What is Audit Risk?

Audit risk is the risk that an auditor will not detect errors or fraud while examining the financial statements of a client. Auditors can increase the number of audit procedures in order to reduce the level of audit risk. Reducing audit risk to a modest level is a key part of the audit function, since the users of financial statements are relying upon the assurances of auditors when they read the financial statements of an organization.

Types of Audit Risk

There are three types of audit risk, which are as follows:

Control risk, which is the risk that potential material misstatement would not be detected or prevented by a client’s control systems. When there are significant control failures, a business is more likely to experience undocumented asset losses, which mean that its financial statements may reveal a profit when there is actually a loss.
Detection risk, which is the risk that the audit procedures used are not capable of detecting a material misstatement. The outcome is that an auditor would conclude that there is no material misstatement of the financial statements when such an error actually exists, which would then lead to the issuance of an erroneously favorable auditor’s opinion.
Inherent risk, which is the probability of loss based on the nature of an organization's business, without any changes to the existing environment. The concept can be applied to the financial statements of an organization, where inherent risk is considered to be the risk of misstatement due to existing transactional errors or fraud.

Example of Audit Risk

A company, Elder Corporation, reports its inventory value at $2 million on its financial statements. However, due to poor inventory controls, a significant portion of the inventory is damaged and should be written down to $1 million. The auditor fails to detect this error during the audit. The components of the auditor’s audit risk are as follows:

Control risk. Elder Corporation’s internal controls over inventory management are weak, increasing the likelihood of undetected errors or fraud.
Detection risk. The auditor’s procedures, such as inventory count and valuation tests, were insufficient or improperly designed, leading to the error going unnoticed.
Inherent risk. Inventory valuation is inherently risky due to estimates and judgments involved, especially if the company deals with perishable or high-value items.

As a result, the auditor issues an unqualified (clean) opinion, but the financial statements are materially misstated due to the overstatement of inventory. This is an example of audit risk.