The complexities of modern day businesses and accounting practices have necessitated the consideration of business risks during the course of the audit.
Business Risk - Definition
Business risks are the factors that could prevent or hinder the achievement of organizational goals and objectives.
Difference between Audit Risk and Business Risk
Business risks facing an organization can be wide-ranging and diverse. The ultimate business risk any organization faces is the risk that it seizes to be a going concern. Business risks therefore comprise any factors that may contribute towards business failure.
Examples of business risks include:
- Loss of customers
- Increase in production costs
- Cash flow problems
- Decline in product demand
- Litigations and claims
- Technological obsolescence
- Increase in market competition
- Decrease in profitability
- Political and economic instability
- Over trading
- Inadequate financing
- High financial risk
- Risk of fraud and theft
Audit risk is the risk that the auditor expresses an inappropriate audit opinion on the financial statements. Audit risk therefore includes any factors that may cause a material misstatement or omission in the financial statements.
Whereas business risks relate to the organization and its stakeholders, audit risk relates specifically to an auditor. Although audit risks and business risks are dissimilar in nature, it is often the case that identification of significant business risks lead to the detection of audit risks as we shall see in the following example.
Example
AM is the audit manager of Energy PLC, a company operating in the energy exploration and production sector. As part of the risk assessment procedures during the planning for audit of Energy PLC, AM identified the following significant matters while examining the minutes of a meeting of the Company’s Board of Directors held at the start of the year.
| Matter | Business Risks | Audit Risks |
|---|---|---|
|
The CFO apprised the Board of the initiation of legal proceedings against Energy PLC regarding damage caused to a customer's pipelines as a result of the supply of low quality gas by the Company. |
The litigation may result in a significant outflow of economic resources in the future. Significant management time will also need to be expended over the course of the litigation. |
Liabilities of Energy PLC might be understated as a result of non recognition of the provision in respect of the litigation. Alternatively, the disclosure regarding contingencies may not adequately disclose the effects of the pending litigation. |
|
The Board accepted the proposal of the Finance Director to sell off a low performing subsidiary of the Company after two year. The Finance Director remarked that the current market price of the subsidiary's shares is too low. |
The full worth of the subsidiary may not be realized by Energy PLC through the sale transaction. |
Financial results of the subsidiary might be manipulated to influence the market value of its shares prior to the sale transaction. Related party transactions with the subsidiary may be misrepresented in order to improve the market perception of financial performance of the subsidiary. |
|
CFO informed the Board about the progress towards the finalization of the gas sales agreement in respect of a gas field which commenced production in the preceding year. CFO explained the basis of the provisional price being charged to the customer at the moment and that any price differential arising on the determination of the final price will be subsequently settled with the customer upon the finalization the gas sales agreement. |
The finalization of the gas sales agreement may result in a significant cash outflow in the form of a price differential adjustment if the final price determined is lower than the price currently charged to the customer. |
Sales revenue is currently being recognized on an estimate basis in respect of the mentioned gas field. The estimate may be biased and not based on realistic assumptions regarding the sales price. The effect of provisional pricing and any future revisions in price may not be adequately disclosed in the financial statement. |
|
The managing director apprised the Board regarding plans to drill a second exploratory well in an area. The drilling of the first exploratory well in the same area in the previous period could not be successful due to unsuitable rock formation. |
The cost to be incurred on drilling of the second exploratory well may not be recoverable if a similar rock formation to the first well is discovered. |
Exploration and evaluation assets of the company may be overstated as a result of the unsuccessful exploratory well whose cost must be immediately expensed in the income statement. The cost incurred in the current period, if any, on the second well may also not be recoverable in which case the assets of Energy PLC may be overstated. |
Importance of considering business risks in audit planning
In view of the high profile accounting scandals in recent times, the role and responsibilities of auditors has been questioned. In the particular instance of Enron, the company auditors, Arthur Anderson, were alleged to have lacked sufficient understanding of the business, risks and exposures of the Company which ultimately caused them to overlook the effects of Enron’s aggressive accounting practices.
It is in view of such scandals that the adoption of a top down approach in auditing has been emphasized where the auditor proceeds by gaining an understanding of the entity, its environment, significant business risks and how these risks might translate into audit risks.
ISA 315 requires auditors to obtain an understanding of the entity and its environment in order to assess the risks of material misstatement of financial statements. This reinforces the importance of obtaining a bird’s eye view of the entity’s business and significant business risks by the auditor at the audit planning stage.