Question

PLEASE EXPLAIN THE FOLLOWING

• Understand the audit risk formula and model
• Understand the relationships between inherent risk and control risk and risk of material misstatement
• Understand the relationships between audit risk, Risk of Material Misstatement and detection risk (is it proportional/direct or inverse) If one goes up foes the other go up or down?
• Understand the impact of changes in inherent risk, control risk, detection risk to substantive testing. If detection or control risks go up or down does an auditor perform more or less work?
• Understand Nature, Timing, and Extent of testing and what do they mean. Which gives you more level of evidence and what gives you less evidence.
• Understand the different types of audit procedures and what they mean (recalculation, reperformance, observation, confirmation, etc.)How to test for existence and completeness using these procedures.
• Understand the different assertions (accuracy, completeness, existence, etc.).

Understand materiality what it means, and related key concepts. How is materiality used in the planning phase, and substantive

Answer 1

INHERENT RISK : Inherent risk (IR) is the risk/susceptibility of an assertion to a material misstatement without considering internal controls. ie it means that there is an error in the first place without placing internal controls there would be a misstatement

CONTROL RISK: Control risk (CR) is the risk that the client’s system of internal controls (i.e. policies and procedures put in place by management to enhance the reliability of the financial statements) will fail to prevent or detect a material misstatement.

DETECTION RISK: Detection risk is the risk that the auditor will not detect a material misstatement although he applied all the procedures.

RISK OF MATERIAL MISSTATEMENT : he risk of material misstatement refers to the risk that the financial statements are materially misstated and do not present true and fair view.

The risk of material misstatement is assessed at two levels

(i) Financial statements level:

To go in depth of the risk of material misstatement, firstly you have to know what exactly the term material misstatement means from the accounting and auditing point of view. Material misstatement is related to the information present in the financial statement. Material misstatement leads the financial statement users suffering from the economic loss. Misstatement means the information suggested to be in there in financial statement is not actually what is written in there. The overall risk increases when such cases arise and thus increasing the risk of financial misstatement.

(ii) Assertions level : At the assertion level, This is further subdivided into inherent risk and control risk

AR= ( IR *CR ) DR

Where:

DR = Detection Risk

AR = Audit Risk

IR = Inherent Risk

CR = Control Risk

ROMM = Risk of material misstatement (IR * CR)

RELATIONSHIP:

Where the auditor's assessment of inherent 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. Conversely, where the auditor believes the inherent and control risks of an engagement to be low, detection risk is allowed to be set at a relatively higher level.