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What is the Risk of Incorrect Rejection?

Risk of Incorrect Rejection

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Risk of Incorrect Rejection

The risk of incorrect rejection, often discussed in the context of audit procedures, refers to the risk that an auditor concludes that a material misstatement exists in a particular audit objective (such as a balance or transaction class) when, in fact, it does not. This error can lead the auditor to believe that the financial statements are materially misstated when they are actually fairly presented.

In simpler terms, the risk of incorrect rejection is the risk that an auditor will mistakenly reject the auditee’s assertion (e.g., that the financial statements are accurate) even when the auditee’s assertion is correct.

Example of the Risk of Incorrect Rejection

Let’s illustrate the risk of incorrect rejection with a hypothetical scenario:

Scenario:

Company: DigitalDreams Ltd., a software development firm.

Auditor: Laura Wilson from Elite Auditors.

Objective: Laura is assessing DigitalDreams Ltd.’s capital expenditures for the year, ensuring all assets were recorded at the appropriate amounts.

Process:

  • Laura selects a sample of assets purchased during the year from the fixed assets register.
  • For one of the sampled assets, a high-end server, Laura notes a discrepancy. The invoice amount from the vendor differs from the amount recorded in the fixed assets register by a significant margin.
  • Based on this discrepancy, Laura suspects that there might be errors in the way assets are recorded, and she informs the management of DigitalDreams Ltd. of a potential material misstatement.

The Reality:

After Laura’s feedback, the finance team of DigitalDreams Ltd. investigates the matter. They discover that the server purchase included a trade-in allowance for an older server, which reduced the effective purchase price. This trade-in allowance was properly documented but had been overlooked during Laura’s initial review. The recorded amount in the fixed assets register was indeed accurate, reflecting the net amount after considering the trade-in.

Result:

Laura’s initial rejection of the assertion that the asset was recorded correctly represents the risk of incorrect rejection. She mistakenly believed there was a misstatement when, in actuality, the recording was correct once all factors (like the trade-in) were taken into account.

The consequence of this incorrect rejection was the additional time taken by both the auditing team and DigitalDreams Ltd.’s finance team to investigate and resolve the perceived discrepancy. While this did not lead to an incorrect audit opinion, it did result in unnecessary additional work and could have created tensions between the auditor and the client.

In this example, the risk of incorrect rejection led Laura to believe there was an error when, in fact, the company’s records were accurate. This emphasizes the importance for auditors to thoroughly investigate discrepancies and maintain open communication with their clients.

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