Engagement risk is the overall risk associated with an audit engagement. It can include a loss of reputation from being associated with a particular client, and financial losses from the association. Engagement risk tends to increase when a client is in a weak financial condition, and especially when it will likely require additional financing in order to survive. In this situation, the client is more likely to go bankrupt, in which case its investors and creditors will be more likely to drag the auditor into any subsequent litigation.
When the auditor is risk-averse, as is more likely to be the case with a large and well-established firm, it is more likely that engagements with high levels of engagement risk will be rejected. Conversely, a newer audit firm that wants to aggressively pursue new business might be more inclined to take on a client with high engagement risk, as long as it expands its audit procedures to offset the risk.
The auditor examines only those controls that are relevant to the engagement risk assessment. This means that the auditor can exclude an examination of the controls associated with certain operating units and business functions when they do not have a direct impact on the financial statements. Instead, the auditor focuses on those controls that can prevent, detect, or correct material misstatements within the client’s financial statements.