What is the relation between the business risk and the risk of material misstatement of the financial statements?

 Business risk is a risk resulting from significant conditions, events, circumstances, actions, or inactions that could damage a company’s ability to achieve its objectives and execute its strategies.

Risk of material misstatement is a risk that the financial statements are materially misstated prior to audit.

Business risk is broader than the risk of material misstatement of the financial statements, though it includes the latter. Business risk may arise from change or complexity. Business risk may arise, for example, from:

● The development of new products or services that may fail.

● A market which, even if successfully developed, is inadequate to support a product or service; or

● Flaws in a product or service that may result in liabilities and reputational risk.

An understanding of the business risks facing the company increases the likelihood of identifying risks of material misstatement, because most business risks will finally have financial consequences and, therefore, an effect on the financial statements. It is worth to mention that the auditor does not have a responsibility to identify all business risks because not all business risks give rise to risks of material misstatement.

A business risk may have an immediate consequence for the risk of material misstatement. For example, the business risk arising from a reducing customer base may increase the risk of material misstatement connected with the valuation of receivables. However, the same risk, especially in combination with a reducing economy, may also have a longer-term consequence, which the auditor considers when assessing the company going concern ability.

Usually, management identifies business risks and develops approaches to deal with them. Such a risk assessment process is part of internal control.

In conclusion, identifying and understanding the business risk helps an auditor to identify the risk of material misstatements of the financial statements.

ISA 315

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