Did you know that every transaction a business has with another business or individual comes with some degree of risk? Risk within business can be found everywhere, so it is important to understand how to evaluate just how risky a transaction really is. When looking to work with a new client, you’ll want to understand the audit risk they pose. There are multiple factors you may not be aware of that directly impact audit risk. We’ll discuss them in the rest of this article!
Every Transaction Has Risk
It may seem a little extreme, but every transaction your business enters into does have some degree of risk associated with it. Whether it is a large transaction like the purchase of supplies and equipment, or something small like a business lunch for a potential client, there is still a risk of a negative outcome.
There is a chance the equipment you purchased is faulty, and when you go to return it from a vendor, you find they’re out of business. Perhaps you realize early on during lunch with a potential client that it won’t be a good fit, but you’re still stuck with the bill at the end of the meeting.
Risk can refer to outcomes that range from anywhere between minimally to catastrophically negative. Some risks are far less important than others, but that doesn’t mean risk should be ignored entirely. As a small business especially, you often need to enter into transactions despite knowing that there is a risk associated with it.
Small businesses tend to have less resources, and therefore less flexibility when it comes to picking and choosing transactions. Newer businesses like startups have a much harder time of this, but if you have a healthy client base and growth strategy, you can be far more selective about clients you decide to work with.
Knowing that every transaction comes with a risk, you should still keep in mind that risk should not always be avoided. Sometimes taking a risk is in your best interest, so how can you know when a risk is worth taking? This can be determined through use of effective risk assessment strategies.
Because of the volatile and risky nature of business, the technique of risk assessment is used to help determine what transactions are worth taking a risk on. They’re also used to determine just how impactful a risk will be if it does come to fruition.
There are several ways to determine how much risk is associated with a transaction, but for the purposes of accounting, using the audit risk model is an excellent tool for determining how likely a transaction is to prompt an audit. This often requires you to look directly at your client, how they operate, and the industry they work in to see if anything raises a red flag.
Audit Risk Model
The audit risk model is an excellent tool to determine how risky separate functions of the accounting process are. When it comes to using the audit risk model, your total audit risk can be found by multiplying your control risk, detection risk, and inherent risk together. Those three risks are explained more below:
- Control Risk – This risk is directly associated with the internal controls of your client. First of all, do they have any? If they do have them, do they work properly, or do they fail? If a client is missing or has poor internal controls, it can lead to faulty financial statements.
- Detection Risk – Detection risk relates to whether or not an error in financial statements is detected. If an auditor is unable to see mistakes and misstatements, it can allow faulty financial statements to post.
- Inherent Risk – Inherent risk is a little harder to tack down. It isn’t anything specific that causes risk, but is a collection of factors related to the client or their industry. Because of the way a client or industry operates, it may by nature be more open to risk.
Once an auditor can determine the control, detection, and inherent risk of a business, they can understand the total audit risk that company has. If the total audit risk is too high, the business may need to adjust their risk factors before you work with them.
Client Risk Factors
When it comes to working with new clients, there is a lot of risk involved. When working with established clients you already have a relationship with, this risk is greatly reduced because you already have an understanding of how they operate and the risks they carry. New clients are a giant unknown, which requires careful evaluation of multiple factors to see if they carry audit risk. Here are some of the biggest client risk factors:
- Industry – The industry your client’s business operates in is very influential to audit risk. Depending upon the industry, there may be special government regulations and exceptions a client can be subject to. Perhaps the industry is still new, like legalized cannabis, which will undoubtedly see more regulation changes as more states opt to legalize. You should definitely consider the ramifications of the industry a client operates in.
- Behavior – This speaks to your client directly. How does your client conduct business? What is their public image? How do other businesses feel about working with them? Do they have a reputation for questionable bookkeeping practices? Depending upon what a client does, they may have some shady habits that pose a serious audit risk.
- Performance – History is not always a perfect way to tell the future, but very often the past does paint a good picture as to how a client will perform. If they were unsuccessful and never reported a profit in years prior, it is hard to believe they’ll post one this year. Likewise, a large company with a rich history of profit and success is quite likely to continue doing so.
Professional Risk Assessment Help!
The world of business is surrounded with risk, but it is an absolute necessity to deal with. Your small business must find a way to navigate through all of the audit risk potential clients may pose to you, which is made much easier through use of the audit risk model!
The audit risk model requires you to analyze a client’s control, detection, and inherent risks. The combined product of all three risks will produce a total audit risk, which can be used to determine whether or not a client has proper systems in place. You’ll also want to look into the client’s industry, their behavior, and past performance to get a better understanding of who you’re dealing with and the innate risk they possess.
You can’t go anywhere in business without finding risk, but that doesn’t mean it has to be stressful! If you want professional assistance in determining audit risk, check out the services offered at the Evergreen CPAs! With a licensed professional by your side, you can be sure you’re effectively evaluating audit risk for every client!