Detection Risk

Detection risk in an audit is the risk of auditors failing to find any errors or mistakes within the financial statements. The purpose of assessing this risk is to improve the quality and reliability of financial reporting, mitigate audit risk, and instill confidence in the users of financial statements.

The detection risk frequency in audits is higher in finance and accounting professionals. There can be various factors that affect it. The auditors can determine its degree depending on the amount of evidence collected. However, they can't eliminate every detection risk from the business. The main reason for its occurrence is the carelessness or ignorance on the auditor's part while auditing the accounting books.

• Detection risk refers to the risk arising when the auditors fail to discover any misstatements, errors, or omissions in a company's financial statements.
• Usually, auditors discover this risk during audit procedures. Therefore, there are equal chances for the audit risk to occur. Therefore, this risk is a vital element of audit risk.
• Three degrees of risk are high, medium, and low. However, it depends on quality auditors, location, compliances, audit team, and control.
• It is widely used in the audit risk model (ARM). The formula for detection risk is the ratio of audit risk to control multiplied by inherent risk.

Detection risk is a threat to the organization when auditors fail to find specific errors in the financial statements. In other words, they need to discover any material misstatements in the books. So, if auditors ignore this risk, it can lead to massive frauds and business scams. Therefore, collecting enough evidence is necessary to prevent this risk.

Audit risk comprises three elements: detection, business, control, and inherent risks. However, the former is unrelated to the other three. Thus, the auditor is not responsible if there are any business, inherent or control risks. But, if these risks are not appropriately treated, they can invite misstatements in the books. Therefore, proper steps must be taken to prevent future consequences.

The degree of this risk is measured as high, medium, or low. So, if the auditors try to ignore or make no attempts to reduce it, it can again lead to higher detection risk. However, correct measures and testing can lead to low detection risk. As a result, it automatically reduces the overall audit risk of the firm.

According to the SEC (Securities and Exchange Commission), PCAOB AS 2401 informs the auditors about their responsibilities if they detect misstatements. Therefore, less efficient auditors lead to a difference in audit quality. Thus, non-efficient auditors lead to high detection risk. Likewise, regions where there is less compliance also cause high detection risk. Therefore, less efficient auditors lead to a difference in audit quality.

Thus, by appropriately managing these risks, auditors can provide reasonable assurance regarding the accuracy and reliability of financial information. Moreover, specific steps are to be followed to assess detection risk including,

• Understanding the entity and its environment
• Evaluate internal control
• Consider the nature of the financial statement
• Evaluate analytical procedures
• Apply professional judgments
• Document the assessment

Since detection risk is a crucial part of the audit risk, it has equal importance in the audit risk model (ARM). So, let us look at the detection risk formula used in this model:

Detection Risk = Audit Risk / (Inherent Risk * Control Risk)           

Where,

Audit risk refers to the risk arising from improper audits conducted by auditors.

Inherent risk is a threat because of error or omission in financial disclosure.

Lastly, control risk is due to inefficient internal control within the firm.

Let us look at examples of detection risk for a better understanding of the concept:

Example #1

Let's assume an auditor is auditing LEK consulting firm in the US. During the audit planning phase, the auditor identifies that the company has a manual invoicing process with limited controls. The auditor recognizes that this increases the risk of undetected errors or fraudulent activities.

In this case, the detection risk is considered high due to the potential for material misstatements in the revenue recognition process. Hence, to address this, the auditor decides to perform additional substantive procedures such as selecting a larger sample size of invoices for detailed testing, verifying the accuracy of revenue calculations, and reviewing supporting documentation for significant transactions.

Thus, by implementing these procedures, the auditor aims to reduce the risk of failing to detect material misstatements related to revenue recognition and provide reasonable assurance of the accuracy of the financial statements.

Example #2

Let us assume that the audit risk of a manufacturing company General Motors Co. was 7%. In contrast, the inherent risk was 30%, and the control risk was 80%. So, let us calculate the detection risk for the firm.

Detection Risk = Audit Risk / (Inherent Risk * Control Risk)

Therefore, Detection Risk   = 0.07 / (0.8*0.3)

                             = 0.07 / 0.24

                             = 0.29 or 29%

Here, the detection risk for the audit firm was 29%, which indicates a high degree.

Auditors can quickly reduce the degree of detection risk rising in the firm in various ways. Let us look at those steps:

#1 - Selecting An Appropriate Audit Procedure

Here, auditors can choose proper audit and testing procedures per the firm's situation. Some of them include classification, occurrence, completeness, and valuation testing. Let us look at them:

1. Type refers to evaluating whether items were classified correctly in specific heads.
2. Completeness testing is a method to check whether any item is missing from the records.
3. Likewise, occurrence helps auditors to determine if a transaction happened or not.
4. The last test helps to find the actual value of balance items.

#2 - Implementing A Solid Control System

Most of these risk cases occur when other risks dominate the former. As a result, it becomes essential to have an effective internal control system. However, if the control system fails, the next option is to increase the substantive audit procedures. Here, more focus lies on the miscalculations in the books.

Although these risks threaten the company, they cannot be reduced fully. There will always be a tiny space for these risks. Auditors and firms are always prone as it is impossible to watch every transaction.

#3 - Conduct Surprise Or Unannounced Procedures

By conducting surprise or unannounced procedures, auditors can minimize the risk of manipulating or concealing records or transactions. In addition, this approach helps detect irregularities that go unnoticed during routine operations.

#4 - Improve Data Quality And Reliability

Auditors should ensure that the data they rely on for testing is accurate, complete, and reliable. Hence, this may involve performing data validation and verification procedures to ensure the integrity of the data used in the audit.

#5 - Maintain Professional Skepticism

Auditors should maintain an attitude of professional skepticism throughout the audit process. Therefore, this involves adopting a questioning mindset and critically evaluating the evidence obtained, looking for potential inconsistencies, biases, or indications of misstatement.

Although detection and control risks are crucial to audit risk, they have vast differences. So let us look at them:

This article has been a guide to what is Detection Risk. Here, we explain its examples, formula, comparison with audit and control risks, and how to reduce it. You may also find some useful articles here -

• Credit Risk Management
• Audit Engagement
• Audit Failure