Two topics in auditing closely relate to each other. These are audit risk and materiality. While both of these are crucial in any audit assignment, they are different concepts. Therefore, it is necessary to know what each of these is to understand them better.
What is Audit Risk?
Audit risk is the risk associated with an auditor expressing an inappropriate audit opinion incase of materially misstated financial statements. Audit risk consists of various other risks, including the risk of material misstatement and detection risk. Therefore, the audit risk associated with an engagement depends on these factors.
Risk of Material Misstatement
The risk of material misstatement occurs when there are material misstatements in financial statements before the audit. This risk does not usually relate to the auditor’s procedures. However, it still affects their audit opinion. The risk of material misstatement consists of two components, inherent risk, and control risk.
Inherent risk is the susceptibility of an assertion about a financial statement item or disclosure to a misstatement that could be material. It is a risk that exists due to a company’s nature or operations. For companies that have complex processes, the inherent risks will be higher.
On the other hand, control risk relates to the client’s internal control systems. It is the risk that a misstatement may occur in the financial statements due to the client’s inept internal control systems. These represent misstatements that the internal control systems should have prevented, detected, and corrected but did not.
Unlike the risk of material misstatement, detection risk relates to the auditor’s work. It is the risk that the procedures that auditors perform may not detect any material misstatements. Auditors perform various audit procedures to reduce the audit risk of an engagement to an acceptably low level. If these procedures fail to identify those misstatements, it is known as detection risk.
What is Materiality?
Materiality is a term associated with accounting. There, it refers to the relative size of an amount. However, it also applies to auditing. In auditing, materiality refers to the importance or significance of an amount, transaction, or difference. An audit engagement’s objective is for auditors to provide their opinion on whether the client’s financial statements conform with an identified financial reporting framework.
Overall, any misstatement that an auditor may deem to affect a financial statement user’s decision is considered material. Due to various reasons, auditors may not provide absolute assurance about whether the client’s financial statement is free from material misstatements. Therefore, they use the concept of materiality to examine specific figures. Auditors use this concept throughout the audit process.
How are Audit Risk and Materiality related?
Auditors set the materiality for an audit engagement after assessing its audit risk. Therefore, audit risk plays a crucial role in determining the amount. Usually, auditors set the materiality for an audit engagement during audit planning, using their professional judgment. Similarly, auditors will need to consider various other factors when determining materiality for a specific engagement.
Audit risk is the risk that an auditor provides an incorrect opinion about a client’s financial statements. It further consists of the risk of material misstatement and detection risk. After assessing the audit risk of an engagement, an auditor must set materiality for it. Materiality is the significance of an amount in influencing a financial statement user’s decisions.