Audit risk refers to the possibility that a clean audited report may be issued when there is significant misstatement in the business financial statement. In other words, the auditor’s opinion is inappropriate as they failed to detect material misstatements in the business financial statement.

Broadly, risk is classified into three types.

1-Inherent risk

Inherent risk is independent of internal controls and organizational efforts to control it. Complex business operations may drive this potential vulnerability, challenging/difficult transactions, and intensive compliance, which is genuinely generated by business operations. For instance, banking and insurance sector audits are inherently risky because of intensive compliance requirements and challenging accounting.

2-Control risk

Internal control weaknesses drive control risks. Overriding or defecting internal controls leads to impaired financial reporting controls and operational vulnerability. From the audit perspective, weak internal controls result in higher risk and extensive audit procedures. Hence, audits consume more time and resources.

3-Detection risk

Detection risk arises as audit procedures are not expected to test 100% of the population. Hence, the sample the auditor selects may skip transactions containing significant misstatements individually or aggregated.

Audit risk model

AR= inherent risk x control risk x detection risk

The audit client and auditor cannot do anything about inherent risk as the nature of the business operations drives this risk. However, audit management can control by implementing robust internal controls, adequate policies, training, and a proactive approach towards risk management.

Similarly, the auditor needs to lower detection risk to an acceptably low level by designing adequate auditing procedures and selecting appropriate sample.

To be conclusive, if risk is higher, the auditor must design extensive procedures and vice versa.

Conclusion

Audit risk refers to the possibility that the auditor will issue a clean audit report when a significant misstatement remains undetected and uncorrected in the business financial statement.

Broadly, there are three components of auditing risk, including inherent risk, control risk, and detection risk. Inherent risk arises from complex business accounting, operations, compliance, and other aspects. Control risk is driven by weak internal controls, and detection risk arises from sampling. So, the auditor is required to develop effective audit planning/strategy, leading to reasonable audit assurance.