Detection risk is the risk that an auditor fails to detect material misstatement in the financial statements being audited.
There is always some amount of detection risk in an audit engagement due to limitations of the audit process. However, detection risk may result in an auditor giving an inappropriate opinion, the most inappropriate opinion being: a clean/unmodified opinion on materially misstated financial statements. Therefore, the auditor aims to keep the detection risk within an acceptable level.
The auditor uses audit risk model to understand the relationship between detection risk and other risks in the audit risk model i.e. the inherent risk, control risk and overall audit risk. This enables the auditor to determine an acceptable level of detection risk.
Factors Affecting Detection Risk
Even though detection risk cannot be eliminated entirely, the auditor can manipulate it by modifying various factors, some of them being:
- Composition of the engagement team, e.g.
- competence/skillfulness of the auditors
- size of the engagement team
- objectivity and independence
- Types of audit procedures, e.g.
- degree of substantive procedures compared to tests of controls
- evidence collection procedures such as whether the evidence is internally generated or external
- testing of year-end and post year-end transactions vs testing evenly throughout the year
- Rigorousness of audit procedures, e.g.
- sample sizes
- duration of audit engagement
- Quality control, e.g.
- audit firm’s system of quality control
- reviews by qualified personnel outside engagement team
- Detection risk is high where a firm has provided non-assurance services to the audit client resulting in material impact on financial statements. This is because the firm is less likely to detect misstatement in the work, they themselves performed. The detection risk may be reduced by changing the composition of the audit team so that those who worked on non-assurance engagement are not part of the audit team and by getting the work reviewed by a highly competent independent auditor.
- Detection risk in the area of inventory and cost of sales is reduced when more rigorous testing is performed on transactions just before year-end and right after the year-end. When the auditor’s assessment of risk of material misstatement near the year-end is high but low during rest of the year, the auditor focuses their work on cut-off testing.
Written by Irfanullah Jan and last revised on