Audit risk examines the relevant assertions related to balances, classes of transactions, or disclosures contained in misstatements that could be material to the financial statements when aggregated with misstatements in other balances, classes, or disclosures and the risk that the auditor will not detect such misstatements. With the collapse of Enron involving the misstatement of one of the Big 4, Arthur Andersen & Co. in the US and the CMC and Uchumi scandals in Kenya involving the big audit firms Delloitte and PwC, the argument for audits for big audit firms as synonymous with detection of misstatement has become questionable. Despite several studies having been done on overall misstatement risk none of them has addressed pervasive audit risk. The general objective of the study was to examine audit risk assessment and detection of misstatement in annual reports in audit firms registered by RAB in Nairobi County. The study evaluated four audit risk assessment i.e. inherent risk, control risk, engagement risk and detection risk against detection of misstatement. The study adopted a descriptive research design and targeted all the registered audit firms by RAB in Nairobi county.the study employed systematic random sampling and had a sample of 254 firms. Data was collected from primary sources which involved a well structured questionnaire with an average reliability of 0.86. The data collected from the questionnaire was analyzed using SPSS and a regression model so as to establish whether the application of audit risk models statistically and significantly affects the detection of misstatement in financial statements. t-statistic was used to determine the significance level wherby the null hypothesis was rejected if it’s less then 0.05. A total of 254 questionnaires were administered and 155 were satisfactorily filled and considered for analysis, this formed 78%. The results revealed that the application of audit risk models statistically and significantly affects the detection of misstatement in financial statements. All the four risks tested had a t-test of less than 0.05, thus all the four null hypotheses were rejected. Hence the study concludes that audit risk model reduces the level of fraudulent financial reporting through detection of misstatement in audit practice and relevant recommendations were provided that would enhance the application of audit risk assessment in the audit of financial statement.

Background of the Study 
The auditing profession is one of uncertainty and high level of business, financial and litigation risk and with the collapse of corporations such as Enron, Tyco international, World com, Global crossing, BCCI, there has been more stringent process to ensure that auditors excise due professional care and skill when performing audit assignment. Therefore, the requirement for professional judgment in assessing risk in this uncertain environment is a prerogative to the auditor, therefore, many studies have been suspicious of auditor’s professional judgmental ability to distinguish audit evidence and proper response to audit risk (Weustemann, 2004). 

The term audit risk is defined by IAASB (2006) as the risk that the auditor expresses an inappropriate audit opinion when the financial statement are materially misstated. Audit risk is a function of material misstatement and detection risk. In the financial context, audit risk is adopted where the term audit risk refers to the probability of the statements not giving a true and fair view after the audit is completed. Just what is true and fair view, this term has been subject to varying interpretations; it means a high, although not absolute, level of audit assurance. The goal of an audit is to form and express an opinion, on whether the financial statement give a true and fair view as a result audit risk is the possibility of a material misstatement remaining undetected even after audit is completed. Such risks can be perceived from the point of management, as well as that of the auditor. From the preceding working definitions, it can be deduced that audit risk is assessed as a function of three variables: the probability that there is threat, the probability that there are any vulnerabilities, the impact to the business (Blay,, 2003). 

There is currently a plethora and growing body of literature that seeks to examine the nature of audit risk assessment and detection of misstatement in financial statement (Bronson et al., (2008); (Bhinmani et al., 2009). The audit risk model provides the framework for risk assessment. The auditor follows risk assessment process to identify the risk of material misstatements in the annual reports of organizations Gupta, (2005), the risk of material misstatement is made up of two components of the audit risk model: inherent risk and control risk. The risk of material misstatement is used to ascertain the acceptable level of risk detection and to plan the audit procedure. According to Austin et al (2002), an assumption underlying risk-based audit is that the presence of certain types of risk factors is indicative of possible misstatement in the clients’ annual reports. therefore the auditor needs to asses the risk that are likely to provide material misstatement, and then conduct audit procedures based on this assessment to ascertain the existence of misstatements (Dobler, 2003). It is on the basis of this assertion that the auditors’ attempts to examine audit risk assessment and the detection of misstatement in financial statements. 

In Kenya, Deloitte after assessing CMC motors financial reports fails to recognize losses from CMC assets that were damaged, failing to disclose the auto firm’s subsidiary in South Sudan in the annual reports, abetting the booking of undelivered vehicle sales as revenues and not capturing interest payments for cars sold on credit (Kamau et al. 2012). A final report on CMC’s operations by the regulator CMA for the 2009 and 2010 released revealed that directors and management signed misleading financial statements, the accounts were not prepared in compliance with the International Financial Reporting Standards, consequently putting the firm on a precarious business model. Such evidence has raised questions concerning the extent to which audit firms participate in failing to detect misstatement and whether shareholders rights are protected moving forward to avoid recurrences. The Deloite saga marked the second time one of the Big Four audit firms in Kenya was being put on the spotlight over the detection of misstatement of its audit reports after the investigation of PwC in the wake of Uchumi Supermarket’s near-collapse in 2006. These latest CMC developments turned the spotlight on the auditors’ responsibility in failing to detect the alleged inflation of invoices and diversion of funds from the company by its directors which greatly impacts on the audit risk in detection of misstatement. 

The audit of financial statement consists of evaluating the quality of assertion versus specific criteria which in the end result in auditor’s opinion on the reliability of the financial statement (Amerongen 2007). The auditors provide reasonable assurance that the financial statements under audit are free from material misstatement. The auditors’ opinion on the reliability of the financial statement can be affected from misstatement of errors and fraud. Therefore an effective and efficient audit requires proper assessment of risk and proper allocation of effort subsequent to risk assessment (Blay,, 2003). Bell et al (2005) stated that the relevance of risk assessment in auditing continues to be emphasized in literature as evidenced by issuance of new risk assessment standards. These standards suggest that financial statement audit is a recursive process in which auditors make risk assessment related to various management assertions based on evidence. Thus the audit team must plan, collect and evaluate audit evidence in response to assessed risks and aggregate the evidence to form an opinion regarding the fair presentation of financial statements ( Dechow et al, 2011). 

It is therefore necessary for the auditor to ascertain and asses the nature of risk in the accounting records before giving an audit opinion. The level of uncertainty and risk in the audit environment influences audit strategy establishment and an audit plan that provides reasonable assurance of detecting misstatement in corporate financial statement (Asare and Wright, 2002). Monroe and Ng (2000) view auditors risk assessment process as a belief revision task, with prior year assessment serving as a starting point. 

According to Eilifsen and Messier (2000), research findings on the association between auditors’ assessments of audit risk to detected misstatements are mixed. Kizirian and Sneathen (2003) documented a strong association between overall misstatement risk and the three characteristics of audit evidence using audit file data. However, they did not address pervasive audit risks. Bedard and Johnstone (2004) documents that auditors increase their engagement efforts and billing rates for clients when corporate governance is weak and when earnings manipulation risk is relatively high. Elder et al (2009) find that auditors are more likely to issue modified opinions for firms with internal control weakness. Jaffar (2009) study on fraud detection: moderating role of fraud risk level reveals that the contextual of fraud risk level has a significant effect on the relationship between the external auditors’ ability to assess fraud risk and their ability to detect the likelihood of fraud. Mock and Turner (2005) study found that extent, staffing, and nature of audit tests are associated with risk and overall risk assessments. De Martins (2005) found evidence that client business and strategic risks Affect audit production outcomes such as aggregate audit hours, disaggregate audit hours and audit fees. Ruhnke, Buszac and Schmidt (2011) study on detecting misstatements in financial statements revealed that a number factors influencing inherent and control risk have significant impact on the number and size of audit adjustments. Therefore, Lemon et al (2000) stated that many audit firms that once employed separate risk assessment now use combine risk assessment.

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Item Type: Kenyan Topic  |  Size: 79 pages  |  Chapters: 1-5
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