In this lecture, 4.02 – Audit Risk, Financial Statement Level and Assertion Level – Lesson 1, there are many questions that students have when it comes to the different types of risk in audit. Many of them are the following: What are the elements of audit risk? What are the elements of the Risk of Material Misstatement (RMM)? What is control risk? What is inherent risk? What is detection risk? What are the elements of detection risk? What are the relationships between these factors of audit risk? Roger reviews these concepts with thorough explanations while introducing how an auditor approaches audit evidence and substantive testing.
Substantive testing consists of tests of details and analytical procedures. Roger provides the ICORRIIA mnemonic for remembering the various methods of substantive testing in an audit. Audit risk equals inherent risk times control risk times detection risk. The risk of material misstatement equals inherent risk times control risk. Detection risk equals AP times TD, or the risk associated with analytical procedures (AP) times the risk associated with tests of details (TD). Detection risk is the probability that the auditor’s substantive tests will not detect material misstatements in the financial statements. On the other hand, detection risk, unlike control risk and inherent risk, is under the auditor’s control and is kept at an acceptable level via substantive testing.
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Sneak Peek Transcript:
Alright let's talk about audit risk and basically how audit risk affects certain areas called financial statement level and relevant assertion level, as far as how we're looking at responding to the level of risk. Now, in your notes it says audit risk. We've covered this. Let's talk about it again.
Audit risk equals what? IR times CR times DR. So as we said, audit risk equals IR times CR times DR. So that means audit risk, the risk that you give the wrong opinion on materially misstated financial statements is inherent risk times control risk times detection risk. In solving for detection risk, we said audit risk over IR times CR equals DR. IRCR together is RMM, risk and material misstatement.
So, as we look at this, as this goes down, this goes up. That means as your control risk goes down, which means internal control doesn't look good. That means you don't think you can rely. Therefore, your detection risk goes up. So as we say this, we're saying okay, if reliance is high that means this is down, control risk is lower, RMM is low. We're willing to let our DR go up. We're going to do less substantive testing.
The other thing we said though is the opposite, which is if reliance is low, control risk or RMM is high, which means we want, and the only risk you, the auditor control, is your acceptable level of detection risk, how much risk you are willing to accept. So, if DR goes down that means you're going to do more substantive testing. So there's the inverse relationship. So that's what we're looking at here is, again, audit risk, IR times CR times DR, solving for DR affects the nature, timing and extent, what, when and how much substantive testing you're going to do.
So it says here, audit risk, RMM, is IR times CR times DR, talked about that. Now DR, which we're going to jump into today in detail, detection risk, whoops. DR, detection risk is the risk that you, the auditor, do not detect the issue. So it says, detection risk, the probability that the auditor's substantive test will not detect material misstatements.
So if it will not detect material misstatements, what does that mean? What it means is that the risk you're not going to detect it while you're doing either TD or AP. What does that mean? TD is test of details, AP analytical procedures. TD is the risk associated with test of details, that they will not be effective in detecting material misstatements. AP, that risk associated with analytical procedures, will not be effective in detecting material misstatements.