Audit Risk Model Essay Research Paper This

Audit Risk Model Essay, Research Paper

This is defined in AUS

402 as .the susceptibility of an account balance . to misstatement that

could be material . assuming there were no related internal controls. (AUS

402.09). Estimating the inherent risk (IR) for each account balance or class of

transactions requires the auditor to take into account such factors as the level

of complexity involved in determining the .correct. balance of an account,

the complexity of transactions involving the particular account(s) and the

.portability. of the assets involved. The estimation of IR is done as though

no internal controls exist . it looks only at the nature of the account being

evaluated. Control Risk AUS 402 defines this as .the risk that misstatements

that could occur in an account balance . that could be material . will not

be prevented or detected on a timely basis by the internal control structure.

(AUS 402.06). The evaluation of the level of control risk (CR) requires the

auditor to have a thorough understanding of the internal control structure that

is in place, and practiced (not necessarily the same thing) within the

organisation to be studied. Elements such as the segregation of duties, the

existence of .management overrides., and the level of formalised policies

and procedures in use are among the factors to be considered. Audit Risk Defined

in AUS 402 as .the risk that the auditor gives an inappropriate audit opinion

when the financial report is materially misstated.. (AUS 402.03) The level

that is set as the acceptable audit risk (AR) reflects the degree of certainty

that the auditor and audit subject wish to achieve. An audit opinion can never

be a guarantee (AR = 0), even if every transaction during the year was tested,

due, at least in part, to the interpretive nature of many of the accounting

decisions involved. Detection Risk The final part of the risk model outlined in

AUS 402 is defined as .the risk that an auditor.s substantive procedures

will not detect a misstatement.. (AUS 402.07) This risk relates to the

volume, effectiveness and sufficiency of the audit testing and investigation

undertaken. Both IR and CR are related to the probability that a particular

balance will contain an error, either accidental or fraudulent, while detection

risk (DR) is the probability that the auditor will not detect the error (Graham,

1985, p.15). The audit risk model is .a joint probability statement of

independent events. (Wade, 1996) which attempts to combine these probabilities

and give an overall .chance. of a misstatement existing (IR * CR) and

remaining undetected (* DR) . leading to the auditor giving an inappropriate

audit opinion (AR). B) Armidale Pty Ltd . Year 1 Inherent & Control Risk

Levels In the first year of an engagement the auditor will have gained only a

limited knowledge of the client and their practices. Faced with a poor internal

control structure the auditor may question the level of management experience

and knowledge, which AUS 402.14(b) suggests may be an indicator of high inherent

risk. This, combined with the newness of the engagement, would be sufficient

cause to set IR at a high level at the financial report level, and for most, if

not all, of the assertions below that. AUS 402.32 & AUS 402.34 mandate the

setting of control risk to high .unless the auditor is able to identify

internal controls . likely to prevent or detect and correct a material

misstatement. (AUS 402.32(a)). Given the conclusion of the auditor that such a

control structure does not exist within Armidale Pty Ltd they would have no

option but to set CR as high . which is a logical choice given our previous

definition of CR. Detection Risk & Evidence Accumulation Assuming that the

auditor wishes to achieve a low level of Audit Risk, especially given the

newness of the engagement and the lack of an effective control structure we can,

by restating the audit risk model as DR = AR / (IR x CR) determine what the

level of detection risk must be set at to achieve the desired level of AR. If,

for example, an AR of 5% is desired with both IR & CR set to 100% the DR

comes out to be: DR = .05 / ( 1 x 1) DR = .05 (5%) This means that the auditor

can only accept a 5% probability that their substantive procedures fail to

detect any material misstatements. Achieving this level of assurance will

require the gathering of a large amount of evidence . large samples will need

to be carefully tested and examined across most assertions. As the accumulation

of evidence is, due to the time and resources required, one of the more

expensive components of an audit the cost of running an audit with high CR &

IR ratings will be greater than .normal.. The auditor must balance the costs

and fees of this initial audit against the long term relationship with this new

client . as well as their l

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