Companies go through a lot of trouble to make sure their financial statements are correct. Firms employ teams of accountants, who diligently keep records and make sure the reporting accurately reflects the company's financials. Beyond this, the company will engage the services of an outside auditor to double check the numbers and add their endorsement that everything looks right.
Even with all this, there's a chance - perhaps very small, but still - that the numbers are wrong in some substantial way. This lingering risk is known as the "audit risk." Basically, the term refers to the possibility that the company's auditor is wrong and at some point down the line, the firm will be forced to restate its financial statements to correct the error.
Audit risk comes in three main varieties: inherent risk, control risk and detection risk.
Inherent risk is basically the risks that arise from the type of business the company conducts. A complicated business or one involving a large number of cash transactions make it harder to track the finances accurately, raising the difficulty to audit the company effectively.
Control risk relates to the strength of the company's internal accounting structure. If it is weak, it makes it more likely that mistakes exist, which might not get caught by the auditor.
Detection risk relates to the auditor's procedures. If these are weak, the auditor might not be able to catch a mistake. (And that is bad.)
Related or Semi-related Video
Finance: What is Adverse Audit Opinion?27 Views
Finance a la shmoop. What is an adverse audit opinion and you know deficiency
letter. Okay people this is not good you thought you had good grades but when [Report card is thrown onto the desk]
you got your report card your teachers had opinions adverse to yours... [Report card has bad grades in it]
They sent your parents a deficiency letter you know the one with all those [Mom looks shocked]
D's on it well when it's a company's audit that has similarly gone awry it's [Boss looks angry and employee looks shocked]
the nice way to say it well then it means they didn't count the beans
properly when they gave their financial reports to their investors or whoever
the auditors were serving usually this implies that companies overstated how [Employee counting coffee beans]
profitable they really were or how well they were really doing so tens of
thousands of investors if you know the company was public when this all [Big line of people waiting to invest]
happened paid twenty seven dollars and 32 cents a share when with the real
numbers the stock probably should have been trading more at like you know
fourteen dollars and 27 cents a share big difference well basically an auditor
is saying that yours are not bread-and-butter misstatements no oops [Bean report with the numbers crossed out]
it's more of a dude there were material ie important
mistakes and they were pervasive like everywhere math, science, english, history
your failure it's no mystery that's how auditors talk really
all right well then there are massive losses to massive numbers of people who hire [Protesters on a street]
massive numbers of lawyers who sue you.. massively.. in the world of finance an
adverse audit opinion is a bit like running over everyone's favorite dog [Car goes over a bump]
several times only you're the one who is likely dead meat [Guy reverses and runs the dog over again and the owner comes to fight]
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