Definition: Control risk is the probability of a misstatement in a financial statement as a result of a failing control mechanism.
What Does Control Risk Mean?
What is the definition of control risk? Control risk is very important in auditing as it can prevent the misstatement of financial information. However, when the control mechanism fails to detect fraud and error, the financial information is misstated, and investors get the wrong picture about a firm’s financial condition.
Especially, in smaller firms that may not have an accounting department, and the financial statements may be prepared by the unskilled workforce, it is possible that misstatements are not prevented or are not corrected, if detected, due to lack of internal control.
Let’s look at an example.
Alex is an accountant in a small manufacturing firm. Each quarter, he prepares the financial statement of the company, and he pays special attention to avoid potential misstatements and inaccurate information. The control procedures that Alex follows involve:
Addressing the proper duties to the proper person: Alex hates it when all people in the company do it all. He believes that a segregation of duties is necessary so that the tasks are carried out efficiently from the right people. Therefore, he cross-checks the duties, and he makes sure that they are distributed to the entire workforce based on the skills, knowledge, and experience of each individual.
Addressing the proper documentation: often, purchase orders or customer invoices get lost in an improper filing system employed in several departments of the firm. Alex checks the documentation and makes sure that they correspond to particular purchases or sales. Then, he follows a numbered system of documentation, and he creates a relevant spreadsheet so that he can easily find all void documents on the spot. For the cases that there are missing invoices, Alex calls the company that had originally issued the invoice, and he asks for a copy to keep in his financial records.
With these simple controlling mechanisms, Alex thinks that he can eliminate potential misstatements from the firm’s financial statements.
Define Control Risks: Control risk means the chance that auditors will not catch and correct a material mistake in the financial statements before they are issued.