Audit Risk Model Explained

The audit risk model is a framework auditors use to assess the risk of material misstatement in a
company’s financial statements. The model comprises three components: inherent risk, control risk,
and detection risk. Inherent risk is the risk that a material misstatement exists, control risk is the risk
that a material misstatement will not be prevented or detected by internal controls, and detection
risk is the risk that the auditor will not detect a material misstatement.

The auditor evaluates each component and determines appropriate audit procedures to mitigate
overall risk. By using the audit risk model, auditors can plan and execute their audits effectively and
ensure the reliability of financial statements.

Components

The audit risk model is made up of three components:

#1 – Inherent Risk

This is the risk of a material misstatement in the financial statements, regardless of any controls. It is
influenced by factors such as the nature of the company’s business, the complexity of transactions,
and financial reporting history.

#2 – Control Risk

This is the risk that a material misstatement will not be prevented or detected by a company’s
internal controls. Instead, it is influenced by the design and effectiveness of the company’s control
environment, including the tone at the top, control activities, and monitoring.

#3 – Detection Risk

This is the risk that the auditor will not detect a material misstatement, even if it exists. It is
influenced by the nature, timing, and extent of audit procedures the auditor performs.

The auditor must assess each component to determine an appropriate level of audit risk and design
and execute audit procedures that address the identified risks. The ultimate goal is to obtain
sufficient and appropriate audit evidence to support the auditor’s opinion on the fairness of the
financial statements.

Formula

The audit risk model can be expressed mathematically as follows:

Audit Risk = Inherent Risk x Control Risk x Detection Risk

This formula shows that the overall level of audit risk is a product of the individual risk components.
Therefore, the auditor must assess each component and determine an appropriate level of audit
procedures to reduce the risk to an acceptable level.

For example, suppose the inherent and control risks are assessed as high. In that case, the auditor
may need to perform more extensive audit procedures. As a result, it reduces detection risk and
achieves an acceptable overall audit risk. Conversely, if inherent and control risks are assessed as
low, the auditor may be able to perform less extensive audit procedures, resulting in a lower overall
audit risk.
By using this formula, auditors can evaluate the risk associated with an audit engagement and design
a plan to perform audit procedures commensurate with the identified risk level.

Examples

Let us look at the following examples to understand the concept better.

Examples #1

Let’s say an auditor is conducting an audit of a manufacturing company. The auditor first assesses the
inherent risk, which is high due to the complex and volatile nature of the industry, as well as the
company’s history of noncompliance with regulations.

The auditor then assesses the control risk, which is moderate due to the company’s implementation
of effective internal controls and procedures, such as regular employee training, quality control
checks, and documentation practices.

Finally, the auditor assesses the detection risk, which is low due to the use of a comprehensive audit
plan, including sampling and testing of the company’s financial records and reports, as well as the
experience and expertise of the audit team.

Based on these assessments, the auditor concludes that the overall audit risk is high. He then
develops an appropriate audit plan to address the identified risks. For example, this might include
additional testing of high-risk areas. In addition, it may include inventory or revenue recognition and
ongoing communication and collaboration with company management to ensure the audit is
conducted effectively and efficiently.

Example #2

Let’s consider a company called Charismatic Electronics Inc. that manufactures and sells electronic
devices. The company has been in business for five years and has recently expanded its operations to
several new markets. It has experienced rapid growth in recent years and has a diverse range of
products.

For Charismatic Electronics Inc., the inherent risk could be considered moderate to high. This is
because the company operates in a rapidly evolving and competitive industry. As a result, there are
inherent risks related to product obsolescence, technology changes, and remaining competitive.
Additionally, the company’s recent expansion into new markets and diverse product portfolio may
increase the inherent risk.

Importance

The audit risk model is an important concept in auditing, as it provides a framework for auditors to
assess the risks associated with a particular audit engagement. For example, the model helps
auditors identify and evaluate the risk of material misstatement. It is the risk that the financial
statements are materially incorrect or misleading.

The importance of the audit risk model can be understood from the following perspectives:

1. Helps to plan the audit: The audit risk model provides a structured approach for auditors to
plan the audit engagement. By assessing the risk of material misstatement, auditors can
identify the areas of the financial statements. Some require more attention and resources
during the audit process.
 2. Enhances audit quality: Using the audit risk model can help auditors enhance the quality of
their audit work. Assessing the risk of material misstatement and developing appropriate
audit procedures are done. Thus, auditors can provide more reliable and relevant
information to the users of financial statements.

3. Assists in making audit judgments: The audit risk model helps auditors to make informed
judgments. They consider the nature, timing, and extent of audit procedures that need to be
performed. By identifying the areas of the financial statements at higher risk of material
misstatement, auditors can focus their audit efforts on those areas.

4. Facilitates communication with stakeholders: The use of the audit risk model can help
auditors to communicate with stakeholders, such as management, audit committees, and
regulators. By explaining the audit risk model and the audit procedures that have been
performed, auditors can provide stakeholders with a better understanding of the audit
process, and the conclusions reached.

Limitations

While the audit risk model provides a structured approach for auditors to assess the risks associated
with a particular audit engagement, its application has certain limitations. Some of the limitations of
the audit risk model are:

1. Subjectivity: The audit risk model involves a degree of subjectivity. Auditors must make
judgments and estimates about the risks associated with the audit engagement. This can lead
to risk assessment variations, particularly when the risks are difficult to quantify or evaluate.

2. Limited scope: The audit risk model is limited. It only considers the risks associated with
material misstatement in the financial statements. It does not address other risks relevant to
the business, such as operational, strategic, or reputational risks.

3. Incomplete information: The audit risk model relies on the information available to the
auditor during the audit. Incomplete or inaccurate information can lead to incorrect risk
assessments and failure to detect material misstatements in financial statements.

4. Fraud risk: The audit risk model may not adequately address the risk of fraud. It is a growing
concern in many industries. Fraud can be difficult to detect and may not be identified
through standard audit procedures.

5. Time and cost constraints: The audit risk model requires significant time and resources to
assess and address the risks. Time and cost constraints may limit the level of assurance that
can be provided to stakeholders.