Whenever an auditor provides a report about a company’s financial statements, there is a risk that the auditor’s opinion is erroneous. This is referred to as audit risk. An incorrect or faulty opinion could mislead investors and regulatory authorities. The auditor must eliminate, or at least, minimize this risk.
What does audit risk mean?
Audit risk can broadly be classified into three types: ⇨ Inherent risk – an incorrect accounting statement is an example of this type of risk. If the employees in the accounting department are inexperienced or lack accounting expertise, the level of inherent risk could be high. ⇨ Detection risk – the auditor may fail to identify an error in the accounting records. This failure is referred to as detection risk. To minimize this risk, it is essential for the auditor to be extremely vigilant during the course of the audit. An adequate volume of transactions should be checked to ensure that errors and frauds are identified. If any discrepancies are detected, it could be necessary to increase the sample size of the transactions that are reviewed. ⇨ Control risk – there could be a lack of internal controls within the organization. This could lead to errors and frauds.
Example of audit risk
The auditors of Enron, an energy company that filed for bankruptcy 2001, clearly failed to carry out their duties in a responsible manner. Enron’s accountants entered into a series of transactions with related entities. By doing this, they fraudulently inflated the profits of the parent company. Arthur Andersen, the accounting firm that was Enron’s auditor, did not raise the alarm when it became aware of the company’s illegal practices. When it finally told Enron’s board that the company’s accounts contained unacceptable misstatements, it was too late. Enron filed for bankruptcy soon after this.
The risk that an audit firm could express an incorrect opinion about a company’s financial statements is called audit risk.