Question

Audit risk is a function of inherent risk, control risk and detection risk. Explain Audit risk. Describe the relationships between all risks and their components?

Answer 1

Audit risk is the function of risk of material misstatement and detection risk.The assessment of risk is based on audit procedures to obtain information necessary for that purpose and evidence obtained throughout the audit.The assesment of risk is matter of professional judgement rather than a matter capable of precise measurement.

Three component of audit risk are:

1. Inherent risk - risk that material errors will occur.
2. Control risk - risk that the client internal control system will not prevent or correct such errors and
3. Detection risk - risk that any remaining material errors will not be detected by the auditor.

Relationships between all risks and their components

• Inherent Risk: Inherent risk is higher for some assertions and related classes of transactions, account balance and disclosure than for others. For example, it may be higher for complex calculations or for accounts consist of amount derived from accounting estimates that are subject to significant estimation uncertainty
• Control risk is a function of the effectiveness of the design,implementation and maintenance of internal control by management to address identified risk that threaten the acheivement of the entity objectives relelvant to preparation of the entity's financial statements.However internal control no matter how well designed and operated ,can only reduce but not eliminate risk of material misstatement in the financial statement , because of the inherent limitations of internal control. These include for example the possibility of human errors or controls being circumvented by collision or inappropriate management override.Accordingly, some control risk will always exist
• Detection risk - for a given level of audit risk ,the acceptable level of detection risk bears an inverse relationship to the assessed risk of material misstatement at the assertion level. for example ,the greater the risk of materila mistatement auditor believes exists, the less the detection risk that can be accepted and accordingly, the more persuasive the audit evidence required by the auditor. Detection risk relates to the nature, timing anf extent of the auditor's procedure that are determing by the auditor to reduce audit risk to an acceptably low level. It is therefore a function of the effectiveness of an audit procedure and of its application by the auditor.