The Audit Risk Model

1. Lanfei Gao, Michael Andrews, and Shanaka DeSilva, The Audit Risk Model

2. Audit Risk • The risk that the auditor may unknowingly fail to appropriately modify the opinion on financial statements that are materially misstated • First fundamental concept of audit procedures

3. Contents of Audit Risk Detailed level: • Account Balance • Class of Transactions Assertion • Material Misstatement Risk -Inherent risk -Control risk • Detection risk

4. Engagement Risk • An auditor’s exposure to financial loss and damage to professional reputation. • client and third party lawsuits • negative publicity

5. Audit Risk Model • Inherent risk (IR) – The likelihood that a material misstatement exist. • Control risk (CR)- Risk that the misstatement will not be prevented, or detected and corrected on a timely basis by the entity's internal control. • Risk Material Misstatement; RMM = CR x IR • Detection risk (DR) – Effectiveness of the audit procedure.

6. Audit Risk Model Audit Risk Model Equation: AR = RMM x DR • Requires professional judgment • Highly subjective • Not intended to be a precise formula

7. How to Use the Audit Risk Model

8. Limitations of the Audit Risk Model • The desired level of audit risk may not actually be achieved • It does not consider potential auditor error • Does not consider nonsampling risk

9. Thank You! • What are the components of the Audit Risk Model? • What is the Audit Risk Model Formula? • How is the Audit Risk Model used? • What are the Audit Risk Model’s Limitations? • Audit, Inherent, Detection, Control • AR = IR x CR x DR or AR = RMM x DR • Determine Audit Risk, Determine RMM, Solve for DR • Audit Risk Level may not be achieved, does not consider auditor error, does not consider nonsampling risk