Definition of Audit Risk

Audit risk is the probability that an auditor expresses an inappropriate opinion on financial statements that contain material misstatements due to errors or fraud​. Even with careful planning and execution, some level of audit risk always exists. The goal of an audit is to reduce this risk to an appropriately low level.

The Audit Risk Model

Audit risk is broken down into three components:

• Inherent Risk (IR) – The likelihood that an account or transaction could be misstated assuming no related internal controls. This risk is influenced by the nature of the business, transaction complexity, and past occurrences of misstatements​.

• Control Risk (CR) – The risk that the client's internal controls fail to prevent or detect material misstatements. Auditors evaluate the design and effectiveness of internal controls to assess this risk​.

• Detection Risk (DR) – The risk that the auditor’s procedures fail to identify a material misstatement. Detection risk is controlled by the auditor and is influenced by the nature, timing, and extent of audit procedures​.

These risks interact as follows:

Audit Risk (AR) = Inherent Risk (IR) × Control Risk (CR) × Detection Risk (DR)

Since auditors cannot control IR and CR (which are determined by the client’s environment and internal controls), they adjust their substantive testing (DR) to maintain an acceptably low level of overall audit risk​.

Audit Planning and Risk Assessment

• Auditors begin risk assessment by understanding the client’s industry, business model, and past financial performance.

• They gather information through public records, internal company data, analytical procedures, and inquiries with management and employees.

• A key outcome of risk assessment is the audit strategy memorandum, which outlines significant risks and the auditor's response​.

Practical Implications for Audit Procedures

• If IR and CR are high, auditors must reduce DR by performing more effective and extensive substantive tests.

• If IR and CR are low, auditors can afford less extensive substantive procedures while maintaining overall audit risk at an acceptable level​.

The assessment of these risks directly influences audit planning and execution, helping auditors allocate resources effectively to areas with the highest risk of misstatement.