What is audit risk? Explain three components of audit risk and also define their relationship.

Auditing and Assurance Revision Questions and Answers

Answer:

Audit Risk (AR): Audit risk is the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. In other words, it is a function of the risk of material misstatement of the financial statements (or simply, the “risk of material misstatement”) (i.e., the risk that the financial statements are materially misstated prior to audit) and the risk that the auditor will not detect such misstatement (“detection risk”).

Three components of audit Risk:
a) Inherent Risk (IR): “Inherent risk” is the susceptibility of an assertion to a misstatement that could be material, either individually or when aggregated with other misstatements, assuming that there are no related controls.
b) Control Risk (CR): “Control risk” is the risk that a misstatement that could occur in an assertion and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis the entity‟s internal control. That risk is a function of the effectiveness of the design and operation of internal control in achieving the entity‟s objectives relevant to preparation of the entity‟s

financial statements. Some control risk will always exist because of the inherent limitations of internal control.
c) Detection Risk (DR): “Detection risk” is the risk that the auditor will not detect a misstatement that exists in an assertion that could be material, either individually or when aggregated with other misstatements. Detection risk is a function of the effectiveness of an audit procedure and of its application the auditor. Detection risk cannot be reduced to zero because the auditor usually does not examine all of a class of transactions, account balance, or disclosure and because of other factors. Such other factors include the possibility that an auditor might select an inappropriate audit procedure, misapply an appropriate audit procedure, or misinterpret the audit results. These other factors ordinarily can be addressed through adequate planning, proper assignment of personnel to the engagement team, the application of professional skepticism, and supervision and review of the audit work performed.
Relationship of Audit Risk with its components:
The relationship is expressed the following Equation: AR=IR*CR*DR
From the definition of various components of audit risk stated above, it is clear that IR and CR cannot be reduced the auditor. In other words the auditor has control over DR only. So, to keep the audit risk at acceptable level based on above equation, if the product of IR and CR is high, the auditor should reduce DR.



(Visited 34 times, 1 visits today)
Share this on:

Leave a Reply

Your email address will not be published.