Distinctions of Business Failure, Audit Failure and an Audit Risk

Accounting professionals believe that majority of Certified Public Account firms face legal action because their auditors do not understand the difference between audit failure and business failure, and the distinction between audit risk and audit failure. This paper examines the difference between business failure, audit failure, and audit risk as well as why it is important for auditors to understand these distinctions. As Pretorius (2009) explains, a company experiences a business failure when it is unable to meet its investors’ expectations or when it cannot repay its lenders due to economic conditions. Examples of economic conditions that may cause business failure include unexpected competition, poor management decisions, and economic recession. Although companies may act appropriately to take care of business failure, extreme cases may be difficult to correct and a company may be compelled to file for bankruptcy (Pretorius, 2009).

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Audit failure occurs when an auditor gives an incorrect audit opinion due to lack of compliance with the requirements of generally accepted auditing standards. Example of an incident that might lead to audit failure is when a company employs an unqualified person to audit its financial statements then he or she fails to identify errors that might have been discovered by a qualified auditor. Normally, audit failure is associated with lack of implementation of auditing standards which leads to issuance of an unqualified audit opinion (Cunnigham, 2007).

Chang and Tsai (2007) defines audit risk as the risk that an auditor will make a conclusion that a company’s financial statement has correctly been stated giving a high possibility of issuing a false opinion, when in fact, the statements have been misstated. Many accounting professionals agree that it is sometimes very difficult to detect properly concealed frauds, and for this reason, there is always a high risk that the auditor will not detect Material Misstatements, even though he or she complied with the generally accepted auditing standards. According to Chang and Tsai (2007), there have been several instances when the auditor has failed to detect Material Misstatements, but this does not necessarily mean that there is audit failure. Suppose the auditor failed to abide by the requirements of the generally accepted auditing standards, then an audit failure occurs.

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Business failure and audit failure are different in terms of the cause of each. According to Cunnigham (2007) business failure occurs due to mismanagement of a company by its managers. Conversely, audit failure is caused by the faults of audit staff who fail to comply with the requirements of the generally accepted auditing standards. Audit failure bears responsibility on the auditor while business failure is borne on the managers of a company’s operations. However, business failure may also result from problems in the economy such as economic recession. Although business failure is different from audit failure, these two concepts are closely related in the sense that, business failure is often induced by failure of the auditor to issue the correct audit opinion due to lack of compliance with the generally accepted auditing standards. This is because, when an organization has management issues, stakeholders will show increased concern about its audit reports. Extreme cases of fraud occur if relevant departments are not concerned about the company’s audit reports (Cunnigham, 2007).

Audit failure and audit risk are also different in terms of the cause of each. According to Pretorius (2009), audit risk is a possibility while audit failure is a fact that is normally determined following a thorough investigation of a company’s audit reports by relevant regulatory authorities. Audit risk occurs because the auditor is not aware of any fraud that might be present in a company’s financial reports while audit failure occurs when an auditor has failed to follow professional standards leading to issuance of an incorrect audit opinion. However, sometimes an auditor may ignore a given fraud when giving audit opinion, which causes an audit failure but not audit risk. Audit failure and audit risk are however similar in the sense that, both are caused when audit opinions have improperly been expressed. Since it is normally difficult to distinguish between subjective and objective reasons when audit opinions are expresses, audit risk is at times translated or identified as audit failure (Pretorius, 2009).

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By understanding the explanations above, an auditor will have no problems describing why there is lack of audit failure when a company has a business failure. When a company is unable to pay its lenders due to economic conditions, an auditor needs to check if the most recently issued financial statements have fairly been stated. Suppose the most recently issued financial reports have fairly been stated, the auditor will conclude that the audit opinions generated from those reports are correct. The fact that the financial reports are correctly stated is an indication that the generally accepted auditing standards were followed. In such a case, a company will only have business failure but no audit failure (Cunnigham, 2007). Consequently, the auditor still needs to involve relevant regulatory authorities in analyzing the company’s audit reports to ensure that there are no audit risks.

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