Audit risk is defined as the risk involved in the auditing process of financial statements of a company. It basically refers to the percentage of errors or flaws within an audit report. The formula used to represent audit risk is ‘Audit Risk (AR) = IR x CR x DR’. IR stands for Inherent risk in the formula representing probability or errors. CR in the formula is Control Risk representing the errors that are either left undetected by the internal control authorities or no control authorities were made for it. DR is detection risk, which represents the probability of the auditor not detecting the errors in his reports.
The audit risk for a specific audit has to be defined as low, medium or high. This classification can only be known after applying the audit formula on the situation. However, the audit risk formula only gives a generic understanding of the risk associated with the audits. It works as a basic plan to ensure the risk involved in auditing, but is never a sure-fire way of assessing it. There are numerous other factors involved in audits which are realized later on when the reports are actually being audited. These factors can play a vital role in determining the outcomes of the audit.
Planning to cut down the audit risk involves a number of strategies. The factors which are responsible for increasing and decreasing the audit risk are examined thoroughly. All the financial statements and account balances of a company are taken into consideration and examined for errors. Auditors assess the risk and the scope of the audit based on the following:
- The experience of personnel involved and the company’s reliability on them
- The simplicity of the Audited transactions
- The internal risk control framework if any
All of these factors are taken into account by the auditors to create a benchmark while developing the nature of the audit, its timings and extent.
Inherent risk is a type of risk associated with auditing. It is the risk related to the errors found in the financial documents of a company. At the end of every year, every company which is bound to go through an auditing process faces such risks. Therefore, the auditor assesses the inherent risk after examining the audited organization’s environment. The percentage that should be allocated to inherent risk depends on the auditor’s judgment, which is why hiring a very skilled professional is required. At times, the inherent risk can be 2% and at times it can be 5% depending on the organizational structure of a company. This means that the auditor judges to let go of a certain percentage of the errors found in the financial documents while auditing them.
Inherent risk is always stated as being low, medium or high. This judgment is made after assessing the risk through a particular scale. Situations in which the risk is high or medium requires a bit of extra work to be performed to conclude that the management’s declarations are correct. In this context, inherent risk is also widely defined as a type of risk which is unable to manage. The chances of inherent risk are always there no matter what type of a strategy the organization adopts.
An auditor can take the following into consideration while determining the inherent risk:
- Complications involved in determining the final account amount
- The overall risk awareness of the management
- The environment of the business and its current situation (the more the fluctuations are, the more the inherent risk will be)
The auditor makes a judgment keeping all these factors in mind. Once the inherent risk is determined, the auditor then starts with the auditing session. The percentage determined for inherent risk remains the same, and the organization enjoys a certain amount of negligence to the errors in the process.