Audit Risk vs. Business Risk
October 30, 2015 by Ed Becker
There is always a risk involved in an audit, because the auditor is giving an opinion. An audit risk is when the opinion is inappropriate on the financial statements. There is a model to calculate this risk, it is the multiplication of inherent risk, control risk and detection risk.
Business risk, on the other hand, includes factors that could hinder the goals and objectives of the company during the course of an audit. We will look at both types of risks in this last segment of the financial statement series.
The three elements of audit risk
- Inherent Risk
The risk of materially misstating in the financial statements caused by errors or omissions, from factors that are not a failure of controls. Inherent risk is usually higher when there is a higher degree of judgement and estimation involved or when the company’s transactions are very complex.
- Control Risk
The risk of materially misstating in the financial statements caused by the lack of or failing of relevant controls in operations of the company. Internal controls and checks and balances must be in place to prevent and alert issues of error or fraud. Control risk tends to be higher when the internal controls are not adequate.
- Detection Risk
The risk of failure to detect the occurrence of material misstatements in the financial statements. The auditor must use proper audit procedures to alert to misstatements whether due to error or fraud. If proper procedures are not followed or not applied correctly a misstatement could be undetected. There is always a certain amount of detection risk due to the inherent limits of an audit, for example, using sampling in selecting transactions. This risk can be lessened by sampling more transactions.
Auditors use the audit risk model to attempt to lessen the audit risks. They will examine inherent and control risk in order to understand the environment of the company.
Business risks
Business risks relate exclusively to the company and its stakeholders. These risks can be very diverse, but the largest risk facing any company is that is ceases to continue. The risks include any factors that could lead to business failure. The following is a list of common business risks, but it is not all-inclusive.
- High financial risk
- Cash flow issues
- High risk of theft and fraud
- Increase in production cost
- Lack of financing
- Decline in demand
- Loss of profitability
- Legal issues
- Increased competition
- Decrease in customers
- Over trading
- Political or economic instability
Audit risks includes factors that can cause a misstatement, error or omission in the financial statements this is directly related to the auditor. Business risks relate to the company itself, including stakeholders. While these risks are very different, if there are large business risks they could lead to higher detection of audit risks. To ensure that business risks are considered in audit planning, a top down approach is encouraged. Ensuring that the auditor fully understands the environment of the company prior to auditing.
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Category: Small Business
