What Is Audit Risk and How to Mitigate It
The Blue dot Team
The Blue dot Team
Is your business about to undergo a financial audit? This process introduces a measure of risk you need to consider ahead of time. This risk, known as audit risk, is defined by the International Standard on Auditing (ISA) as “The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk.”
Translated – it means that an audit could say that a company’s financial data and statements are free from mistakes or any material misstatements, but there is the risk that these financial statements and data are incorrect. If an audit does not detect that your financial statements are incorrect or that the data surrounding these statements is incorrect, then your company, audit firm, and/or individuals undertaking the audit could be held legally responsible for these errors. The risk lies in that your teams do not detect the discrepancies in the financial statements during the audit.
Audit risk is when your financial statements are incorrect and the audit says they are correct. The risk lies in that the audit does not detect that the financial statements are incorrect and this places your business at risk. It can be interpreted as fraud or malpractice rather than an error in auditing judgement, which makes it critical that companies put processes and plans in place to mitigate audit risk to the best of their abilities.
Audits are designed to minimise audit risk and to ensure companies are as clean as possible for stakeholders, investors, and creditors who rely on financial statements to inform decision-making.
There are three types of audit risk: inherent risk, control risk, and detection risk. According to This type of risk is defined by ISA 200, as “The risks of material misstatement at the assertion level consist of two components: inherent risk and control risk. Inherent risk and control risk are the entity’s risks; they exist independently of the audit of the financial statements.”
Inherent risk is generally a risk of financial statement errors or omissions that have taken place outside of the organisation’s internal controls. This type of risk is prevalent in highly complex, data-intensive and challenging transactions and financial accounts.
Unlike inherent risk, which takes place outside of internal controls, control risk occurs due to the failure of these internal controls. This could be, for example, errors creeping in during the preparation of a company’s financial statements, which would then affect the overall outcome of the audit.
Detection risk is straightforward – it is the risk that an auditor does not find mistakes in financial statements. Detection risk is defined by the ISA 200 as “The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements.”
An example of this could be that an auditor provides an audit of employee spend statements but doesn’t have all the statements available. Or perhaps they undertake an assessment of a company’s inventory but don’t physically check every item, instead relying on accounting records. In both instances, the audit has potentially missed records or items that could affect the audit outcome.
The European Union describes the audit risk formula as:
Audit Risk (AR) = Inherent Risk (IR) x Control Risk (CR) x Detection Risk (DR)
An audit risk model provides auditors with a clearly defined framework within which they can operate to ensure they minimise risks as effectively as possible. This tool builds on the above audit risk formula to ensure that evidence, data and accounts are always balanced. The following steps are required to apply an effective audit risk model:
Step 1: Ensure that the audit risk model is used at the start of the audit process during the initial planning phase. This will ensure that all data, statements, insights and concerns are established at the outset.
Step 2: Apply the formula to every financial document to ensure the data is accurate. This includes accounts, income statements, balance sheets, cash flow and more.
Step 3: Use the insights from each assessment to determine the type of evidence needed to ensure the audit is comprehensively correct with minimal risk of error.
Step 4: Outline potential risks clearly so these can be addressed and managed before the audit is completed.
Auditors would need to spend time unpacking an organisation’s operational processes and financial reporting to ensure they have comprehensive visibility into the company’s finances and approaches. They would also need to look at regulatory requirements, government policy, market conditions, financial performance, management and operational strategies, and the internal controls the company has put in place.
When you want to strengthen your internal controls, you need to focus on the following steps:
This step should focus on ensuring that all information within the business is consistently validated and assessed to ensure that any unexpected, unusual, or alarming transactions or events are quickly identified and remedied. This allows for audit teams and internal teams to promptly catch issues before they become entrenched and to reduce the risk of financial statement errors.
Technology has evolved extensively in recent years and can provide audit teams and organisations with tools to better manage their internal controls, processes, documentation, data, analyses and operations. By leveraging artificial intelligence (AI), machine learning, data analytics, and automation, organisations can rapidly identify fraud, risks and errors before an audit and significantly reduce risk.
The Blue dot tax compliance platform is designed to support audit teams and organisations by providing end-to-end visibility into expense data, documentation and tax reporting. It allows the organisation to gain complete control over employee-driven transactions, with the ability to automatically track, report and analyse transaction data and evidence. It embeds trust and reduces risk with market-leading technology designed for organisations that want to optimise their audits.
An external auditing firm can support the business in establishing best practice internal controls and ensuring that systems are as closely aligned to global standards as possible, but its primary role lies in ensuring that your detection risk is significantly reduced. In collaboration with your internal controls and procedures, an external auditing team adds additional value to your auditing processes and planning.
When employees and finance teams understand the risks and the importance of their role in mitigating those risks, then your organisation is in a much stronger position. Employee transactions can often get complicated and messy, especially if people are not paying attention to the requirements, and specifically how missing or incorrect data can affect the organisation’s overall risk profile. Training and awareness go a long way towards ensuring everyone is aligned with your policies and the regulations prescribed by tax authorities.
The one thing that every organisation can count on is change. Changes in regulation, operational policies, and audit requirements are common and can directly affect an organisation’s risk profile. You must consistently update your policies and procedures to keep up with these changes so you can measurably reduce audit risk. Think of these policies and procedures as living documents you must constantly keep updated.
Whether it is internal finance teams, internal controls or an external audit team, the job of continuous monitoring of all processes, policies, tools, and systems is essential. This will catch any loopholes or vulnerabilities that may have been missed in the past or perhaps introduced by regulatory changes. Continuous monitoring should form part of your organisation’s audit lifecycle as a standard.
Here are the most relevant ISAs for organisations wanting to understand, manage and mitigate risk:
ISA 315 – This is described as a standard that ‘recognises that there could be risks of material misstatement from the entity’s use of IT such as risks to the integrity of information in the entity’s information system due to ineffective design or operation of controls in the entity’s IT processes’.
ISA 330 – This International Standard on Auditing (ISA) deals with ‘the auditor’s responsibility to design and implement responses to the risks of material misstatement identified and assessed by the auditor in accordance with ISA 315 (Revised)1 in an audit of financial statements.’
ISA 300 – this International Standard on Auditing (ISA) deals with ‘the auditor’s responsibility to plan an audit of financial statements. This ISA is written in the context of recurring audits. Additional considerations in an initial audit engagement are separately identified.’
ISA 240 – This International Standard on Auditing (ISA) deals with ‘the auditor’s responsibilities relating to fraud in an audit of financial statements. Specifically, it expands on how ISA 315 (Revised)1 and ISA 3302 are to be applied in relation to risks of material misstatement due to fraud.’
ISA 250 – This International Standard on Auditing (ISA) deals with ‘the auditor’s responsibility to consider laws and regulations in an audit of financial statements. This ISA does not apply to other assurance engagements in which the auditor is specifically engaged to test and report separately on compliance with specific laws or regulations.’
Blue dot’s AI-driven expense analysis platform provides your organisation with unprecedented data quality and control to mitigate audit risk through intelligent and comprehensive automation. The Blue dot tax compliance platform is designed to minimise the complexities that go hand-in-hand with the explosive growth of unstructured employee-triggered transactions. By delivering complete and transparent visibility of Travel and Entertainment (T&E) expenditures, finance and tax teams can optimise VAT reporting with unrivalled confidence. Centralising this process across all entities enables maximum VAT recovery for global enterprises.
With Blue dot, your finance teams are less overloaded with manual labour and gain control over their processes and policies, aligning with tighter, cleaner audits. Together with Blue dot, your business can effectively mitigate audit risks while streamlining financial operations.