Auditing standards require auditors to identify and assess the risks of material misstatement due to fraud and to determine overall and specific responses to those risks. Here are some answers to questions about what auditors assess when interviewing company personnel to evaluate potential fraud risks. ISA 200 states that auditor should plan and perform the audit to reduce audit risk to an acceptably low level that is consistent with the objective of an audit. (Auditing and Assurance Standard) AAS-6(Revised), “Risk Assessments and Internal Controls”, identifies the three components of audit risk i.e. inherent risk, control risk and detection risk.

Relationship Between Acceptable Audit Risk and Audit Assurance

When there are significant control failures, a client is more likely to experience undocumented asset losses, which means that its financial statements may reveal a profit when there is actually a loss. In this situation, the auditor cannot rely on the client’s control system when devising an audit plan. The auditor should assess audit risks before accepting the audit engagements by understanding the nature of its client’s business and the complexity of financial reporting in that sector.

Audit Risk = Inherent Risk * Control Risk * Detection Risk

• For example, the valuation of complex financial instruments like derivatives and structured products involves multiple assumptions and complicated fair value calculations.
• In other words, the material misstatements of financial statements fail to identify or detect by auditors.
• The UK Auditing Practices Board announced in March 2009 that it would update its auditing standards according to the clarified ISAs, and that these standards would apply for audits of accounting periods ending on or after 15 December 2010.
• Inherent risk arises from the possibility of committing an error or omission in a financial statement for reasons other than a failure of internal controls.
• Hence, auditors’ professional judgment which is based on their knowledge and experience is very important here.

Inherent risk comes from the size, nature and complexity of the client’s business transactions. The more complex audit risk model business transactions are, the higher the inherent risk the client will have. Each scenario will have a variety of audit risks and candidates should, as part of their planning, aim to identify as many as possible. They should then decide which of the identified risks they will explain/describe in their answer. If the question asks for five risks, candidates should aim to identify six or seven points during their initial reading of the question.

Types of Audit Risk: Definition Model Example Explanation

• The main reasons behind inherent risks lie as a result of the nature of the transaction involved.
• You can facilitate the fraud risk assessment by anticipating the types of questions we’ll ask and the types of audit evidence we’ll need.
• The detection risk of audit evidence for an assertion failing to detect material misstatements is 5%.
• Professional scepticism is defined as an attitude that includes a questioning mind and a critical assessment of evidence.
• If the question asks for five risks, candidates should aim to identify six or seven points during their initial reading of the question.

Unqualified audit opinions state that financial statements are presumed to be free from material misstatements. For example, if the risk of material misstatement is high, auditors need to reduce the level of detection risk. If auditors believe that the client’s internal control can reduce the risk of material misstatement, they will assess the control risk as low and perform the test of controls to obtain evidence to support their assessment. Inherent risk is the risk that the financial statements may contain material misstatement before considering any internal control procedure. It is considered the first one of audit risk components in which the risk is inherited from the client’s business.

• This means auditors can reduce their substantive works and the risk is still acceptably low.
• Hence, audit risk is made up of two components – risks of material misstatement and detection risk.
• As a result, the auditor issues an unqualified (clean) opinion, but the financial statements are materially misstated due to the overstatement of inventory.
• A common mistake made by candidates is to provide a response that management would adopt rather than the auditor.
• It involves identifying, assessing, and mitigating risks in a holistic manner, considering both internal and external factors that could impact the organization’s objectives.
• For example, the auditor needs to set up a proper audit plan, audit approach, and audit strategy.
• In this type of risk, the auditor may be unable to point out any misstatement in the financial statement.

It provides organizations with a clear understanding of risk levels and guides them in implementing necessary safety measures. Above, we have mentioned the audit risks model, and by that, you might think of casting audit risk. If the client’s internal control seems to be strong, the audit needs to confirm if the control is working by testing internal control. If there is a low detection risk, there is a minor probability that the auditor will not be able to detect a material error; therefore, the auditor must complete additional substantive testing. Auditors may also tick the control risk as high when they believe that it is more effective to perform the test of detail rather than reliance on internal control. For example, those businesses that involve more with hedge accounting tend to have higher inherent risk than those of trading companies.

The audit, therefore, provides (1 – .05) assurance that the financial statements are free from material misstatement. Inherent risk is the auditor’s assessment of the susceptibility to material misstatement of an assertion about a transaction class, an Insurance Accounting account balance, or an attached disclosure, quoted individually or an aggregation. The assessment is performed before the consideration of relevant internal controls in place.

The bank is not going to provide this type of information to the auditor, especially if they have not yet informed the company, and therefore unearned revenue this response will not generate any marks. This step involves using simulation tools to predict what would happen if a hazard materialized. Fire spread, toxic gas dispersion, or explosion impact are analyzed to understand the potential severity of incidents. Nuances such as an interviewee’s tone and inflection, speed of response, and body language provide important context to the spoken words. An auditor is also trained to notice signs of stress when an interviewee responds to questions, including long pauses before answering or starting answers over. The auditor will also assess the leadership of the management team as well as the entity’s culture.

• Quantitative Risk Assessment (QRA) is a structured process used to identify, analyze, and quantify risks in numerical terms.
• And as a result, auditors would not be able to properly plan the nature, timing and extent of the audit procedures.
• It is the second one of audit risk components where auditors usually make an assessment by evaluating the internal control system that the client has in place.
• Therefore, in relation to the risk of going concern, the response is to focus on performing additional going concern procedures, such as reviews of cash flow forecasts.
• Audit Risk Model is a tool that is used by the auditors in order to understand the relationship between various risks that exist during the normal course of the audit process.

Every financial statement has sections where misstatements are more likely to occur—that’s just the nature of accounting. Some transactions and account balances are inherently more susceptible to material misstatement than others. For example, calculating depreciation expenses is trickier to audit accurately than simple cash transactions since you’re dealing with estimates and technical accounting judgments.