Audit risk refers to the possibility that an error will go unnoticed during the auditing process, hence an auditor will end up giving an inappropriate opinion of the financial records. An auditor is required to carefully plan his auditing so that the risk is reduced when giving a report on the financial statements. Furthermore in conforming to Generally Acceptable Accounting Principles fair presentation require that important matters are considered and those that are less important are ignored, which is a concept of materiality. However even with a carefully planned auditing process, audit risk will always exist, therefore an auditor can only limit the risk to acceptable levels. This audit risk can be as a result of misstatement of materiality, lack of adequate controls to prevent the risk from happening or the auditor failing to detect the errors (Dauber et al, p. 53).
Audit risk is always elevated during boom when the economy is growing, particularly because in such periods the contributors of audit risk have high chances of occurring. Materiality of assets and transactions changes rapidly during economic boom because transactions or assets that were previously deemed material will no longer be material due to growth in transactions and also previously non material items will become material.
Considering that determination of materiality is based on the auditor’s judgment the following are factors that increase audit risk: Due increased profitability, a company can venture in to new opportunities which are not distinct from its main operations and therefore profit trends can be misstated. Particularly because the main venture may be incurring losses but the supplements from the new venture might conceal that fact (Dauber et al, p. 54-55).
An auditor can also misreport on the financial statements of an organization that is experiencing economic boom by failing to notice accumulating misstatement of materiality of an item. This is whereby an item is regarded as immaterial; however its accumulation over a given number of periods makes it material. For instance when the economy is growing and the business is also experiencing positive growth some expenses by management can be considered as immaterial however when their cumulative value is considered it might be significantly affecting a company’s financial growth. This in most cases can go unnoticed by the auditor because as a business grows some of its expenditures are increasingly considered as immaterial hence are not included in evaluation. For example incentive compensation to the management can be increasing with the growth of a business and though insignificant can be an avenue of fraud every year (Puttick et al, p. 247-250).
Incapability of current controls can also be a cause for increased audit risk during economic growing period, in that as the company grows the set up controls which previously worked effectively may be perforated. The reason behind this is that such controls could only manage a given level of transactions compared to the increasing levels. Therefore an auditor relying on such controls to assess compliance to procedures risks giving an inappropriate verdict on the financial statements. For instance an organization can invent other income sources that are not clearly outlined in the financial records hence the auditor can easily miss them. Such new income avenues can be misclassified because they might be contributing significantly to the company’s profitability however they are not in the main line of the business (Collier & Agyei-Ampomah, p. 3-7)
Audit Risk during an Economic Boom
During economic boom audit, risk also increases because the frequency of audit visits might be reduced. Precisely because auditing processes are associated with business interruptions. As a result, when the economy is doing well businesses also have a lot of activity and they would not like interruptions. Therefore, many transactions take place and if there is, any fraud-taking place in the company the auditor might not discover it easily, especially if some of those transactions are not material at the time of audit.
For instance if a newspaper company regarded sales from newspapers as material at the beginning of the year, however due to increased sales in advertisement space within the financial year the newspaper sales become immaterial. As a result, if there was fraud in that segment of newspaper sales, the auditor might not discover hence increased risk (Dauber et al, p. 29-32).
During economic boom the chance of detection risk occurring is increased which in turn elevates audit risk. When a business is growing rapidly, it will open new branches where there are different regulations from the current operation area. It might also acquire other entities that deal in other lines of business apart from its line. Therefore, an auditor on carrying out auditing process on such a company might give an inappropriate opinion on its performance because of various reasons, which include choosing an auditing procedure that is not appropriate, selecting the right procedure but applying it wrongly or after choosing the right procedure and applying, it correctly ends up misinterpreting the results. Therefore, as a business grows it will reinvent itself and as a result present potential scenarios for auditing risk to occur (Dauber et al, p. 59).
In recession times, auditor’s risk can also increase due to unprecedented economic downturns that make certain regulations ineffective as each company tries to remain in business. Therefore, some auditing procedures may be applied wrongly or their results misinterpreted. However economic growth presents potential situations that increase audit risk because businesses are making more money, hence they outgrow previous procedures. New developments that were not captured by the existing laws also occur in the market and this leads an auditor to misreport on a company’s financial statement
Collier, Paul M. and Agyei-Ampomah, Samuel CIMA official learning system management accounting risk and control strategy. Burlington, MA: Butterworth-Heinemann, 2008.
Dauber, Nick A. Levine, Marc H., Qureshi, Anique Ahmed and Siegel, Joel G. Wiley, the complete guide to auditing standards, and other professional standards for accountants. Hoboken, NJ: John Wiley and Sons, 2008.
Puttick, G. Esch, Sandy van, Esch, S.D. van and Kana, Suresh. The principles and practice of auditing. Cape Town: Juta and Company Ltd, 2008.