What is Engagement Risk?

Engagement risk is the overall risk associated with an audit engagement. It can include a loss of reputation from being associated with a particular client, and financial losses from the association. Engagement risk tends to increase when a client is in a weak financial condition, and especially when it will likely require additional financing in order to survive. In this situation, the client is more likely to go bankrupt, in which case its investors and creditors will be more likely to drag the auditor into any subsequent litigation.

When the auditor is risk-averse, as is more likely to be the case with a large and well-established audit firm, it is more likely that engagements with high levels of engagement risk will be rejected. Conversely, a newer audit firm that wants to aggressively pursue new business might be more inclined to take on a client with high engagement risk, as long as it expands its audit procedures to offset the risk. These additional procedures will increase the audit firm’s engagement costs.

The auditor examines only those controls that are relevant to the engagement risk assessment. This means that the auditor can exclude an examination of the controls associated with certain operating units and business functions when they do not have a direct impact on the financial statements. Instead, the auditor focuses on those controls that can prevent, detect, or correct material misstatements within the client’s financial statements.

What Causes Engagement Risk?

Engagement risk is likely to be higher in the following situations:

Adverse economic conditions. If a client is in a struggling industry or faces significant financial challenges, there’s a higher risk of failure or financial misreporting.
Adverse prior audit findings. If the client has a history of restatements or significant audit findings, the current engagement carries more risk. This may reflect issues with internal controls or accounting policies.
Broad or poorly defined audit scope. An engagement with an overly broad or ill-defined scope increases the likelihood of misunderstandings or unmet expectations, contributing to engagement risk.
Changing laws or regulations. When there are changes in tax codes, accounting standards, or regulatory requirements, clients may struggle to comply, raising the risk of non-compliance or incorrect reporting.
Complex transactions. Engagements involving complex accounting rules, mergers and acquisitions, international operations, or derivatives can heighten risk.
Controversial clients. Working with a client that is already facing public scrutiny, negative media coverage, or stakeholder pressure can increase the reputational risk to the service firm.
Financial instability. If the client is experiencing financial difficulties, there’s a greater chance they may manipulate financial statements or fail, creating both financial and reputational risks for the firm.
High reliance on estimates and judgments. Certain engagements require a significant amount of management estimates (e.g., asset impairments, allowances), making them harder to verify and more prone to error.
High-profile clients. Engagements with large, well-known companies can expose the service firm to greater public attention and reputational damage if the engagement goes wrong.
Industry risk. Some industries are inherently more volatile or susceptible to fraud and error, such as technology, real estate, or finance. This increases the likelihood that issues may arise during the engagement.
Lack of transparency. If the client is unwilling or unable to provide clear and reliable information, this can increase the chances of errors or misrepresentations being overlooked during the engagement.
Liquidity issues. Companies that struggle to meet short-term obligations may be tempted to misrepresent their financial health, leading to a higher likelihood of audit problems.
Poor management control. This can signal that the client may not have adequate checks and balances in place, increasing the likelihood of financial misstatements or errors.
Tightened enforcement. A client operating in an environment where regulators are increasingly scrutinizing compliance may face higher risks, which also extend to the service firm handling the engagement.
Time constraints. Short deadlines can cause errors, omissions, or insufficient attention to detail, which raises the risk of an incomplete or inaccurate engagement.
Unethical behavior by a client. This can include manipulating financial information, can increase the risk. If a company is involved in fraudulent activities, the firm conducting an audit or advisory service could face legal consequences.
Unresolved legal or regulatory issues. Ongoing litigation, government investigations, or past legal trouble can add to engagement risk.
Weak internal controls. Poor internal controls increase the likelihood of material misstatements, errors, or fraud, making it riskier for auditors or consultants to rely on the client’s financial information.