Question

Question 4 Short answer question on audit risk model & audit strategies

Briefly explain how the audit risk model should be applied in a financial statement audit. How do audit strategies affect audit testing? You do NOT need to define the components of the audit risk model.

Answer 1

In the process of analyzing the chances that an audit risk can occur, three factors are taken into account: inherent risk, control risk, and detection risk, and the formula is as follows:

Audit Risk = Inherent Risk x Control Risk x Detection Risk

Auditor’s aim is to reduce the audit risk to an acceptable level. In order to do that, they will first assess the levels of each component risk of the model. The risk values are not readily quantifiable though and auditors use professional judgment to assess the risks. This means that the above equation is not typically used to calculate risks like other mathematical equations are normally used.

The auditors then use the model to establish a relationship between the risks and take action to reduce overall audit risk to an acceptable level. The risk of material misstatement is under the control of the management of the company and the auditor can only directly manipulate detection risk. So, if their assessment of the risk of material misstatement and audit risk is high, they must decrease the detection risk in order to contain overall audit risk within an acceptable level.

Detection risk can be manipulated by various means some of them being: changing the composition of the engagement team, changing the types of procedures, and changing the duration of audit work. For example, detection risk and thus audit risk is normally reduced when more skilled personnel are assigned to the engagement team or when larger sample sizes are selected or when the substantive tests of details are performed instead of analytical procedures.

Preliminary audit strategies refer to an auditor’s preliminary judgments about an audit approach applied to assertions. A preliminary audit strategy may be based on certain assumptions. The two extreme preliminary audit strategies are the primarily substantive approach and the lower assessed level of control risk approach. These approaches are used to specify the four components of an audit strategy.

This has an impact on the use of the audit risk model. Audit risk related to the opinion on the overall financial statements discusses the risk of material misstatements due to fraud as well as an error. It requires the auditor to assess the risk of material misstatement of the financial statements due to fraud specifically. Also, certain fraud risk factors identified here may be described as inherent risks and others as control risks. The auditor’s response to fraud risk factors may be reflected in determining acceptable levels of detection risk for assertions pertaining to specific transaction classes and accounts.