Question

Discuss the audit risk model:

a. Show the audit risk equation

b. Define each component on the equation

c. Explain how the equation works, include a comment on the controllability of each component

Answer 1

AUDIT RISK: THE RISK THAT THE AUDITOR EXPRESS AN INAPPROPRIATE/WRONG AUDIT OPINION WHEN THE FINANCIAL STATEMENTS ARE MATERIALLY MISSTATED.

A. AUDIT RISK EQUATION: AUDIT RISK = INHERENT RISK x DETECTION RISK x CONTROL RISK.

THERE IS AN INVERSE RELATION BETWEEN DETECTION RISK AND COMBINATION OF INHERENT RISK AND CONTROL RISK. WHEN INHERENT RISK AND CONTROL RISK INCREASE, DETECTION RISK SHOULD DECREASE.

B. COMPONENTS OF AUDIT RISK:

i. INHERENT RISK: THE SUSCEPTIBILITY OF AN ASSERTION ABOUT A CLASS OF TRANSACTION, ACCOUNT BALANCE OR DISCLOSURE TO A MISSTATEMENT THAT COULD BE MATERIAL, EITHER INDIVIDUALLY OR WHEN AGGREGATED WITH OTHER MISSTATEMENT.

INHERENT LIMITATION OF AUDIT:

1. TEST NATURE OF AUDIT.

2. AUDIT EVIDENCE IS PERSUASIVE AND NOT CONCLUSIVE.

3. HUMAN JUDGEMENT.

4. INHERENT LIMITATION OF INTERNAL CONTROL.

5. AUDIT BASED ON SAMPLING.

ii. DETECTION RISK: DETECTION RISK IS THE RISK THAT A MATERIAL MISSTATEMENT IN THE FINANCIAL STATEMENT CANNOT BE PREVENTED AND DETECTED BY AUDITOR'S SUBSTANTIVE PROCEDURES.

iii. CONTROL RISK: THE RISK THAT CLIENT'S INTERNAL CONTROL SYSTEM CANNOT PREVENT AND DETECT MATERIAL MISSTATEMENTS ON A TIMELY BASIS.

C. AUDIT RISK MODEL IS USED BY THE AUDITOR TO MANAGE THE OVERALL RISK OF AN AUDIT ENGAGEMENT.

WHERE THE AUDITOR'S ASSESSMENT OF INHERENT RISK AND CONTROL RISK IS HIGH , THE DETECTION RISK IS SET AT A LOWER LEVEL TO KEEP THE AUDIT RISK AT AN ACCEPTABLE LEVEL. LOWER DETECTION RISK MAY BE ACHIEVED BY INCREASING THE SAMPLE SIZE FOR AUDIT TESTING. WHERE THE AUDITOR BELIEVE THE INHERENT AND CONTROL RISK OF AN ENGAGEMENT TO BE LOW, DETECTION RISK IS ALLOWED TO BE SET AT A RELATIVELY HIGHER LEVEL.

AUDITOR NEEDS TO OBTAIN AUDIT EVIDENCE BY INSPECTION, OBSERVATION, EXTERNAL CONFIRMATION, RECALCULATION, REPERFORMANCE, ANALYTICAL PROCEDURES & INQUIRY.

AUDITOR NEED TO CHECK WEAKNESS POINT IN INTERNAL CONTROL AND WRITE A LETTER OF WEAKNESS TO MANAGEMENT AND SUGGESTS MEASURE BY WHICH THE WEAKNESS IN THE SYSTM BE CORRECTED AND CONTROL SYSTEM BE MADE BETTER PROTECTED.

LAPSES IN OPERATION OF INTERNAL CONTROL SHOULD ALSO BE REPORTED IN COMMUNICATION OF WEAKNESS.