from error or fraud, exist in a company’s books and the auditor fails to detect them.
The goal of an audit is not to eliminate all risk, but to reduce it to an acceptably low level. This process ensures that users of the financial statements, such as investors and lenders, can have reasonable assurance in the information presented. The audit process is built around identifying, assessing, and responding to this risk.
The Core Components of Audit Risk
Audit risk is a function of three distinct components that, when combined, determine the overall level of risk for an engagement. The first two components, inherent risk and control risk, are related to the company’s circumstances and environment. The third component, detection risk, is directly related to the work performed by the auditor. Auditors must evaluate these components to design an effective audit.
Inherent Risk
Inherent risk is the natural susceptibility of a financial account or transaction to misstatement, assuming the company had no internal controls in place to mitigate it. This risk exists independently of the audit and is tied to the nature of the business and its industry. Factors like the complexity of business operations, the degree of judgment required in accounting estimates, and pressures on management can all increase inherent risk.
For example, valuing complex financial instruments like derivatives involves significant estimation and market volatility, leading to a high inherent risk of misstatement. In contrast, verifying the balance of a company’s primary checking account is straightforward and has a low inherent risk. A business that deals heavily in cash has a higher inherent risk of theft or unrecorded sales, while an industry experiencing rapid technological change faces a high risk that its inventory could quickly become obsolete.
Control Risk
Control risk is the risk that a company’s own internal controls will fail to prevent or detect a material misstatement in a timely manner. After assessing inherent risks, auditors evaluate the systems and procedures the company has implemented to manage those risks. If these controls are poorly designed or not operating effectively, control risk is considered high.
A common example of high control risk is a lack of segregation of duties, where a single employee is responsible for authorizing transactions, recording them, and maintaining custody of the related asset. If one person handles cash receipts, records the sales, and prepares the bank deposit, the opportunity for misappropriation is significant. Another area of control risk involves information technology, such as a failure to enforce strong password policies, which could allow for unauthorized manipulation of records.
Detection Risk
Detection risk is the risk that the audit procedures performed by the auditor will fail to detect a material misstatement that exists. This is the only component of audit risk that the auditor can directly influence.
This risk has two main elements: sampling risk and non-sampling risk. Sampling risk arises because auditors test only a selection of transactions, not the entire population, and the chosen sample may not be representative. Non-sampling risk occurs when an auditor uses an inappropriate procedure, misinterprets evidence, or fails to recognize a misstatement. An auditor’s experience, training, and professional skepticism are important factors in managing this risk.
Understanding Materiality in Audits
The concept of materiality is closely related to audit risk. An audit is not designed to find every single error, but rather to detect misstatements that are “material.” According to U.S. auditing standards, a misstatement is material if there is a substantial likelihood that it would have influenced the judgment of a reasonable person relying on the financial statements.
Auditors must establish a materiality level for the financial statements as a whole during the planning phase. This is a quantitative threshold that guides the extent of audit procedures. Calculating this figure requires professional judgment, as the choice of benchmark depends on the company’s circumstances. Auditors typically use stable benchmarks, such as 0.5-1% of total assets or total revenues, especially for companies with unstable earnings.
This overall materiality figure is then used to determine “tolerable misstatement” for specific accounts. Tolerable misstatement is set at a lower amount to reduce the probability that the sum of uncorrected and undetected errors exceeds the overall materiality level. For instance, if overall materiality is $100,000, an auditor might set the tolerable misstatement for the inventory account at $60,000, depending on its risk.
Materiality is not just a quantitative calculation; it also involves qualitative considerations. A small, intentional misstatement designed to manipulate earnings or conceal an illegal act could be deemed material even if it falls below the quantitative threshold. Auditors must consider the surrounding circumstances and the nature of a misstatement when evaluating its importance.
How Auditors Manage Audit Risk
The primary way auditors manage audit risk is by adjusting detection risk to offset the assessed levels of inherent and control risk. There is an inverse relationship between these components. If an auditor determines that a company has high inherent and control risk, they must set a very low detection risk to achieve an acceptably low overall audit risk, which requires more extensive testing.
To lower detection risk, auditors modify the nature, timing, and extent of their substantive procedures. Changing the nature of a test involves selecting more effective procedures, such as directly confirming account balances with third parties like banks or customers, which provides stronger evidence than relying on internal documents.
Altering the extent of testing often means increasing sample sizes. If control risk is high for sales transactions, an auditor might increase the sample of invoices they examine from 75 to 150. Adjusting the timing of procedures involves performing tests closer to the company’s fiscal year-end. Testing inventory on December 31st provides more reliable evidence than testing it on November 30th and rolling forward the activity.