[reiko]

Hi everyone,

i really have problem with inherent risk,control risk and detection risk especially in the simulation questions. Can someone help me to clarify?

Control risk, inherent risk, audit risk

if the company buys derivative starting this year but also hire more skilled employees for it.What effect it would have on inherent risk, control risk, detection risk?

the company enter an international derivative/hedge fund market but it does not pay cash for the entering. What would be the effect on the control risk, inherent risk and detection risk?

the company starts to buy derivatives this year. Part of the derivatives depends on the interest rate which affects the returning on the investment. What will be the effect on inherent risk and detection risk?

Thanks a lot

[WaivingMyHands_ALOT]

The way I was taught is as follows:

Inherent risk = the risk a transaction or account has an error in it. Typically this risk is associated with the type of transaction or type of account in question. For example, when you are looking at a cash balance, it has a low inherent risk. Five $100 bills will always equal a balance of $500. There is no risk that five $100 bill will suddenly equate to a balance of $400 or $600.

On the other hand, stock options would have a higher inherent risk. There is a large degree of estimate and judgment that goes into valuing the options, especially if they are not traded on an active market. I might think the options are worth $500 and you might think they are worth $1,000. It's not so black and white. So it has a higher inherent risk of misstatement.

Control risk = The risk a misstatement will not be caught by controls. For example if you have new, uneducated employees who are in charge of overseeing transactions/accounts, they is a higher control risk than if you have well educated, experienced employees overseeing the same transactions/accounts. You are more likely to catch in error in the latter situation.

Detection risk = The risk a misstatement will not be caught by the auditor. For example, if an auditor sampled 100 of 1,000 accounts, there would be a higher detection risk than if the auditor sampled 900 of the 1,000 accounts.

Audit risk is the risk that a material misstatement will exists in the financial statements. It is equal to the product of control risk, detection risk, and inherent risk.

For example, if you were dealing with risky transactions with a high degree of inherent risk (let's say 50% for argument sake), and no controls were in place (a 100% control risk), but the auditor did substantive testing on ALL transactions, (i.e., there was no chance they would miss detecting the error and thus a 0% detection risk), then the audit risk would be 0%

50% x 100% x 0% = 0%

Now, to get to your specific example…

1) Derivative have a high inherent risk (there is a good chance they will be misvalued), so inherent risk would go up. More skilled employees would likely mean there is a better chance they would recognize an error in a derivative transaction, and thus control risk would go down (less chance a misstatement will go undetected). Detection risk likely would not change as that has to do with the auditor.

2) I don't quite understand what you're describing in the second transaction, but I'm guessing inherent risk would go up (international derivatives would likely be considered inherently risky), and control risk and detection risk would be unchanged.

3) Inherent risk up, detection risk unchanged.

AUD 99
BEC 96
FAR 94
REG 96

[Anonymous]

You should google audit risk and and aicpa. The AICPA website/pdfs have specific examples of all of these items.

[reiko]

For the third question, do we usually assume the audit risk remains the same hence the detection risk should decrease since the inherent risk increased?

[WaivingMyHands_ALOT]

I would avoid assuming anything if possible. But depends on what the question is asking. You are correct though that increasing substantive testing (decreasing inherent risk) would be one way to keep audit risk the same when inherent risk goes up.

You could make the argument that testing for controls (and assuming they are in place and working properly, relying on those controls) would be another way to keep audit risk the same (inherent risk up, control risk down).

It really depends on how the question is worded, and what options you are given as far as answer choices go (assuming this is an MCQ).

AUD 99
BEC 96
FAR 94
REG 96

[WaivingMyHands_ALOT]

**Typo in first paragraph above…increasing substantive testing decreases detection risk, not inherent risk

AUD 99
BEC 96
FAR 94
REG 96

[Anonymous]

question 2 this may help

Whether the transaction that gave rise to the derivative or security involved
the exchange of cash. Derivatives that do not involve an initial
exchange of cash are subject to an increased risk that they will not be
identified for valuation and disclosure considerations. For example, a
foreign exchange forward contract that is not recorded at its inception
because the entity does not pay cash to enter into the contract is subject
to an increased risk that it will not be identified for subsequent
adjustment to fair value. Similarly, a stock warrant for a traded security
that is donated to an entity is subject to an increased risk that
it will not be identified for initial or continuing measurement at fair
value.
source AICPA
AU Section 332
Auditing Derivative Instruments, Hedging
Activities, and Investments in Securities1

[Skynet]

Think of Inherent risk, Control risk and Detection risk is like “Dating”

Inherent Risk : She's HOT and WAAAAAY out of your league, sees for the first time at the restaurant & takes off while the wait staff is taking bets on how long you'll wait before you figure out you've been stood up.

Control : Only you can stop yourself from looking like a Doofus on the first date.

Detection Risk : She's finds out that you are not really a Kennedy.

[Author]

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