Question

Audit Risk Model- Example 1

You are assigned to conduct the audit procedures for the inventory account at Tech Toys, a public company in the technology industry that sells the latest technology for fitness watches. Inventory obsolescence and the product’s susceptibility to theft is a business risk that management has identified for its inventory.  As part of your procedures you have to evaluate the overall risk assessment for the inventory account using the audit risk model.  Your team has decided that the acceptable level of overall audit risk for this account is Very Low or Low.  

You perform a walkthrough of Tech Toys’ process for its inventory, which includes internal controls surrounding the existence, completeness, and valuation of inventory.  Based on your walkthrough and test of control procedures, you find that Tech Toys has inadequate internal controls in place surrounding its inventory processes.

Given the above, what is the assigned level of risk (low, moderate, or high) for each of the components of the audit risk model that will enable a Very Low or Low level of audit risk for the inventory account? Briefly describe your judgment regarding the level of risk for each component.  What does your assessment for each of the components of the Audit Risk Model indicate about the nature, timing, and extent of substantive procedures that will be performed?

Audit Risk Model- Example 2

Assume instead that based on your walkthrough and test of control procedures, you find that Tech Toys has adequate internal controls in place surrounding its inventory processes.  How does this change your assessment?

Answer 1

Audit Risk:

Audit risk is the risk that auditors issued the incorrect audit opinion to the audited financial statements. For example, auditor issued unqualified opinion to the audited financial statements even though the financial statements are materially misstated. Or the qualified opinion is issued as the result of immateriality found in financial statements which the correct opinion should be unqualified.

Audit risks come from two main different sources: Clients and Auditors themselves. The risks are classified into three different types: Inherent risks, Control Risks and Detection Risks.

The below is the formula for audit risk :

Inherent risk*Control Risk*Detection Risk

Inherent Risk :

Inherent risk refer to the risk that could not be protected or detected by entity’s internal control. This risk could happened as the result of complexity of client nature of business or transactions. Sometime, that nature of business could link to complexity of financial transactions and require high involvement with judgement.

Control Risks :

Control risk or internal control risk is the risk that current internal control could not detect or fail to protect significant error or misstatement in the financial statements. Basically, managements are required to set up and assess the effectiveness and efficiency of internal control over financial reporting to make sure that financial statements are free from material misstatements.

Detection Risk :

Detection risk is the risk that auditor fail to detect the material misstatement in the financial statements and then issued incorrect opinion to the audited financial statements.

The common cause of detection risk is improper audit planning, poor engagement management, wrong audit methodology, low competency and lack of understanding of audit client. Detection risk is occurred because of auditor part rather than client part.

AUDIT REPORT

Once the audit is completed,the auditor issues an opinion via the audit report on the financial statements that falls into one of the following four categories:

• “Unqualified” or Clean Audit Opinion: In this context, “unqualified” means that in the auditor’s professional opinion, the financial statements passed muster without any qualifications or exceptions. This is the most common audit outcome.

Unqualified Opinion With an Explanatory Paragraph:

This type of report is issued when the auditor believes the financial statements are fairly presented in all material respects in conformity with GAAP, but additional information should be disclosed.

“Qualified” Opinion:

In a qualified opinion, the auditor reports that the financial statements are fairly presented in all material respects in conformity with GAAP, but with one or more specific exceptions, which the auditor describes. For example, the auditor might have identified a deviation from GAAP that has a material effect on the financial statements.

Adverse or Disclaimer Opinion:

An adverse opinion is a failing grade that is issued when an auditor believes the financial statements taken as a whole are materially misstated or do not conform to GAAP. An adverse opinion typically signals significant problems that will make it difficult for a company to attract investors or access capital.

AUDIT RISK MODEL EXAMPLE 1 :

In this scenario the auditor will submit the “Qualified” Opinion.

For Inventory related the below is the Risks and Precentages :

Audit risk : High (5%)  

Inherent risk. This risk is caused by an error or omission arising from factors other than control failures. This risk is most common when accounting transactions are quite complex, there is a high degree of judgment involved in accounting for transactions

Inherent Risk : Low (50%)

Control risk : Moderate

Planned detection risk : Moderate

Amount of evidence required : Moderate

AUDIT RISK MODEL EXAMPLE 2 :

In this scenario auditor will give the unqualified or clean report. So this Audit report it self says that the company is having adequate internal controls and processes.