What is Financial Statement Risk?

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The term or concept with the name Financial Statement Risk has NOT been defined, at least, in International Standards on Auditing and not even in any other pronouncements issued by IAASB related to assurance engagements and related services. So it is possible that this term is from such pronouncements issued by other auditing boards.

Most of the time authors or teachers make up their own terminologies if they think that actual term is a bit too technical. So it might be the case that term financial statement risk has come out of for the same reason.

To my understanding financial statement risk is the risk that financial statements may be materially misstated prior to audit i.e. financial statement risk is just another name given to Risk of material misstatement. And in that case financial statement risk has the same relation with audit risk as risk of material misstatement has i.e. Audit risk is a function of risk of material misstatement and detection risk. Further risk of material misstatement consists of two components as Inherent risk and Control risk.

That is what to my understanding best suits the term financial statement risk itself. However, it can be different as this word has not been specifically defined in the standards and thus depends on the person who coin this term up to give what meanings to this term.

Another possible meaning or use of the term financial statement risk  is to mean business risk. If this is taken equivalent to business risk then we must understand that business risk is very different from risk of material misstatement. As in ISA 315 para 30 it is stated that:

Business risk is broader than the risk of material misstatement of the financial statements, though it includes the latter.

Therefore we must be very clear that risk of material misstatements may arise from business risks as every business risk has economic effects thus may affect financial statements of the entity thus giving risk to risk of material misstatement.

Further understanding the difference between risk of material misstatement and business risk is important from auditor’s point of view as well because audit risk is connected with risk of material misstatement which is lowered by lowering detection risk but auditor is not responsible to lower business as it is the responsibility of the management of the entity. Also, auditor is not required to assess or identify every possible business risk of the entity as not every business risk amounts to risk of material misstatements.

Once again I must emphasize that, we must avoid the use of such terminology that is not backed officially by the Standards as it may create significant confusion. Also, use of different terms other than the ones used in standard may also result in confusing responsibilities. Take the above situation for example. If we mean risk of material misstatement by financial statement risk than auditor’s responsibilities are different in this context but if the term financial statement risk means business risk than auditor’s responsibilities are altogether different.

NOTE
Many ACCA qualification students studying ACCA P7 Advanced Audit and Assurance subject have approached me recently asking about the meaning of this term i.e. financial statement risk. On investigation it was revealed that previous P7 syllabus and study guide used the word “financial statement risk” which was later replaced in updated syllabus with “risk of material misstatement” and thus made many students confused about how it is going to affect the syllabus.

The use of clear term is appreciated but students must understand the context in which the term ‘financial statement risk’ is used. If the situation is dealing with risk of material misstatement then student should avoid discussing matters related to business risk. And if question relates to business risk then any discussion directed towards risk of material misstatement will get no appreciation from the examiner.

Important
ISAs use the same words which have been defined in the standard or somewhere else in the standards and no other words beside them even if there are really close equivalents of such words or terms. It means that ISAs discourage the use of terms other then the terms defined in the ISAs. This helps minimize the confusion that can be caused as if the word has not been defined in the standard then it can be interpreted in more then one way.

One of the examples confirming the fact that ISAs discourage the use of more than one word to mean the same can be found in para 12 of ISA 200 where footnote 3 is given to “(or resign)”.

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