Detection Risk: Figuring Out Your Chances of Overlooking Inaccuracies
Detection risk is the risk that you won’t detect material errors, whether they’re intentional or not. Detection risk occurs when you don’t perform the right audit procedures.
Changing the audit risk model formula
Take the audit risk model, which states that:
AR = IR x CR x DR
Next, isolate DR on one side of the equation by dividing both sides of the equation by (IR x CR):
DR = AR / (IR x CR)
So what does this mean? You solve the detection risk formula by inputting the other three risks into the DR formula. Specifically, you assess inherent and control risk and set your audit risk to an acceptable level.
For example, you’re auditing your client’s accounts payable balance. Based on your firm’s audit practices, your audit supervisor determines an acceptable level of AR is 0.05. Using the same criteria, CR is set at 0.60 and IR at 0.80. Solving for the DR component in the audit risk model, your detection risk is:
DR = 0.05 / (0.80 x 0.60) = 0.05 / 0.48 = 0.10
You use the appropriate audit procedures to make sure your detection risk while auditing accounts payable is 10 percent.
Considering detection risk and sampling
Keep in mind that the only way to eliminate detection risk completely is to examine every transaction. Because reviewing every item isn’t practical, auditors use sampling methods to assess transactions and balances. Here’s a typical sampling procedure for accounts receivable:
Based on risk assessments and other factors, the auditor selects a specific number of items to sample; for example, every account receivable balance over $10,000.
The auditor performs procedures on the sample items. In this example, the auditor agrees each receivable balance to the shipping document. This process verifies that product was shipped to the customer listed on the receivable listing.
Based on the number of exceptions noted, the auditor makes a judgment about the entire balance. Assume that 2 percent of the sampled receivable items didn’t have a related shipping document. The auditor assesses whether the 2 percent exception rate can be applied to the entire receivable balance.
You always have some risk of overlooking a misstatement; your goal is to keep it to an acceptable minimum.
Going over elements of detection risk
Here are the three major elements of detection risk:
Misapplying an audit procedure: A good example is when you’re using ratios to determine whether a financial account balance is at face value accurate (reasonable) — and you use the wrong ratio.
Misinterpreting audit results: You use the right audit procedure but just flat out make the wrong decision when evaluating your results. Maybe you decide accounts payable is fairly presented when it actually contains a material misstatement.
Selecting the wrong audit testing method: Different financial accounts are best served by using specific testing methods. For example, if you want to make sure a particular sale took place, you test for its occurrence — not for whether the invoice is mathematically correct.
Consider an example of detection risk during a common audit procedure. While examining accounts payable, you test to see whether payments made shortly after year-end relate to payables in the prior year. You examine these payments to search for unrecorded liabilities (payables) at year-end.
That’s a correct audit procedure to use for the accounts payable assertion. You correctly implement your audit procedure and make the accurate decision that the accounts payable balance contains no material misstatements.
However, you fail to test for segregation of duties between the employee who processes the payments and the employee who updates the vendor file marking the invoice as paid. This incomplete testing causes you to misinterpret audit results, which increases your detection risk. In other words, you heighten the risk that you’ll fail to recognize or detect errors in the client’s purchasing process.