The-Accountant-Jul-Aug-2017

Governance
an understanding of the entity and
its environment in order to assess
the risks of material misstatement of
financial statements. This reinforces
the importance of obtaining a bird’s
eye view of the entity’s business
and significant business risks by the
auditor at the audit planning stage.
The complexities of modern day
businesses and accounting practices
have necessitated the consideration of
business risks during the course of the
audit.
Business risks are the factors that
could prevent or hinder a company
from achieving its goals and objectives.
Audit Risk on the other hand, is
the risk that the auditor expresses
an inappropriate audit opinion on
the financial statements. Audit risk
therefore includes any factors that
may cause a material misstatement or
omission in the financial statements.
The auditor’s work therefore will be
to detect these misstatements and
omissions.
Whereas business risks relate to the
organization and its stakeholders, audit
risk relates specifically to an auditor.
Although audit risks and business risks
are dissimilar in nature, it is often the
case that identification of significant
business risks lead to the detection of
audit risks.
The auditor will try as much
Although audit risks and business risks are
dissimilar in nature, it is often the case that
identification of significant business risks
lead to the detection of audit risks.
as possible to lower the level of audit
risk. This is done by assessing the audit
risk model that is Inherent Risk (IR),
Control Risk (CR) and Detection Risk
(DR) which are all functions of Audit
Risk (AR) giving rise to the audit
risk model equation AR=IR*CR*DR.
Inherent risk is the risk that an account
might be materially misstated due to its
nature for example in a school with a
high population, receivables has a high
inherent risk.
Business risk and inherent risk both
bear on; the audit, the audit risk model,
the nature, timing and extent of work
performed. Inherent risk and business
risk have an inverse relationship to
detection risk and have a direct effect on
the level of work performed. Neither of
risk can be eliminated totally and neither
is controllable by the auditor. Business
risk relates to the financial statements
and affects overall audit risk; inherent
risk applies to an individual audit area.
Inherent risk is explicitly included in the
professional standards and the audit‐risk
model while business risk is not and has
only an indirect bearing on the model.
Management can take steps to affect the
level of inherent risk, but the perceptions
of users of the financial statements bear
on business risk.
According to the glossary accompanying
the IAASB pronouncements on assurance
engagement and related services business
risk has been defined as follows:
A risk resulting from significant
conditions, events, circumstances, actions
or inactions that could adversely affect an
entity’s ability to achieve its objectives and
execute its strategies, or from the setting
of inappropriate objectives and strategies.
The risk that business is facing problems
in achieving its business objectives have
important implications on the auditor’s
work. Thus ultimately business risk gets
connected with audit risk which the
auditor wants to set very low.
Business risks facing an organization
can be wide-ranging and diverse. The
ultimate business risk any organization
faces is the risk that it seizes to be a
going concern (ISA 570). Business risks
therefore comprise any factors that may
contribute towards business failure.
Examples of business risks include;
loss of major customers, increase in
production costs, decline in product
demand, litigations and claims,
technological obsolescence, increase
in market competition, political and
economic instability, inadequate financing,
high financial risk.
Why audit risk arises?
Audit risk arises because of existence of
material misstatements in the financial
statements which audit procedures were
unable to detect hence DR=AR /(IR*CR).
Why material misstatements are in
financial statements?
Material misstatements exist because of
two reasons:
i. There are no controls to stop such
misstatements from entering the financial
statements.
ii. Controls are in place but they are not
effective against misstatements and thus
are unable to prevent such misstatements
to enter the financial statements. And
after they have entered control system
is unable to detect and correct such
misstatements.
Business risks can arise from any
situation for example; government bans
the use of a particular raw material to be
used, as it causes pollution. This example
fulfils the definition of the business risk
given above; as due to this government
ban, a manufacturer might not be able to
achieve their target profit which is one of
the business objectives.
Now let’s understand how this
government policy will raise inherent risk.
Because of this order certain production
machinery and raw materials may be
rendered useless or written off as the
manufacturer cannot use any other raw
material and thus carry no value. Now
this event requires adjustments in the
amounts of asset and this event must be
detected by the internal control system.
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