A2 M8 Audit Risk

Audit Risk

The risk that the auditor may unknowingly fail to appropriately modify the opinion on financial statements that are materially misstated.

Material Misstatement

An omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced.

Factual Misstatements

Misstatements about which there is no doubt.

Judgmental Misstatements

Differences arising from management's judgments concerning accounting estimates or inappropriate policy selections.

Projected Misstatements

The auditor's best estimate of misstatements in a population derived by projecting sample results to the total population.

Audit Risk Model

The mathematical relationship expressed as Audit Risk = Risk of material Misstatement * Detection Risk

Risk of Material Misstatement (RMM)

The combined assessment of inherent risk and control risk representing the likelihood and magnitude of potential misstatements.

Inherent Risk (IR)

The susceptibility of an assertion to a material misstatement before considering any related internal controls.

Spectrum of Inherent Risk

A scale framing the significance of risk based on the degree to which inherent risk factors like complexity, subjectivity, uncertainty, or bias exist.

Control Risk (CR)

The risk that a material misstatement will not be prevented or detected (and corrected) on a timely basis by internal controls.

Detection Risk (DR)

The risk that audit procedures will fail to detect a material misstatement that exists in a relevant assertion.

Subdivisions of Detection Risk

Detection risk is comprised of tests of details risk and substantive analytical procedures risk.

Relationship Between RMM and Detection Risk

An inverse relationship where higher assessed RMM requires setting detection risk at a lower level.

Relationship Between RMM and Substantive Procedures

A direct relationship where higher RMM requires more persuasive evidence, larger sample sizes, or testing at year-end rather than interim.

Control Risk Assessed at Maximum

Assessed when controls are nonexistent, ineffective, or when testing control operating effectiveness is not planned.

Required Substantive Procedures

Substantive procedures must always be performed for each relevant assertion of each significant transaction class, account balance, and disclosure.

Relationship Between Audit Risk and Materiality

An inverse relationship where the risk of a very large misstatement is lower, while the risk of a small misstatement is higher.

Steps to Assess Audit Risk in Planning

1. Determine audit risk

2. Assess inherent risk

3. Assess control risk

4. Determine detection risk

Determine audit risk

The auditor sets the overall audit risk level for the engagement (typically low) to prevent issuing an inappropriate opinion.

Assess inherent risk

Evaluating the susceptibility of assertions to material misstatement based on account characteristics, complexity, and business environment before considering controls.

Assess control risk

Evaluating the design and implementation of internal controls to determine whether they prevent or detect misstatements, assessing CR at maximum if controls are not tested.

Determine detection risk

Calculating acceptable detection risk based on assessed inherent risk and control risk using the formula DR = AR / (IR * CR)

Detection of material misstatements

The principle that the more material a misstatement is, the less likely it is that the auditor will fail to detect it