ACG 6685 Florida Atlantic University Calculation to Audit Risk Discussion

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Issues can arise when an auditor does not thoroughly understand that client business model. An auditor must have a thorough understanding of many aspects of the client’s business and environment. The understanding of client’s business model should be obtained during the audit planning phase. In this phase of planning/understanding, the auditor will be able to assess risk, decide on an appropriate audit strategy, and be able to design and perform effective audit procedures.

Audits are performed to reduce audit risk to an appropriate level, which is done through sufficient testing and evidence. Audit risk is the risk that financial statements are materially incorrect. There are three elements to an audit risk – control risk, detection risk and inherent risk. The calculation to audit risk is: Control Risk x Detection Risk x Inherent Risk

Control risk is caused by the failure of existing controls at the client’s business, or the lack of controls. Detection risk is caused by the failure of the auditor to discover a material misstatement in the financial statements. Inherent risk is caused by an error or omission from other factors than control failures. For example, training level of accounting staff is low or there is a high degree of judgement in accounting for transaction. These three elements contribute to the audit risk.

Therefore, it is important to understand the client’s model which the auditor will then be able to assess the risks. Once risk is established, the auditor will be able to decide on audit strategy. For instance, if the overall risk level is too high, the auditor my conduct additional procedures to reduce risk. Or if control risk and inherent risk is high, the auditor may increase sample size for audit testing. It all starts with the understanding of the client’s business. If understanding is not established, risk can be incorrect, which then may lead to an incorrect opinion.