Acceptable Audit Risk
Describe about the Audit Strategic Planning for Devoid of Risk.
It is a common parlance that each business is vulnerable to various kinds of risks. The companies are unable to keep the risks at bay even after proper consideration of the risk and strategic planning. Such a risk is define as inherent risk and is relate to the activity of the business without any consideration of the nature of business. Financial fraud is on the rise and hence, it is important to have strong audit in practice. There are certain factors that need to be taken into consideration. Even the audit is not devoid of risk (Gilbert et. al, 2005). There are various factors that influence the audit process and the auditor need to shed light on it. Auditor plays a vital role and therefore, the decision provided by the auditor plays a leading role. It is the duty of an auditor to maintain personal touch with the management so that information associated with errors and frauds in the financial statements can be effectively assess. Such an auditor must make proper enquiries with the management to ascertain the truthfulness of financial information. Furthermore, the auditor’s opinion depends on the notion of reasonable certification and hence he must not assure any traces of errors and frauds in the financial statements.
An auditor is a key functionary in building the credibility of the company. His assessment and judgement go a long way in creating a stable report with sincerity and with honest facts and opinions. His responsibility is not to just plan and perform the auditing responsibility with reasonable assurance but also create value for the stakeholders in the entire process. In doing so, he carries residual risk or the audit risk of issuing an unqualified report due to his failure to detect misrepresentation, fraud, or errors (Fazal, 2013). His opinion gives the confidence whether the financial statements are error free and of any material misstatement.
A later discovery of fraud or misrepresentation by the company that the auditors could have detected within his powers can attract penalty and criminal charges against the audit firm and the auditor. Audit firms subscribe to malpractice insurance to manage this risk and the potential legal liability (Manoharan, 2011). While communicating about the discovery of errors and frauds with the management, auditors must take into account the integrity of financial information. During the audit process, if an auditor has reasonable grounds to believe that even the management is involved in the fraud, then he must make proper steps to communicate such happenings with the superior authorities and must consider the position of indulged personnel in such fraud.
Components of Audit Risk
The auditor in his best judgement and experience has to consider the best outcome factors that will determine his issuance of the unqualified report. However, the audit reports can go wrong in matters such as – issuing an unqualified report where qualification is reasonably justified, issuing a qualified opinion without substance, failing to magnify an important factor in the audit report, and providing an opinion on the financials where the limitation of the scope does not require that opinion (Parker et. al, 2011).
Audit risk is a component of various factors that lead to an audit activity. The entire process of audit can be broken up into components that make up the entirety of audit risk. These components by a commonly accepted model are Inherent Risk, Control Risk, and Detection Risk.
Audit Risk = Inherent Risk * Control Risk * Detection Risk
Audit risk is a product of all these three risks. The auditor has to have a measure of these risks and ensure these stay in their acceptable limits to allow the Audit risk to be minimize.
Inherent Risk – It is the risk of material misstatement in the financials due to errors of omission or commission and specific control failures. These risks are especially broad in where a large spectrum is judgement and estimation is involved or transactions get very complex.
For example, financial organisations indulging in hedging and speculative derivatives will pose a risk of loose control and highly informal way of recording risk. This risk will get reduced in a en established environment for a company where method of control and recording are stable and developed (Roach, 2010).
Control Risk – It is the risk arising due to failure or absence of operational controls in the organization. Organizations need to have adequate internal controls for prevention and detection of frauds and errors (Livne, 2015). This assessment needs to be more carefully for smaller firms where there is no specialization of tasks/processes and many control features might not be established which could actually minimize the effects of control risks.
Detection Risk – This is the risk that inspite of certain indications, auditors might fail to add up the signals and reach to the potential fraud or misrepresentation. It is the auditor’s responsibility to apply audit procedures and detect material misinterpretations, or representations. The failure to follow certain procedures and potential omissions happens due to limitations that are inherent in respect of sampling selection. This can be reducing by increasing the number of sample transactions (Livne, 2015).
External Factors that Affect Audit Risk
These form part of the audit risk model where the auditors examine the inherent and control risks of audit engagement while understanding the environment and operational efficacy of the organisation.
Detection risk is the residual risk after into consideration the previous two risks as mentioned and the overall audit risk that the auditor is comfortable to take upon himself.
These above factors form the basis of the audit risk and there are some external factors which might make the auditors consider their opinion on the risks of the organization for which audit is carried out. We discuss below how the below factors affect the audit risk.
It is known as Engagement risk at the financial statement level and is affected by the final use and urgency or seriousness of the use by the end user. For example, if the financial statements are to be use for a credit appraisal process, the motivation of the management to influence the auditor will be very high and the auditor will have an added pressure to adhere to the exact standards or create favourable opinion (Hoffelder, 2012). This might in instances lead to ‘window-dressing’ of the statements. Essentially the risk of the end usage increases the risk of closer scrutiny which might create a bias in the mind if the auditor whether to really grasp all the nuances or let few slides if the end user is just for common public.
The going concern principle applies to all commercial entities unless specified so or indications are seen through the liquidity of the organization. It is the auditor’s responsibility to detect and magnify areas that can be potential for continuity issues and for such examination, desired level of evidence has to be collected. If a doubt arises, the management plans should be consider mitigating destructive information reflected in the financial statements (Horngren, 2013). The management can also mislead such information and it takes a very incisive and sometimes experienced auditor to see through the planning to check if the company will really be serious. It is important for the auditor to keep aside his personal biases in determining the facts in such cases (Lapsley, 2012).
The integrity of the management is an important factor in controlling the auditor’s risk. A way to document this is the client’s acceptance/continuance form. Management’s attitude towards standards, follow-ups, setting policies for internal control and their seriousness will make the auditor’s job that much easier (Cappelleto, 2010). This will also set the tone for the employees to follow and the component risks can be minimize or measured. It is in the auditor’s well-being that he keeps reminding the management about the importance of strong internal controls, documentations, which will help, reduce his own bias and judgement issues in giving a qualification on the audit. Effective use of the decision of auditors by the audit firms facilitates in contracting the gap. As per various studies, audit standards can be effectively maintained through the proper assistance of auditor’s decisions, thereby providing great help to the people. Furthermore, when an auditor performs audit processes with dubiousness, it facilitates in high quality audit because it ensures that every uncertain situations are taken into account.
Audit strategies for large and small firms will vary on the factors of complexity and management efficiency levels. Sometimes large firms use a lot of procedural rules and by-laws to manipulate the same information a small company cannot hide from its auditors/end users (Cappelleto, 2010). The risk of audit hangs not just in the necks of the auditor but the company at large. It will assist him to be attentive about the information incorporated in the financial statements and he is bound to accept such received information only when other details oppose with the former one. Hence, investigation must not be conducted before this. Such examples happen repeatedly where auditors and management work hand-in-glove to create Enrons of the world. To avoid such fallen standards of auditing, it is important for the auditing companies to build models to be following and procedures to be report for all audits.
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Hoffelder, K 2012, New Audit Standard Encourages More Talking, Harvard Press.
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Livne, G 2015, Threats to Auditor Independence and Possible Remedies, viewed 15 September 2016, https://www.financepractitioner.com/auditing-best-practice/threats-to-auditor-independence-and-possible-remedies?full.
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