Audit Risk Model
Lesson:
Not all audit engagements are the same. Sometimes a company may have characteristics that make it look harder or easier to audit than others.
As auditors, we try to be efficient with our resources, and only use as many as we think are necessary.
As a result, it's crucial that we can get a feeling for how much effort we will need to put in. The formula that is used for this purpose is called the Audit Risk Model:
AUDIT RISK = INHERENT RISK * CONTROL RISK * DETECTION RISK
- Audit Risk - The odds of coming to the wrong conclusion in our audit
- Inherent Risk - The odds of a material statement, before considering any internal controls
- Control Risk - The odds of internal controls missing a material misstatement
- Detection Risk - The odds of the auditor not detecting a material misstatement
Often auditors will consider inherent risk and control risk together, as they are out of the auditor's control, and simplify it to a single number known as risk of material misstatement:
RISK OF MATERIAL MISSTATEMENT = INHERENT RISK * CONTROL RISK
Sometimes auditors will use terms like HIGH and LOW for the values, but it's often easier to use actual numbers.
- A value of 1.0 means that the risk of a problem is 100%.
- A value of 0 means that the risk of a problem is 0%.
The only relevant information you've discovered is as follows:
- The risk of material misstatement is 0.200.
- The audit risk is 0.120.
Answer:
- The detection risk is 0.600.
Explanation:
- First, let's remember the formula we need:
AUDIT RISK = RISK OF MATERIAL MISSTATEMENT * DETECTION RISK - Next, let's plug in the numbers that we know. The order that we fill in the numbers doesn't matter.
- Let's plug in the audit risk.
0.120 = RISK OF MATERIAL MISSTATEMENT * DETECTION RISK - Let's plug in the risk of material misstatement.
0.120 = 0.200 * DETECTION RISK - Finally, we just have to solve for detection risk.
0.600 = DETECTION RISK