17/12/2019 Audit Risk Definition

TRADING SKILLS & ESSENTIALS RISK MANAGEMENT

Audit Risk
By ALICIA TUOVILA | Updated May 23, 2019

What Is Audit Risk?

Audit risk 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. The purpose
of an audit is to reduce the audit risk to an appropriately low level through adequate testing
and sufficient evidence. Because creditors, investors, and other stakeholders rely on the
financial statements, audit risk may carry legal liability for a CPA firm performing audit work.

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Over the course of an audit, an auditor makes inquiries and performs tests on the general
ledger and supporting documentation. If any errors are caught during the testing, the
auditor requests that management propose correcting journal entries. At the conclusion of
an audit, after any corrections are posted, an auditor provides a written opinion as to
whether the financial statements are free of material misstatement. Auditing firms carry
malpractice insurance to manage audit risk and the potential legal liability.

Types of Audit Risks

The two components of audit risk are the risk of material misstatement and detection risk.
Assume, for example, that a large sporting goods store needs an audit performed, and that a
CPA firm is assessing the risk of auditing the store's inventory.

Risk of Material Misstatement

The risk of material misstatement is the risk that the financial reports are materially incorrect
before the audit is performed. In this case, the word "material" refers to a dollar amount that
is large enough to change the opinion of a financial statement reader, and the percentage or
dollar amount is subjective. If the sporting goods store's inventory balance of $1 million is
incorrect by $100,000, a stakeholder reading the financial statements may consider that a
material amount. The risk of material misstatement is even higher if there is believed to be
insufficient internal controls, which is also a fraud risk.

Detection Risk

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Detection risk is the risk that the auditor’s procedures do not detect a material
misstatement. For example, an auditor needs to perform a physical count of inventory and
compare the results to the accounting records. This work is performed to prove the existence
of inventory. If the auditor's test sample for the inventory count is insufficient to extrapolate
out to the entire inventory, the detection risk is higher.

Related Terms
Voucher
A voucher is a document recording a liability or allowing for the payment of a liability, or debt, held by
the person or company who will receive payment. more

Detection Risk Definition

Detection risk is the chance that an auditor will fail to find material misstatements that exist in an
entity's financial statements. more

Generally Accepted Auditing Standards (GAAS)

Generally Accepted Auditing Standards are a set of guidelines for conducting audits of a company's
financial records. more

How Independent Auditors Protect Investors From Company Fraud

An independent auditor is a certified public or chartered accountant who examines the financial
records of a company with which he is not affiliated. more

What is an Audit?
An audit is an unbiased examination and evaluation of the financial statements of an organization.
more

Sampling Definition
Sampling is a process used in statistical analysis in which a group of observations are extracted from a
larger population. more

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