Question

(TCO H) Audit risk consists of inherent risk, control risk, and detection risk. (a) Please completely define each of the above. (b) Indicate whether each of the statements below is true or false and explain your position. (1) The risk that material misstatement will not be prevented or detected on a timely basis by internal controls can be reduced to 0 by having effective controls in place. (2) Detection risk is a function of the efficiency of an auditing procedure. (3) Cash is more susceptible to theft than an inventory of coal because it has greater inherent risk. (4) The inherent risk of the theft of an inventory of cell phones at a mall store is greater than the misappropriation of cash at a COSTCO store.

Answer 1

Inherent Risk: Inherent risk is the risk that a financial statement may be materially mis-stated due to presence of factors other than a control failure. This is normally evident in complex business transactions.

Control Risk: Control risk is the risk which materialises due of lack of proper accounting control in the firm/ business thus resulting in financial mis-statement. This type of failure leads to Fraud.

Detection Risk: Detection risk is a risk that auditors have failed to detect an evident error in financial accounts. This can normally be countered by increasing the sample size of the transactions to be reviewed under audit perview.

(1) The risk that material misstatement will not be prevented or detected on a timely basis by internal controls can be reduced to 0 by having effective controls in place.

FALSE. Inherent risk is always present in any business inspite of having effective internal controls. Hence, it can not be reduced to 0.

(2) Detection risk is a function of the efficiency of an auditing procedure.

TRUE. The more efficient the audit functions are, the less is the detection risk.

(3) Cash is more susceptible to theft than an inventory of coal because it has greater inherent risk.

FALSE.  Cash is more susceptible to theft than an inventory of coal because it has greater control risk. Cash has greater chances of control failure thus resulting in fraud and accounting mis-statement.

(4) The inherent risk of the theft of an inventory of cell phones at a mall store is greater than the misappropriation of cash at a COSTCO store.

TRUE. The risk of teft of a cell phone from a mall store is greater that mis-appropriation of cash because there could be instances that instead of having sound internal controls there might be a factor which would lead to robbery whereas in case of cash, there will be someone who is accountable of.