Which of the following are components of the risk of material misstatement?

The goal of an audit is to form and express an opinion, on whether the financial statements give a true and fair view. The term audit risk refers to the probability of the statements not giving a true and fair view after the audit is completed.

As a result, audit risk is the possibility of a material misstatement, remaining undetected even after the audit is completed.

PERSPECTIVE

Such risk can be perceived from the point of view of the management, as well as that of the auditor.

Management Viewpoint

The management of any entity is saddled with the following responsibilities: Safeguarding the assets created out of the resources of the shareholders. Preventing, detecting and correcting frauds and errors. Maintaining books of account as required by the law in force. Preparing and presenting financial statements from the books of account maintained by the company.

Auditor's Point of View

There are three components of an audit risk from the viewpoint of the auditor — inherent risk, control risk and detection risk.

Inherent risk lies inherent in the audit. This springs from the reason that the systems, as designed by the management, may not be implemented in true letter and spirit. Control risk emanates from the inadequacy or inefficiency of the internal control systems in place.

Especially in small entities, the internal control systems may not exist at all, or even if the systems exist, they may not be followed by the managements.

Detection risk is that component of the audit risk resulting from the failure on the part of the auditor to notice a misstatement.

This could be due to want of experience, negligence, sacrificing integrity, or frauds being skilfully woven into the financial statements.

MITIGATION OF RISK

The auditor has the following recourse at his disposal to minimise the inherent risk to a limited extent:

Updating himself with the latest position of law, regulations, etc. Thorough knowledge of the business of the client and understanding the critical areas. Exercising proper care in selecting his own staff and their training. Comprehensive audit strategies, plans, programmes. Diligence in selecting outsourcing agencies, such as experts. Meticulous planning and scrupulous execution of the procedures. Thorough professional approach.

CONTROL RISK

The internal control systems are designed and developed by the management. Hence control risk isn't in the hands of the auditor. Control risk is said to be high if the systems or their functioning isn't up to the mark.

It is advisable that the auditor presumes the control risk to be high at the planning stage of the audit. Evaluation of the internal control systems is crucial for an auditor, since it is critical for the auditor to Determine the extent of test check to be carried out. Fix up the materiality levels for the substantive procedures to be carried out by him. Decide upon the size of sample to be verified. Decide the nature , extent and timing of the audit procedures to be carried out by him, based upon his evaluation of internal control systems.

After careful evaluation of the internal control systems, the auditor may decide the extent of control risk. He may presume the control risk to be less than high. It isn't advisable for the auditor to presume the control risk to be low at any time.

DETECTION RISK

The probability of the auditor's failure to detect any misstatements during the course of his audit is termed as detection risk. The auditor has to design his substantive procedures to minimize the audit risk.

The extent of overall risk the auditor is willing to take and the efficiency of the internal control systems decides the nature, extent and timing of the audit procedures to be carried out by him.

The auditor would carry out intensive audit procedures on presuming the control risk to be high. Intensive audit procedures would lower the detection risk.

If the auditor presumes the control risk to be low, he would reduce the intensity of the audit procedures, thereby running a higher detection risk.

3-prong assessment

Audit risk is a combination of three components:

1. Control risk. Sometimes a company’s internal controls are inadequate to prevent or detect material misstatements. Control risk increases when the company fails to deploy and enforce effective internal controls, or when employees or third parties override them without the company discovering their actions.

2. Inherent risk. This term refers to susceptibility to a material misstatement, regardless of whether the company has strong internal controls. Certain transactions and industries present greater inherent risk than others.

For example, companies operating in developing countries face a greater threat of bribery and corruption by government officials, regardless of the internal controls they put in place. Inherent risk is also greater when accounting transactions are complex or involve a high degree of judgment.

3. Detection risk. Audit procedures are designed to uncover material misstatements. Detection risk is high when there’s a high probability that substantive audit procedures will fail to detect a material misstatement. When detection risk is elevated, the auditor might, for example, test a larger sample of transactions to mitigate audit risk.

Control risk and inherent risk stem from a company’s industry and actions. Conversely, detection risk is typically managed by the audit team.

Customized audit procedures

The auditor’s role is to attest to your company’s financial statements. Specifically, your audit firm assures that your financial statements are “fairly presented in all material respects, compliant with Generally Accepted Accounting Principles (GAAP) and free from material misstatement.”

Unqualified (or clean) audit opinions require detailed substantive procedures, such as confirming accounts receivable balances with customers and conducting test counts of inventory in the company’s warehouse. Generally, the more rigorous the auditor’s substantive procedures, the lower the likelihood of the audit team failing to detect a material misstatement.

Collaborative effort

Audit season for calendar year-end entities is here. Before the start of fieldwork, let’s discuss changes in your business operations, accounting methods and industry conditions, along with other factors, that could create audit risk. We’ll adjust our audit programs accordingly to ensure that your financial statements are prepared with the highest level of quality and efficiency.

What are the 3 components of audit risk?

What are the 4 types of audit risk?

What are the three types of misstatements?

What are the major components of risk considered by auditors?