Magazine article The CPA Journal

Engagement Risk

Magazine article The CPA Journal

Engagement Risk

Article excerpt

Recent AICPA audit risk alerts utilize the term "engagement risk" in describing various risks auditors consider in performing an engagement. A major portion of the introduction to the 1995 Audit Risk Alert (the alert) deals with the concept of engagement risk. Engagement risk encompasses risks borne by both the auditor and the client entity. Although use of the term engagement risk may be relatively new, the risks comprising engagement risk and factors bearing on those risks are not unfamiliar to practitioners. The concept of engagement risk serves to formalize the auditor's consideration of the factors and risks affecting an engagement.

Engagement Risk Defined

Engagement risk represents the overall risk associated with an audit engagement. Engagement risk consists of three components: client's business risk (also referred to as entity's business risk), audit risk, and auditor's business risk.

An entity's business risk is the risk associated with the entity's survival and profitability. The concept recognizes that because of factors such as rapid changes in the industry, liquidity problems, or speculative ventures, the possibility exists the client may not achieve its profit goals or even continue in existence. As yet, entity's business risk has not been formally recognized in a statement on auditing standards (SAS).

In contrast to entity's business risk, the concept of audit risk is discussed in SAS No. 47, Audit Risk and Materiality in Conducting an Audit (1983). The SAS and the alert define audit risk as the risk that the auditor may unknowingly fail to appropriately modify the opinion on financial statements that are materially misstated.

The concept of auditor's business risk was introduced in the standards in a footnote to SAS No. 47 as simply business risk. Specifically, SAS No. 47 indicates that addition to audit risk, the auditor is exposed to loss or injury to his professional practice from litigation, adverse publicity, or other events arising in connection with financial statements that he has examined and reported on. This exposure is present even though the auditor has performed his examination in accordance with generally accepted auditing standards and has reported appropriately on those financial statements.

The SAS No. 47 focus on business risk relates to risks associated with the issuance of financial statements. However, recent audit risk alerts have added to this concept. In addition to the risk of potential costs from an alleged audit failure, auditor's business risk includes the risk of other costs (whether an audit failure is alleged or not) such as fee realization and reputational effects from association with the client.

Fraud Task ForceAdditional Insights

The SEC Practice Section Detection and Prevention of Fraud Task Force (fraud task force) recently developed a list of cir cumstances that may lead to a higher assessment of engagement risk and its components. The factors provide additional insights into the concept of engagement risk. These factors are sometimes called red flags or warning signs, because they signal the need for caution on the auditor's part.

Entity's Business Risk. As indicated in Exhibit 1, numerous factors may lead to a higher assessment of entity's business risk. The entity's business risk factors are organized into three categories-management, entity, and industry. Factors related to management deal primarily with integrity, attitude, experience, and actions. Entity factors relate to marketing and markets, liquidity, capitalization, and suspect business practices. Industry factors include technology, competition, entry barriers, and regulations.

Audit Risk. The fraud task force also notes numerous factors that may affect audit risk. As indicated in Exhibit 2, the list includes such items as high volume of year-end transactions, significant and unusually complex transactions, and affiliates that are unaudited or audited by others. …

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