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2-Audit Risk

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38 views2 pages

2-Audit Risk

Uploaded by

Aqsa shahjahan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Auditing Notes Compiled by: Noman, ACA

AUDIT RISK
The audit risk model
A standard audit risk model is available to help auditors identify and quantify the main elements making up
overall audit risk.

Definition: Audit risk


The risk that the auditor expresses an inappropriate audit opinion when the financial statements
are materially misstated. Audit risk is a function of the risks of material misstatement and
detection risk

Audit risk is the risk (chance) that the auditor reaches an inappropriate (wrong) conclusion on thearea under audit.
The audit risk is derived from errors arising out of inherent risk which are not prevented/detected by entity’s internal
controls and are not detected by further audit procedures. For example, if the audit risk is 5%, this means that the
auditor accepts that there will be a 5% riskthat the audited item will be misstated in the financial statements, and
only a 95% probability that it is materially correct.
The audit risk model can be expressed as follows:

× ×

Definition: Inherent risk


The susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that
could be material, either individually or when aggregated with other misstatements before consideration of any
related controls.
Inherent risk is the risk that items may be misstated as a result of their inherent characteristics.
Inherent risk may result from either:
❑ the nature of the items themselves. For example, estimated items are inherently risky because
their measurement depends on an estimate rather than a precise measure; or
❑ the nature of the entity and the industry in which it operates. For example, a company in the
construction industry operates in a volatile and high-risk environment, and items in its financial
statements are more likely to be misstated than items in the financial statements ofcompanies in a
more low-risk environment, such as a manufacturer of food and drinks.
When inherent risk is high, this means that there is a high risk of misstatement of an item in the
financial statements.
Inherent risk operates independently of controls. It cannot be controlled. The auditor must accept
that the risk exists and will not ‘go away’.
Control risk

Definition: Control risk


The risk that a misstatement that could occur in an assertion about a class of transaction, account balance or
disclosure and that could be material, either individually or when aggregated with othermisstatements, will not be
prevented, or detected and corrected, on a timely basis by the entity’s internal control.
Control risk is the risk that a misstatement would not be prevented or detected by the internal control systems
that the client has in operation.
In preparing an audit plan, the auditor needs to make an assessment of control risk for different areas of the audit.
Evidence about control risk can be obtained through ‘tests of control’.

The initial assumption should be that control risk is very high, and that existing internal controls are insufficient to
prevent the risk of material misstatement. However, tests of control may provide sufficient evidence to justify a
reduction in the estimated control risk, for the purpose of audit planning

Detection risk

Definition: Detection risk


The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a
misstatement that exists and that could be material, either individually or when aggregated with other misstatements.

Detection risk is the risk that the audit testing procedures will fail to detect a misstatement in a transaction or in
an account balance. For example, if detection risk is 10%, this means that there is a 10% probability that the audit
tests will fail to detect a material misstatement.
Detection risk can be lowered by carrying out more tests in the audit. For example, to reduce the detection risk
from 10% to 5%, the auditor should carry out more tests.
In preparing an audit plan, the auditor will usually:
❑ set an overall level of audit risk which he judges to be acceptable for the particular audit,
❑ assess the levels of inherent risk and control risk, and then
❑ adjust the level of detection risk in order to achieve the overall required level of risk in the audit.
In other words, the detection risk can be managed by the auditor in order to control the overall audit risk that can
be reduced by increasing testing and reducing detection risk.

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