Detection Risk

What Is Detection Risk?

Detection risk is the chance that an auditor will fail to track down material misstatements that exist in an element's financial statements. These misstatements might be due to either fraud or blunder. Auditors utilize audit procedures to identify these misstatements.

Be that as it may, in light of the idea of audit procedures, some detection risk will continuously exist. For instance, auditors frequently sample a certain type of company transaction in light of the fact that looking at each transaction is unfeasible. Expanding the sample size can reduce detection risk, however some risk will constantly remain.

Detection risk is one of the three components that comprise audit risk, the other two being inherent risk, and control risk.

Understanding Detection Risk

Detection risk can arrive at unacceptable levels when an auditor fails to execute the correct audit procedures, carries out the right procedures incorrectly, or fails to correctly judge the outcomes. Auditors must survey both control and inherent risk first, then, at that point, assign detection risk to bring the total audit risk to an acceptable level. In any case, it's far-fetched that an auditor can wipe out detection risk completely, basically on the grounds that most auditors will always be unable to look at each and every transaction that offers up a financial expression. All things being equal, auditors ought to aim to keep detection risk at an acceptable level.

These are the three principal components of detection risk.

1. Applying an audit strategy incorrectly. For instance, when an auditor applies some unacceptable acceptable ratio while utilizing ratios to assess the face value precision of an account balance.
2. Incorrect audit testing method. Picking an audit testing method that isn't right for the type of financial account being audited, for instance, testing for exactness of the invoice instead of the occurrence of a specific sale.
3. Misconstruing the aftereffects of the audit, or just assessing the outcomes wrongly.

A common error that auditors make is to conclude that a distinguished misstatement is unimportant. At times a misstatement that is trifling in one unit of a company might become material when totaled over different business units, having a tremendous effect on the company's financial statements. Detection risk might be higher in locales where regulatory bodies are moderately incapable. Detection risk is likewise higher when the relationship among auditors and audited substances' employees becomes cozy. Social differences likewise can increase or diminish this risk among countries and areas around the world.

There are a number of audit procedures that auditors use to limit detection risk, including classification testing, completeness testing, valuation testing, and occurrence testing.

Classification Testing

Classification testing is utilized to decide if transactions were classified correctly. For instance, a cost to the company could be classified as either a expense or a asset contingent upon its total cost and the length of its useful life. An auditor might apply certain audit procedures to decide if a large expenditure groups as an asset or an expense.

Completeness Testing

Completeness testing is utilized to inspect in the event that any transactions are missing from the accounting records. For instance, an auditor might survey a client's bank statements to decide whether payments to providers that exist in the bank statement were likewise recorded in the accounting system.

Valuation Testing

Valuation testing is utilized to test whether the value of the assets and liabilities on the company's books are accurate. This test could require an auditor to acquire an outer valuation judgment on the asset or liability being referred to.

Occurrence Testing

Occurrence testing is utilized to decide if recorded transactions have really happened. This test could include analyzing specific invoices recorded on the sales ledger and following them back to the original customer order and delivery documentation.

Detection Risk versus Control Risk versus Inherent Risk

Inherent risk is consistently present and is specific to the company in view of its given industry and business environment. Inherent risk is the probability that a material misstatement exists in the company's financial statements in light of these given factors. Control risk is the risk that the company's own internal controls will be unable to forestall, identify, or correct material misstatements or errors that are available in the financial statements. In the event that the auditors realize the company being audited has poor internal control processes, this risk will be assessed higher.

Both inherent risk and control risk increase the level of audit procedures required to reduce the detection risk to an acceptable level. Since audit risk is comprised of each of the three components, assuming both control risk and inherent risk are high, detection risk should be limited through increased audit procedures. Assuming inherent risk and control risk are both low, the level of audit procedures required will be lower.

Smith and Co. Certified Public Accounting (CPA) firm is recruited to perform a audit of ABC Corp's. financial statements. Accountants from Smith and Co. have worked with ABC Corp. in the past, and they have recently communicated concerns to management around ABC's lack of internal controls around the company's payroll process. Going into the current year's audit, Smith and Co. will survey the control risk as high for this specific area. ABC Corp's. payroll system is likewise highly complex, and it includes a large degree of manual contribution by the payroll representative. This would increase the inherent risk too.

Since both the inherent risk and control risk are high, detection risk-the risk of the auditor's missing material issues-should be limited adequately by an increase in audit procedures and required evidence. Ordinarily, Smith and Co. would audit the supporting documentation for three payroll cycles. Nonetheless, due to the riskiness of this specific area, Smith and Co. has mentioned documentation and backup reports for six payroll cycles.

The auditors might trace the payroll expense recorded for specific people in the ledger back to their time cards, to confirm hours worked, and to their human resources (HR) file, to confirm pay rate. The auditors may likewise guarantee the representative's supervisor has approved all time cards and the HR Manager has assessed and approved all payroll checks. By expanding the amount of testing done around the payroll cycle, the auditors have successfully diminished the detection risk associated with these transactions.

Highlights

• There are three types of audit risk: detection risk, inherent risk, and control risk.
• A certain amount of detection risk will constantly exist, however the auditor's goal is to lower the detection risk adequately for overall audit risk to keep an acceptable level.
• Detection risk happens when an auditor fails to distinguish a material misstatement in a company's financial statements.
• Auditors must execute correct audit procedures to limit detection risk.