Question

ASA 200 (Objectives and General Principles Governing an Audit of a Financial Report) states that audit risk is a function of the risk of material misstatement of the financial report (or simply, the “risk of material misstatement”) and the risk that the auditor will not detect such misstatement.

Required:

a) Explain the three (3) components of audit risk and outline the impact an external auditor has on each ofthese components of audit risk.

b) Explain why it is important for the auditor to properly assess these risks. In your answer indicate how the assessment of these risks influences the auditor’s evidence collecting procedures.

Answer 1

3 Components of Audit Risk

Inherent Risk -

The risk that the financial statements will show material misstatement which is there due to reasons other than lacking of internal controls. This risk arises mainly because of the complex nature of the transactions and the business. Where high-level management estimation and judgment is involved.

Control Risk - This risk of misstatements in Financial statements arises because of the failure of internal controls to detect them. This is generally higher in the organization where there is a lack of adequate internal controls.

Detection Risk

Detection risk is the risk that audit procedures done by the auditor will fail to detect the material misstatements in the financial statements. This depends on the extent and timing of the substantive audit procedures done by the auditor.

Auditor's Impact

The auditor has limited impact on the inherent risk of the firm as it outside the control of the auditor and depends majorly on the judgment and estimation. Still, the auditor can take external opinion to reduce the inherent risk.

The auditor can also increase the extent of audit procedures to reduce control and detection risk. The larger the extent of the procedures performed by the auditor, lessen the risk. The simplest way to increase the extent is to increase the sample size.

Why It's important to assess audit risk

The auditor is responsible to give his opinion on the true and fair view of the financial statements and that they are free of material misstatements. Therefore, it becomes really important for the auditor to assess audit risks and mitigate them as far as possible.

The major influence from assessing the risks comes in the form of change in the extent that the auditor will perform his procedures. For example, if there is high detection risk then the auditor will raise the sample size and will perform the audit procedures on a larger population. If there's a lack of internal controls, then the auditor will create its own manual controls and perform the procedures.

If there's an inherent risk with respect to any transaction then the auditor will take confirmations from third parties and will prefer external expert opinion on the same.