Reviewed by Aug 27, 2020| Updated on
Definition of Audit Risk
Audit risk is the danger of financial statements being significantly inaccurate unless the audit opinion notes that the financial results are free from any factual mistakes. An audit aims to reduce the audit risk by adequate testing and appropriate evidence to a suitably low level.
Since creditors, investors, and other stakeholders depend on the financial statements, audit risk can be subject to legal liability for an audit work of a CPA company.
An auditor performs inquiries and checks on the general ledger and the relevant documents during an audit. If any mistakes are found during the study, the auditor demands that management recommend that the journal entries be corrected.
At the end of an audit, an auditor gives a written opinion after any corrections have been made as to whether the financial statements are free of material misstatement. Auditing companies provide insurance to handle the audit risk and the possible legal liability.
Audit Risk Types
The two components of audit risk are the risk of material misstatement and risk identification. For example, a large sporting goods store needs an audit, and a CPA firm is evaluating the risk of auditing the store's inventory.
Risk of Material Misstatement
The risk of material misstatement is the possibility of the financial results being significantly inaccurate before the audit. The term "money" in this case refers to a sum that is significant enough to alter a reader's view on a financial statement, and the percentage or sum is subjective.
Considering the example above, if a stakeholder of the store identifies that the inventory balance of Rs.10,00,000 has an error of Rs.1,00,000, it can be considered to be a significant amount.
Risk identification is the danger that a material misstatement is not identified by the auditor's procedures. For example, an auditor must perform a physical inventory count and compare the results to the accounting records.
Continuing the example, an auditor must perform an actual count of the inventory and compare the results with the books of accounts. The count proves the existence of an inventory. If the test sample for the inventory count is insufficient to extrapolate the entire inventory, the degree of risk identification is higher.