Table of Contents

1. Introduction

2. Reasonable Assurance

3. Material Misstatement

4. Audit Risk

5. Inherent Risk

6. Control Risk

7. Detection Risk

8. Benefits of Risk Based Audit

9. Concept of Risk Assessment

Check out
Taxmann’s Audit of Financial Statements which is a comprehensive guide that assists auditors conducting financial statement audits, covering every step from auditor appointment to audit report issuance. It incorporates practical examples, detailed procedures, relevant legal requirements, and templates for documentation. While it is specifically geared towards auditing companies not following Ind AS, its core concepts apply to all auditing scenarios.

1. Introduction

The transactions that make up financial statements, including the balance sheet, were the focus of a traditional audit. A risk-based approach looks for risks that could have the biggest impact.

A risk-based audit methodology is recommended by the Institute of Chartered Accountants of India’s Standards on Auditing. In a risk-based audit, the auditor’s goal is to achieve reasonable assurance that the financial statements are free of major misstatements, including those brought on by fraud or mistakes.

2. Reasonable Assurance

Reasonable assurance relates to the whole audit process. It is a high level of assurance but is not absolute. Reasonable assurance is obtained when the auditor has obtained sufficient appropriate audit evidence to reduce audit risk to an acceptably low level.

The auditor cannot provide absolute assurance due to the inherent limitations in the work carried out, the human judgments required, and the nature of evidence examined. The following are some of the inherent limitations of an audit:

1. The preparation of financial statements involve judgment and subjective decisions or assessments (such as estimates) by the management;

2. Much of the audit evidence obtained by the auditor tends to be persuasive in character rather than conclusive;

3. Audit procedures, however, well designed, will not detect every misstatement. This is because:

a. Any sample of less than 100% population introduces some risk that a misstatement will not be detected;

b. Management or others may not provide the complete information required. This may be intentional or unintentional;

c. Frauds are generally sophisticated and carefully organised schemes designed to conceal it;

d. Audit procedures may not be able to detect misstatement.

3. Material Misstatement

A material misstatement (either individually or collectively of all unrepaired misstatements and omitted/misleading disclosures in the financial statements) is considered to have occurred when it is conceivable that it will have an impact on the users’ ability to make sound financial decisions.

Two levels of the possibility of substantial misrepresentation exist

• The overall financial statement level; and
• The assertion level for classes of transactions, account balances, and disclosures.

4. Audit Risk

Audit Risk is defined as:

· The risk that financial statements contain a material misstatement; and;

· The risk that the auditor will not detect such a misstatement.

In other words, the risk of expressing an incorrect audit opinion on financial statements that are materially false is what is meant by audit risk. As an illustration, the auditor provides an unqualified opinion when, in reality, a qualified opinion was required. Financial statement audit’s goal is to lower audit risk to an acceptable level..

5. Inherent Risk

It is the susceptibility of an assertion to a misstatement that could be material, individually or when aggregated with other misstatements, assuming that there are no related controls. Inherent risk is addressed at both the financial statement level and at the assertion level.

Inherent risk includes events or conditions (whether internal or external) that could result in a misstatement (whether due to error or fraud) in the financial statements. The sources of risk can arise from the entity’s objectives, the nature of its operations/industry, the regulatory environment in which it operates, and its size and complexity.

Example of Inherent risk: Technological developments might make a particular product obsolete, thereby causing inventory to be more susceptible to overstatement as the same may have to be sold at heavy discount thus having lower net realisable value.

6. Control Risk

It is the risk that the entity’s internal control system will not prevent, or detect and correct on a timely basis, a misstatement that could be material, individually or when aggregated with other misstatements.

Example of Control risk: Lack of inventory controls such that employees at a store could walk away with inventory undetected. This may result in a possible risk of material misstatement if the inventory were small, portable and valuable, such as jewellery.

7. Detection Risk

Detection Risk is the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements.

8. Benefits of Risk Based Audit

Performing an audit as per Risk Based approach has several benefits, some of which are:

(a) Time flexibility for audit work

Risk assessment procedures do not involve the detailed testing of transactions and balances and therefore, can be performed well before the year end, assuming no major operational changes are anticipated. This can help audit firms to balance the workload of its staff more evenly throughout the year.

Performing risk assessment procedures prior to year-end also provides the client with time to respond to identified (and communicated) weaknesses in internal control and other requests for assistance before the commencement of year-end audit fieldwork.

(b) Audit team’s effort focused on key areas

Under the risk based audit, the auditor understands where the risks of material misstatement can occur in the financial statements and therefore, audit team’s effort can be directed towards high-risk areas rather than towards lower-risk areas. This will also ensure efficient utilisation of audit staff resources.

(c) Audit procedures focused on specific risks

Further audit procedures are designed to respond to assessed risks. As a result, tests of details/substantive procedures that only address risks in general terms may be significantly reduced or even eliminated. An understanding of internal controls enables the auditor to make informed decisions on whether to test the operating effectiveness of internal controls. Performing tests of controls will significantly reduce the work of auditor as compared to performing extensive tests of details.

(d) Communication of matters of interest to management

The improved understanding of internal control may enable the auditor to identify weaknesses in internal controls that were not previously recognised. Communicating these weaknesses to management on a timely basis will enable the management to take appropriate corrective action. This may further save time in performing the audit.

9. Concept of Risk Assessment

Risk-based audits require auditors to understand the entity and its environment, including internal controls. The objective is to identify and assess the risks of material misstatement of the financial statements.

A thorough understanding and assessment of the risks of material misstatement, whether due to fraud or error, in the financial statements is fundamental to performing an efficient and effective audit and is at the core of standards on auditing.

Risk assessment requires considerable professional judgment and it is, therefore, important that the audit partner and senior audit team members be actively involved in identifying and assessing the various types of risks and develop an appropriate audit response.

The risk assessment phase of the audit involves the following steps:

· Performing client acceptance or continuance procedures (in accordance with requirements of SQC 1 issued by ICAI);

· Planning the overall engagement;

· Performing risk assessment procedures to understand the business and identify inherent and control risks;

· Identifying relevant internal control processes and assessing their design and implementation of those controls that will either prevent material misstatements from occurring or detect and correct misstatements after they have occurred;

· Assessing the risks of material misstatement in the financial statements;

· Identifying the significant risks that require special audit consideration and those risks for which substantive procedures alone are not sufficient;

· Communicating any material weaknesses in the design and implementation of internal control to management and those charged with governance; and

· Making an informed assessment of the risks of material misstatement at the financial statement level and at the assertion level.

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• Source: https://www.finextra.com/blogposting/24494/a-comprehensive-guide-to-assessing-material-misstatement-risks?utm_medium=rssfinextra&utm_source=finextrablogs