• Th
The auditor
dit also
l needs d to
t understand
d t d the
th
financial health in order to:
– assess management’s
management s motivation to
misstate the financial statements
– identify areas that are likely to be misstated
– identify account balances that appear
unusual.
Other Factors Affecting
E
Engagement Ri
Risk
k
• Auditors should evaluate a company’s
company s economic
prospects to ensure important areas are investigated
and the company
p y is likelyy to stay
y in business.
• High-risk companies are generally characterised by:
– inadequate
q capital
p
– lack of long-run strategic and operational plans
– low cost entry y into the market
– dependence on limited product offerings
– dependence on technology subject to obsolescence
– instability of future cash flows
– history of questionable accounting practices
– previous inquiries by regulatory agencies.
Material Misstatement Risk
AR = IR x CR x DR
• AR = audit risk
• IR = inherent risk
• CR = control risk
• DR = detection
d t ti risk
i k
Th A
The Audit
dit Ri
Risk
kMModel
d l((cont.)
t)
• Th
The audit
dit risk
i k model
d l allows
ll the
th auditor
dit tot
consider the following:
–C
Complexl or unusuall transactions
t ti are more
likely to recorded in error than are simple or
recurring transactions.
transactions
– Management may be motivated to misstate
earnings or assets.
assets
– Better internal controls mean a lesser
likelihood of misstatement.
misstatement
– The amount and persuasiveness of audit
evidence gathered should vary directly with
the likelihood of material misstatements.
The Audit Risk Model (cont.)
(cont )
• Inherent risk: susceptibility of transactions to be
recorded in error. Inherent risk is higher for some
items.
– Complex
C l transactions
i are more likely
lik l to be
b
misstated than simple transactions.
– Estimated balances more likely to be misstated
than fact-based balances.
– The auditor assesses inherent risk
• Control risk: risk client controls will fail to
prevent or detect a misstatement.
– The quality of controls often varies between
classes of transactions.
– The auditor assesses control risk.
Th A
The Audit
dit Ri
Risk
kMModel
d l((cont.)
t)
• Environment risk: inherent and control risks
combined.
– Reflects the likelihood of material
misstatements occurring.
• Detection risk: risk that audit procedures will fail
to detect material misstatements.
– Relates to the effectiveness of audit
procedures and their application.
– Is controlled by the auditor and is an integral
part of audit planning.
– The level of detection risk set directly
determines the rigour of the substantive audit
work performed.
The Audit Risk Model (cont.)
( )
AR = IR x CR x DR