Risk concepts and the audit risk model

Audit risk

The risk that the auditor expresses an inappropriate opinion when the financial statements are materially misstated.

Inherent risk

Susceptibility of an assertion to material misstatement before considering internal controls.

Control risk

The risk that client controls fail to prevent, or detect and correct, material misstatement on a timely basis.

Detection risk

The risk that the auditor's procedures fail to detect an existing material misstatement.

Risk of material misstatement

The combined effect of inherent risk and control risk; RMM = IR × CR.

Audit risk model

AR = IR × CR × DR.

Planned detection risk formula

DR = acceptable AR ÷ (IR × CR).

Risk assessment responsibilities

The auditor sets an acceptable audit risk target, assesses inherent and control risk, and determines the needed effectiveness of audit procedures.

Audit risk relationship

For a fixed acceptable audit risk, higher inherent or control risk requires lower planned detection risk.

Lower planned detection risk response

Use more effective procedures, test closer to year end, and increase the extent of testing when warranted.

Higher planned detection risk response

A lower assessed risk of material misstatement may permit less intensive procedures, interim testing, or fewer tests while preserving sufficient appropriate evidence.

Nature of audit procedures

The type and effectiveness of procedures and evidence selected.

Timing of audit procedures

When testing occurs, including interim dates versus year end.

Extent of audit procedures

How much testing is performed, such as sample size or number of items examined.

Inherent risk factors in the slides

Business nature and strategy, major transaction types, management and accountant integrity and effectiveness, account size, liquidity, transaction volume, complexity, and subjective estimates.

Control risk factors

Control environment, the existence and effectiveness of control activities, and monitoring such as audit committee oversight.

Account dollar size and inherent risk

Larger accounts can have greater potential material misstatement exposure.

Liquidity and inherent risk

Liquid assets such as cash are readily transferable and susceptible to theft.

Transaction volume and inherent risk

Many transactions create more opportunities for errors, omissions, and processing problems.

Transaction complexity and inherent risk

Complex transactions make accounting judgments and processing more difficult.

Subjective estimates and inherent risk

Estimation uncertainty and management judgment increase susceptibility to bias or error.

Invalid transactions recorded

Violation of occurrence.

Valid transactions or disclosures omitted

Violation of completeness.

Inaccurate transaction amounts

Violation of accuracy.

Wrong account used

Violation of classification.

Improper aggregation or unclear description

Violation of presentation.

Transaction recorded in the wrong period

Violation of cutoff.