As internal accountants, we are concerned with two elements of financial statement risk

INHERENT RISK: risk that the account balance is materially misstated (e.g. incorrect, incomplete)

Risk increases when:

The account is more complex

There are many transactions within the account

CONTROL RISK: risk that internal controls will not prevent or detect material misstatements

As internal accountants, we are concerned with two elements of FS risk

Inherent risk: risk that the account balance is materially misstated

 – Basically the risk that the number we have recorded is wrong

 – Higher risk when the account is complex or when there are many transactions

Control risk: risk that the internal controls we have will not prevent or detect material misstatements

The external auditor is concerned with two other risks

DETECTION RISK: risk that audit procedures will not detect material misstatements

AUDIT RISK: risk that the auditor gives the wrong audit opinion

Detection risk: risk that the audit procedures do not detect material misstatements

Audit risk: risk that the auditor gives the wrong opinion

Again, as internal accountants, we don’t need to worry about this.

However, When management selects their external auditors, they must be confident that the audit firm is sufficiently competent to reduce these risks to appropriate levels

putting it all together

This diagram helps show where these risks fit in, and who is responsible.

We can see the rain at the top of the diagram represents inherent risk. Similar to rain, it is inevitable that mistakes do happen.

The first umbrella represents the internal controls the company has in place to stop the errors from happening.

The second umbrella is the external auditors, who work independently to detect any errors the internal controls haven’t caught.

Qs: After reviewing this diagram, any question on materiality or risk so far?

How do we assess financial statement risks?

We ask the question “What could go wrong?”

We want to determine all the ways a transaction can go wrong, whether intentionally or by mistake. This will allow us to identify the risks affecting the transaction and how to mitigate those risks.

As we mentioned before, when thinking about risk, we always have to think about What could go wrong

Now we need to apply that to the transactions we record and the financial statements.