S11: Risk Based Audit

Approach

Session Objectives

To define audit risks and establish the relationship

between materiality and audit risk
To discuss the Audit Risk Model
To explain different kinds of audit risks and the
factors that determine them

Audit Risk

Audit accepts the risk that the audit conclusion may

be wrong and that Audit may have allowed material
error to remain undetected in the account.
Only a very small degree of audit risk would be
acceptable as otherwise the audit process may lose
its purpose.
A very high level of assurance (or confidence) is
required when expressing the audit opinion.

Relationship between materiality and

audit risk
Higher the materiality level, lower the audit risk
and vice versa.
To calculate the level of assurance (or
confidence) required from substantive audit
tests, risk model is employed.

Risk Model

Analytical tool for planning and execution.

Detects high-risk areas for concentrated audit
efforts.
Audit can thus focus on areas which are likely to
generate better assurance instead of sampling and
testing of larger but low risk areas.
Structures the audit procedures and reorganizes the
audit work in terms of risk perception

Risk Model

Audit Risk

Inherent Risk

Control risk

Detection Risk

Inherent Risk
The risk that an error will occur in the first
place.
Determined by the susceptibility of the
classes of transactions to be audited to
material misstatement, irrespective of the
related internal controls in the organization.

Control Risk
The risk that internal controls will fail to
detect the error
Determined by the efficacy of internal
control environment in the auditee
organization

Detection Risk
Risk that the audit procedures will fail to
detect the error.
Risk that auditors substantive tests do not
detect a material misstatement in the
transactions audited by him.

Overall Audit Risk

All the three risks are independent of each
other.
Overall Audit Risk (AR) is defined as:
OAR=CR x IR x DR
The overall audit risk is defined by the audit
institution and hence is a constant predetermined quantity.

Objective for the Auditor

To assess inherent and control risks in the
entity
To
design and perform appropriate
compliance and substantive procedures that
provide sufficient assurance that the product
of the risks identified is less than or equal to
the overall audit risk that the auditor is willing
to accept.

Determinants of Inherent Risk

The number and significance of audit adjustments and

difference waived during the audits of previous years.
Complexity of underlying calculations of accounting
principles
The susceptibility of the asset to material fraud or
misappropriation
Experience and competence of accounting personnel
responsible for the component
Judgment involved in determining amount
Mix and size of items subject to the audit test
The degree to which the financial circumstances of the entity
may motivate its management to misstate the component in
regard to this assertion
Integrity and behaviour of the management.
Management turnover and reputation

Assessment of Control Risk

Evaluate

the control environment

Evaluate the control systems

Determinants of control environment

Management philosophy and operating style

The functioning of the board of directors and its
committees, particularly the audit committee
Organizational structure
Methods of assigning authority and responsibility.
Systems development methods
Systems development methodology
Personnel policies and practices
Management reaction to external influences
Internal audit

Determinants of control
environment (Contd.)

Segregation of incompatible functions

Controls to ensure completeness of transactions being
recorded
Controls to ensure that transactions are authorized
Third party controls (e.g. confirmation of events)
Control over accounting systems
Controls over computer processing
Restricted access to assets (only allow access to
authorized personnel)

Case Study