Define audit and accounting risk, give 3 specific example of each type of risk and explain why they are called audit and accounting risk. * Accounting risk is the risk that errors associated with forecasts used in GAAP accounting estimates are not properly disclosed. Accounting risk is primarily the responsibility of accounting standards. It is dealt with only indirectly in accounting standards. For example: * Bad debts on loans had an historic rate of 1% of outstanding loans but this deteriorates to 3%. * A legal dispute was assumed to have a favourable outcome but was lost resulting in additional liabilities. * Accounting policy changes causes income reduction.
* Audit risk is the risk of insufficient evidence being gathered on the facts concerning the entity’s economic circumstances. Audit risk is the product of the following three interrelated factors: * Inherent risk: the risk that an assertion is susceptible to a material misstatement, assuming there are no related controls. For example, accounting receivable must be shown a realizable value. This is an accounting estimate. Valuation is very difficult for A/R that affects many accounts. Eg, the company is having financial problems. They may try to overstate sales and understate expenses. * Control risk: the risk that a material misstatement could occur. The assertion will not be prevented or detected on a timely basis by the entity’s internal control. Or, the auditor decides that it would not be efficient to test the controls. Eg, the company fails to discover employee fraud on a timely basis because bank reconciliation is not prepared monthly. It means the internal controls are poor. * Detection risk: the risk that the auditor will not detect a material misstatement that exists in an assertion. In other words, the auditor reduces substantive testing.