Chapter 9a - Risk assessment Flashcards
What are the key stages in a risk assesment conducted by auditors at the planning stage?
- Understanding the entity and its environment
- Identify risk of material misstatements (audit risk)
What is business risk?
Business risk refers to the potential for conditions, events, or circumstances—both internal and external—that could negatively impact an organization’s ability to achieve its goals and successfully implement its strategies
What are the three general categories of buisness risk? Define each
- Financial Risk – This type of risk arises from a company’s financial activities or the financial consequences of its operations. It includes risks such as cash flow problems, excessive debt, fluctuating interest rates, and overtrading, which can threaten a business’s stability and profitability.
- Operational Risk – These risks stem from internal processes, systems, or external events that impact day-to-day business operations. Examples include supply chain disruptions (such as losing a key supplier), equipment failures, human errors, or cybersecurity threats, all of which can hinder business performance.
- Compliance Risk – This risk arises when a business fails to adhere to laws, regulations, or industry standards. Non-compliance can lead to legal penalties, fines, reputational damage, or even business closure. For example, a restaurant not following food hygiene regulations could face fines, legal action from customers, or forced shutdowns.
What is the impact of business risk on an audit?
Auditors focus on business risk because any significant threats to a company’s operations, financial stability, or regulatory compliance could lead to material misstatements in the financial statements. Since business risks can affect the accuracy and reliability of financial reporting, auditors assess these risks to determine the likelihood of errors, fraud, or misrepresentations. Identifying and understanding business risks helps auditors plan their procedures effectively, ensuring that they address areas most susceptible to misstatement, which is a key aspect of audit risk.
What is audit risk?
A: Audit risk is the risk that an auditor provides an incorrect audit opinion on financial statements that contain material misstatements. This means the auditor may mistakenly conclude that the financial statements are free from significant errors or fraud when, in reality, they are not.
Audit risk is a key concern in the auditing process and is typically broken down into three components:
* inherent risk
* control risk
* detection risk
Define inherent risk with regards to audit risk and outline the key factors that can influence it
Inherent risk is the susceptibility of a financial statement assertion to material misstatement, either individually or when aggregated with other misstatements, before considering internal controls. It arises due to the nature of the business, industry complexities, and external factors that increase the likelihood of errors or fraud.
Key factors affecting inherent risk include:
* Complexity – Compliance with regulations, risk of non-compliance, and business model complexities (e.g., joint ventures, alliances).
* Subjectivity – Choices in accounting standards, valuation techniques, and estimation uncertainties.
* Change – Economic stability, shifts in customer base, supply chain disruptions, or new products/services.
* Uncertainty – The degree of estimation involved and susceptibility to errors.
* Susceptibility to bias and fraud – Motivations to manipulate financial statements, such as securing financing, meeting performance targets, or preparing for a sale.
Auditors assess each of these factors in terms of their likelihood and material impact, placing them on a spectrum from low to high inherent risk to determine areas requiring more scrutiny.
Define control risk with regards to audit risk
Control risk is the risk that a material misstatement in the financial statements will not be prevented, detected, or corrected on a timely basis by the entity’s internal controls. If internal controls are weak or ineffective, errors or fraud may go unnoticed, increasing the risk of inaccurate financial reporting.
Control risk is assessed at two levels:
Indirect Controls – These influence the overall financial statement level and the general risk of misstatements. They include:
* Control Environment – The company’s overall attitude, awareness, and commitment to internal controls. It includes management’s integrity, ethical values, governance structure, and enforcement of accountability.
* Entity’s Risk Assessment Process – How an organization identifies, analyzes, and responds to risks that could affect financial reporting. This includes assessing business risks, fraud risks, and operational risks.
* Entity’s Process to Monitor Internal Controls – The organization’s ability to review, test, and improve its internal control system over time. This may involve internal audits, management reviews, and corrective actions to address control weaknesses.
Direct Controls – These affect specific financial statement assertions and reduce the risk of misstatements in particular transactions or account balances. They include:
* Information System and Communication – The processes and systems used to record, process, summarize, and report financial transactions.
* Control Activities – Specific actions taken to mitigate risks at the transaction level. These include:
Authorization Controls – Ensuring that transactions (such as payments, purchases, or credit approvals) are properly authorized by designated personnel.
Reconciliation Controls – Comparing records (e.g., bank statements vs. internal ledgers) to ensure they match.
Segregation of Duties – Distributing key financial responsibilities among multiple employees to prevent fraud and errors.
Physical Controls – Safeguarding assets, financial records, and sensitive data through security measures like restricted access, password protection, inventory counts, and locked storage
Define detection risk with regards to audit risk
Detection risk is the risk that the audit procedures performed by the auditor will fail to identify a material misstatement in the financial statements, even though such a misstatement exists. This risk is directly related to the effectiveness of the audit procedures and the auditor’s judgment in planning and executing them
Detection risk consists of two key components:
Sampling Risk - This is the risk that a material misstatement is not detected because the auditor examines only a sample of transactions rather than the entire population. Since it is impractical to test 100% of transactions, auditors use sampling techniques to draw conclusions about the overall financial statements. However, if the sample is not representative, a material misstatement could go undetected.
Non-Sampling Risk - This is the risk that a material misstatement goes undetected due to factors unrelated to sampling. It arises from human errors, poor audit procedures, or a flawed approach. Common causes include:
* Recent appointment – If the auditor is newly appointed, they may have limited understanding of the business and its risks, increasing the likelihood of missing key issues.
* Rush job – Time constraints may lead auditors to rush through procedures, potentially overlooking important details.
* Poor approach – An ineffective audit strategy, such as failing to focus on high-risk areas, may result in missing misstatements.
* Lack of objectivity & professional skepticism – If auditors fail to critically assess management’s assertions or challenge questionable financial reporting, they may overlook material misstatements.
To minimize detection risk, auditors must design effective procedures, apply professional skepticism, allocate sufficient time for testing, and ensure appropriate sample selection.
Which of the three components of audit risk are within the auditors control?
Unlike inherent and control risk, which are influenced by the entity, detection risk is within the auditor’s control and can be reduced by applying rigorous audit techniques.
What is a significant risk with regards to audit risk? How do auditors deal with these if identified?
A significant risk in an audit is an identified risk of material misstatement that ranks high in terms of likelihood and/or materiality on the risk spectrum. These risks typically involve complex transactions, areas of high estimation uncertainty, or susceptibility to fraud.
Significant risks require special audit attention because they have a greater potential to impact the financial statements. Examples include:
* Revenue recognition – due to risk of manipulation to meet earnings targets.
* Valuation of financial instruments – involving complex estimates and judgment.
* Management override of controls – where executives may bypass internal safeguards.
* Going concern issues – if a company faces financial distress.
When a risk is deemed significant, the auditor is required to:
* Perform a detailed evaluation of internal controls related to that risk.
* Design and execute enhanced substantive audit procedures to gather sufficient evidence.
* Apply professional skepticism to challenge management’s assumptions and estimates.
By identifying and addressing significant risks, auditors ensure they provide a robust opinion on whether the financial statements present a true and fair view.
