What is the relationship between risk of material misstatement and audit risk?
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Audit risk is the risk that financial statements are materially incorrect, even though the audit opinion states that the financial reports are free of any material misstatements. Show
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Understanding Audit RiskThe purpose of an audit is to reduce the audit risk to an appropriately low level through adequate testing and sufficient evidence. Because creditors, investors, and other stakeholders rely on the financial statements, audit risk may carry legal liability for a certified public accountancy (CPA) firm performing audit work. Over the course of an audit, an auditor makes inquiries and performs tests on the general ledger and supporting documentation. If any errors are caught during the testing, the auditor requests that management propose correcting journal entries. At the conclusion of an audit, after any corrections are posted, an auditor provides a written opinion as to whether the financial statements are free of material misstatement. Auditing firms carry malpractice insurance to manage audit risk and the potential legal liability. Types of Audit RiskThe two components of audit risk are the risk of material misstatement and detection risk. Assume, for example, that a large sporting goods store needs an audit performed, and that a CPA firm is assessing the risk of auditing the store's inventory. Risk of Material MisstatementMaterial misstatement risk is the risk that the financial reports are materially incorrect before the audit is performed. In this case, the word "material" refers to a dollar amount that is large enough to change the opinion of a financial statement reader, and the percentage or dollar amount is subjective. If the sporting goods store's inventory balance of $1 million is incorrect by $100,000, a stakeholder reading the financial statements may consider that a material amount. The risk of material misstatement is even higher if there is believed to be insufficient internal controls, which is also a fraud risk. Detection RiskDetection risk is the risk that the auditor’s procedures do not detect a material misstatement. For example, an auditor needs to perform a physical count of inventory and compare the results to the accounting records. This work is performed to prove the existence of inventory. If the auditor's test sample for the inventory count is insufficient to extrapolate out to the entire inventory, the detection risk is higher. The risk of material misstatement is the risk that the financial statements of an organization have been misstated to a material degree. This risk is assessed by auditors at the two levels noted below. When the risk of material misstatement is high, the level of detection risk is lowered (increases the amount of evidence obtained from substantive procedures). Doing so reduces the overall audit risk. Risk of Material Misstatement at the Assertion LevelThis risk is further subdivided into inherent risk and control risk. Inherent risk is the susceptibility of an assertion to misstatement because of error or fraud, before considering controls. Control risk is the risk of misstatement that will not be prevented or detected by a reporting entity's internal controls. Risk of Material Misstatement at the Financial Statement LevelThis risk relates to the financial statements as a whole. This risk is more likely when there is a possibility of fraud.  Our sites
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Audit risk has an inverse relationship with materiality. The lower the materiality, the higher the audit risk as a lower materiality means there is less room for error. Previous Question Next Question Back To All Questions Audit risk is the risk that the auditor will fail to modify an opinion on the financial statements when they are in fact materially misstated. This will typically arise because an auditor will never be able to obtain absolute assurance by conducting audit procedures. Audit risk will only be able to be reduced to an... Read More Detection risk has an inverse relationship with the assessed risk of material misstatements (Inherent risk X control risk). Therefore, if risk of material misstatement is high, then detection risk would be set to high. This means that the audit team can rely on controls and can decrease the amount of substantive testing that needs to... |
