Audit risk is the risk that the auditors will reach an incorrect audit opinion, in particular that they will give an unmodified audit opinion when the financial statements actually contain a material misstatement.

There are some inherent risks that are unavoidable. These are the risks that are most clearly apparent from the information provided.

1. The company has eight locations and there are presumably transfers of automobiles and parts between the locations. This gives rise to a risk that there will be misstatements in the inventory count, and either omissions or double-counting of some inventory items.
2. Many used cars are sold for cash. In businesses with large cash sales, risks of theft are high. When this happens, and cash takings are not recorded in the accounting system, revenue will be understated.
3. The company has expanded from four to eight locations. There is insufficient evidence to reach any judgement, but there may be some risk that by expanding so quickly, AM is actually overtrading and may have serious cash flow and liquidity problems. The audit risk is therefore the risk that the auditors will give an unmodified audit opinion by failing to identify doubts about the going concern status of the company.
4. There are also audit risks relating to specific items (at the ‘assertion level’). Some inventory consists of vehicles that have been accepted in part-exchange from customers. The agreed part-exchange value of these vehicles may be higher than their actual realisable value. If so there is some risk that these vehicles might be over-stated (at cost) rather than at their lower net realisable value.
5. The new cars are bought on consignment from the supplier. The supplier is the legal owner, but AM never returns new cars in practice. The audit risk in this case is that the new cars may be excluded from the statement of financial position because of ‘substance over form’. It would seem in this case that it is appropriate to report the new cars as inventory, in spite of the legal ownership still remaining with the supplier.
6. There is some risk that the interest charge from the supplier of new cars will be included in the cost of the inventory, when it should be reported as a finance charge. The audit risk is that as a consequence of this misstatement, expenses will be reported in the wrong financial year.
7. Work in the service workshops is usually finished on the same day that it is begun, but there is an important difference between work still in progress (for which parts should be valued at cost) and completed work for which an invoice has been prepared (which should be reported as revenue and a receivable). The audit risk is that the distinction between work in progress and finished work is not properly reported.
8. AM must make some provision for provisions and contingent liabilities under the terms of its own one-year guarantees and under the supplier’s two-year warranty. The risk is that suitable provisions are not made or contingent liabilities disclosed, and the auditor fails to identify the misstatement.
9. Automobiles will lose value when they are used by senior sales executives as demonstration models. The auditor must check to make sure that suitable allowance is made for the loss in value of these models, and that this is recorded as an expense in the financial statements.
10. There is also some audit risk with the purchased brand name. The auditors must be satisfied with the assertion of the AM management that the StrongSpares brand name has an indefinite useful life. The risk is that management assertions are invalid and that impairment (as well as amortisation) should be provided for the asset.
11. Audit risk can be reduced by appropriate controls. The internal audit function is new in AM, and there is little work that has been done on which the external auditors can use. The external auditors may be able to use the work of internal audit if the internal auditors are involved in the check and count of inventory at the end of the year. The auditors may also be able to rely on the perpetual inventory system and continual checking of inventories of parts.