Audit risk = Inherent risk x control risk x detection risk
Audit risk is the risk that the auditor will issue an unmodified opinion when a qualified opinion is needed. Or a qualified opinion when an unmodified opinion is needed.
Risk of Material Misstatement = Inherent risk x control risk. Which is exactly like it sounds, the risk that misstatements exist in the financial statements.
Inherent risk is the amount of risk that exists before the company's controls can mitigate them. This risk can arise from the environment the company operates in, or activities that the company is involved in. For example, derivatives are inherently complicated and so a company starting to venture into derivatives will raise the inherent risk.
Control risk is the risk that the company's controls will not prevent misstatements. Proper controls will result in a low control risk, and controls not working properly or that have inadequate design will result in higher control risk.
Inherent risk and control risk exist outside of the audit. Meaning that nothing the auditors due can effect the amount of inherent or control risk. They are completely the company's responsibility.
Detection risk is the risk that the auditor will not detect misstatements. The level of detection risk can be raised or lowered by the auditor to achieve the level of audit risk that is needed. So if inherent risk and control risk are high, this means that the auditor is willing to accept a smaller level of detection risk. If we are willing to accept a lower level of detection risk, this means that the auditor will probably conduct more tests of controls to see if they can justify a reduction in control risk, and/or perform more substantive procedures (or change substantive procedures from an interim period to closer to the balance sheet date).
Pretty much the opposite happens if the auditor determines that the risk of material misstatement (inherent risk x control risk) is low. The detection risk will be higher, meaning that the auditor is willing to accept a higher level of detection risk. More test of controls will not be necessary, and substantive tests can be done at an interim date instead of year end.
Hope that helps
AUD 93 Jan 16
BEC 83 Feb 16
FAR 83 Apr 16
REG 84 May 16
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