Audit risk refers to the possibility that an error will go unnoticed during the auditing process, hence an auditor will end up giving an inappropriate opinion of the financial records. An auditor is required to plan carefully his auditing so that the risk is reduced when giving a report on the financial statements. However, even with a carefully planned auditing process, audit risk will always exist. Therefore, an auditor can only limit the risk to acceptable levels. This audit risk can be because of misstatement of materiality, lack of adequate controls to prevent the risk from happening or the auditor failing to detect the errors (Dauber et al, p. 53).
There are various reasons that lead to the increase in audit risk during boom periods; this can be explained as follows: First, most companies tend to start new ventures when the economy is doing well However, this can be an avenue for the management to form a front company or a shell company. This refers to a company that only exists on paper, has no employees or physical address and does not produce goods or services.
They can legally incorporate the new venture; yet, it may have no operations. They will ensure that they comply with all the required statutory fillings including tax returns. After doing all this, they will direct some of the current company’s finances to the new venture as expenses. Therefore, if the auditor is not keen, he might not detect such a fraud on the company’s expenditure (Vona, p. 83-118).
Secondly, during boom periods companies experience increased business, such as increased orders that the current workforce cannot manage effectively. Therefore, most companies do hire more employees either on permanent or contractual basis. However, some officers at the company can take this opportunity to have ghost workers in the payroll. These can either be fictitious employees who are in the payroll who were never employed, or they can be former employees whose services were terminated yet their names are still in the payroll. Therefore, the auditor may fail to detect this hence misreporting on the true state or the company’s performance (Vona, p. 145-150).
Incapability of current controls can also be a cause for increased audit risk during economic growing period, in that as the company grows the set up controls, which previously worked effectively may be perforated. The reason behind this is that such controls could only manage a given level of transactions compared to the current increasing levels. Therefore, an auditor relying on such controls to assess compliance to procedures risks giving an inappropriate verdict on the financial statements. For instance, new income avenues can be misclassified if they are contributing significantly to the company’s profitability yet they are not in the main line of the business (Collier & Agyei-Ampomah, p. 3-7).
During economic boom the chance of detection risk occurring is increased, which in turn elevates audit risk. When a business is growing rapidly, it will open new branches where there are different regulations from the current operation area. It might also acquire other entities that deal in other lines of business apart from its line. Therefore, an auditor carrying out auditing process on such a company might give an inappropriate opinion on its performance due to various reasons. These include choosing an auditing procedure that is not appropriate, selecting the right procedure but applying it wrongly or after choosing the right procedure and applying it correctly, ends up misinterpreting the results (Dauber et al, p. 59).
During economic boom, audit risk also increases because the frequency of audit visits might be reduced. Precisely because auditing processes are associated with business interruptions. As a result, when the economy is doing well businesses also have a lot of activity and they would not like interruptions. Therefore, many transactions re done and if there is any fraud taking place in the company the auditor might not discover it easily, especially if some of those transactions are not material at the time of audit. For instance if a newspaper company regarded sales from newspapers as material at the beginning of the year, however due to increased sales in advertisement space within the financial year the newspaper sales become immaterial. As a result, if there was fraud in that segment of newspaper sales, the auditor might not discover hence increased risk (Dauber et al, p. 29-32).
Another cause for increased audit risk during economic boom is the desire to optimally seize all profit opportunities that are presented with the growing economy. A business might be making high profit; however, it might be relying on borrowed money. Therefore, as it accumulates loans in order to maximize on profit its state as a going concern is put at risk. This is because the management might rush in to risky investments expecting to make a quick fortune.
Although the investment might be giving good returns currently, it might end up collapsing. For example, in the 1920, most investors in the US borrowed money from banks to invest in the NYSE expecting to make a quick return and pay the loans using returns from the sale of shares. Auditors were focused on the profitability of firms hence they did not realize when the stock exchange was collapsing. This shows that their interpretations of the businesses as a going concern were wrong, because when the stock exchange collapsed it went down with all those businesses (Western, p. 8-30).
Boom periods are characterized with lucrative business opportunities and it is always the desire of any manager to maximize profits in such profits. However, managers can be tempted to use illegal means to secure some business deals for the company. Therefore, they will end up circumventing the law probably to get a contract that promises high returns. For instance, the managers may bribe some officials to help them in purchasing public land. If the company sets up its branch on that piece of land, it puts it future at risk. The auditor on the other hand might, if not keen might miss to see the illegal acquisition. S a result he/she might give a wrong statement concerning the future of the company (Vona, 119-130).
In recession times, auditor’s risk can also increase due to unprecedented economic downturns that make certain regulations ineffective as each company tries to remain in business. Therefore, some auditing procedures may be applied wrongly or their results misinterpreted. However economic growth presents potential situations that increase audit risk because businesses are making more money, hence they outgrow previous audit procedures. New developments that were not captured by the existing laws also occur in the new markets that companies expand to and this leads an auditor to misreport on a company’s financial statement.
Bibliography
Collier, Paul M. and Agyei-Ampomah, Samuel CIMA official learning system management accounting risk and control strategy. Burlington, MA: Butterworth-Heinemann, 2008.
Dauber, Nick A. Levine, Marc H., Qureshi, Anique Ahmed and Siegel, Joel G. Wiley, the complete guide to auditing standards, and other professional standards for accountants. Hoboken, NJ: John Wiley and Sons, 2008.
Vona, Leonard W. Fraud risk assessment: building a Fraud Audit Program. Hoboken, NJ: John Wiley and Sons, 2008.
Western, David L., Booms, bubbles, and busts in US stock markets. New York, NY: Routledge, 2004.