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This report is presented as an audit senior of S and Co. about the audit planning of their client Rainbow Paints Co. The report provides an understanding of the assurance concept in audit and explains the meaning of audit risk along with its components. The audit risk components are explained with examples for better understanding of the concept of audit risk in assurance engagement by the professional auditors. It evaluates the internal audit control system and disclosure procedures of the company Rainbow Paints. It also identifies the weaknesses of the system to be addressed during the assurance engagement in accordance with the UK (ISA) standards and IAASB standards. It defines the audit risk at the planning stage of the audit for the company and describes the need and usefulness of risk assessment at the planning stage of the audit. Thus, the report helps learn about the audit engagement risks and weaknesses in the internal control system with guidance to the standards of IAS and IAASB.
1. Audit Risk and three components of audit risk
The risks of auditing can be described as the possibility that during the examination of the financial reports of a corporation or an entity, the auditor does not detect any mistakes or deliberate weaknesses (Han et al., 2016). Audit risk is the vulnerability that if the financial results are materially inaccurate the auditor holds an incorrect judgement. The risk is that an auditor would give the financial report an erroneous opinion. The below are instances of deficient audit reports:
Components of audit risk:
The risk of the audit can be seen as the outcome of the multiple risks faced during the process of the audit. The auditor should evaluate the risks of each aspect of the audit risk in order to maintain the total audit risk of commitments within an acceptable level.
The three audit risk elements are explained as follows:
Inherent risk: The inherent risk is the vulnerability of substantial mistake in the financial report owing to a mistake or misstatement due to non-control variables (Zhang, 2018). This probability is usually shown to be higher if the assessment and estimate of the activities are extremely complicated then this risk may be found higher.
Example: A considerable trading and participation of complicated securities products can be deemed considerably higher by the inherent audit risk of a recently established finance company than an audit for a developed output company operating in a reasonably secure competitive setting (Zhang, 2018).
Control risk: The possibility of a significant mistake in the financial records due to lack of negligence to operate a company's respective measures is the control risk. In order to deter and identify events of theft and mistake, companies should have effective internal control in effect (Zamboni, and Litschig, 2018). In the lack of sufficient internal checks to deter and identify the cases of theft and mistake in the annual report, the control risk of such a company is deemed to be higher.
Example: The control risk evaluation could be larger for a small company with a lack of well-defined responsibilities separation and financial reporting by persons that lack the professional know-how required to prepare account and manage finance (Zamboni, and Litschig, 2018).
Detection risk: Detection risk is the vulnerability that a factual error in financial reporting may not be found by an external auditor. An auditor shall use audit techniques to find substantive errors, either due to theft or omission, in the financial reports. A substance error left unidentified for the auditor may lead in the misinterpretation or failure of important audit assessment (Sardasht, and Rashedi, 2018). Due to the intrinsic constraints of the audit, there is often a detection risk. By raising the size of sampled transfers for thorough testing, auditors can decrease the detection risk.
Example: Risk present in using the sampling methods to provide an audit opinion on the large-sized data in financial statements (Sardasht, and Rashedi, 2018).
According to International Standard on Auditing (ISA) 315, "Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment" in conjunction with ISA 200, "Overall Objectives of the Independent Auditor and the Conduct of an Audit following International Standards on Auditing"; The auditor's purpose is to recognise and evaluate, by knowing the organisation and its environment, which include internal monitoring of the organization, the possible risks of material mistakes, whether attributable to theft or negligence and therefore to devise and incorporate alternatives to the risk assessment of material mistaking (Broberg et al., 2018).
ISA 330, "The Auditor's Responses to Assessed Risks", convey how to collect adequate evidence of measured risks of material errors by the creation and execution of the required approaches to these risks from auditors. ISA 330 allows an auditor to both conduct substantial material things proceedings, regardless of the risk identified by material errors, and to establish and enforce substantive proceedings in reference of each material type of purchases, account balance and reporting (Velte and Issa, 2019).
Rainbow Paints Co. is a manufacturer of paint and has provided with certain internal control and disclosure information that should be identified for the assessment of audit risks at the stage of planning. These risks are the material items that should be audited with due diligence to provide a true and fair opinion on the financial statements of the entity (Velte and Issa, 2019). Some of these audit items are pointed as follows:
The identification of the audit risks provides an insight that there is high control risk in Rainbow Paints Co. due to a weak inventory management system and internal disputes leading to the vacancy of office by the finance director. The auditor should follow the ISA practices to carry out the audit procedure for providing reasonable assurance (Patriarca et al., 2017).
ISA 315 (the UK and Ireland): "Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment", allows the auditors at a financial reporting and claim stage to define and measure the likelihood of material errors, whether triggered by fraud or accident (Council, 2015).
Risk management assessments are carried out to develop an overview of the business and the environment, like internal monitoring, and recognise and evaluate the hazards of the financial results, either owing to fraud or omission, as a consequence of material errors. These activities are typically carried out until the financial year is finished and entail numerous methods like management investigations and other chosen staff, review procedures, organisational control assessments, and record examination to established controls (Council, 2015).
There are numerous reasons which explain the significance of assessing the risk of audit at the initial stage of audit procedure, that is the planning stage. Some of these are pointed out as follows:
The report has described the audit risk and the three elements of audit risk with suitable examples for the clear understanding of the audit risk concept. It has assessed the inherent and control risk of Rainbow Paints Company. It has identified the various audit risks present in the entity at the time of audit planning. The study has also explained the relevant standards of auditing that helps the auditor in the risk assessment procedure. The study has also highlighted the significance of risk assessment at the initial stage of audit planning and provided the advantages of the risk assessment in the planning stage. Therefore, the report has provided an understanding of the audit risks, their identification and assessment importance in the audit process at the planning stage for providing reasonable assurance to the entities.
Broberg, P., Umans, T., Skog, P. and Theodorsson, E., 2018. Auditors' professional and organizational identities and commercialization in audit firms. Accounting, Auditing & Accountability Journal.
Cannon, N.H. and Bedard, J.C., 2017. Auditing challenging fair value measurements: Evidence from the field. The Accounting Review, 92(4), pp.81-114.
Chou, D.C., 2015. Cloud computing risk and audit issues. Computer Standards & Interfaces, 42, pp.137-142.
Council, F.R., 2015. Enhancing confidence in audit: Proposed revisions to the ethical standard, auditing standards, UK corporate governance code and guidance on audit committees.
Han, S., Rezaee, Z., Xue, L. and Zhang, J.H., 2016. The association between information technology investments and audit risk. Journal of Information Systems, 30(1), pp.93-116.
Patriarca, R., Di Gravio, G., Costantino, F. and Tronci, M., 2017. The Functional Resonance Analysis Method for a systemic risk based environmental auditing in a sinter plant: A semi-quantitative approach. Environmental Impact Assessment Review, 63, pp.72-86.
Sardasht, M.S. and Rashedi, E., 2018. Identifying Influencing Factors of Audit Risk Model: A Combined Fuzzy ANP-DEMATEL Approach. The International Journal of Digital Accounting Research, 18(24), pp.69-117.
Velte, P. and Issa, J., 2019. The impact of key audit matter (KAM) disclosure in audit reports on stakeholders' reactions: a literature review. Problems and Perspectives in Management, 17(3), pp.323-341.
Zamboni, Y. and Litschig, S., 2018. Audit risk and rent extraction: Evidence from a randomized evaluation in Brazil. Journal of Development Economics, 134, pp.133-149.
Zhang, J.H., 2018. Accounting comparability, audit effort, and audit outcomes. Contemporary Accounting Research, 35(1), pp.245-276.
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