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Audit Risk
The risk that an auditor will give an
inappropriate audit opinion when the
financial statements are materially
misstated
Audit risk
 If the auditor seeks 90% confidence in
their opinion, then the audit risk is 10%
 Auditor rarely reaches 100% confidence
level and therefore determining an
acceptable level of audit risk is important
 In setting desired audit risk the auditor
seeks an appropriate balance between
the costs associated with an incorrect
audit opinion and the costs of performing
additional audit procedures to reduce
audit risk to an acceptable level
Audit risk
 Audit risk has 3 components
 Inherent risk
 Control risk
 Detection risk
Inherent risk

Inherent risk is the possibility that material
misstatements are contained in the financial
statements

In estimating inherent risk the focus is on:
1. The nature of transactions & resultant balances eg
cash is more susceptable to misappropriation than
are plant assets
2. The clients operating environment eg foreign
exchange dealings
Inherent risk
1. The nature of transactions & resultant
balances

Factors contributing to inherent risk:
 Accounts and transactions that are difficult to audit e.g.
insufficient evidence
 Complex accounting issues – difficulty in recording
 Transactions that require estimate & judgment i.e.
doubtful debts
 Assets that are susceptible to theft, loss or
misappropriation e.g. stock, accounts receivable
 Sensitivity to valuation to economic activity i.e.
revaluation of assets
 Unusual transactions
 Past fraud or error in subsystem
Inherent risk
2. The clients operating environment
• Matters to be considered
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Management integrity
Management turnover and experience
Profitability of the client relative to the industry
Current economic environment of the clients
industry
Going concern problem, such as lack of
working capital and interest commitments
Nature of clients operations
Control risk
 Possibility that misstatements, such as material error and fraud will
not be prevented or corrected by the client’s internal control system
 Control risk can never be zero because internal controls cannot
provide complete assurance that all material misstatements will be
prevented or detected
 Linked to quality of clients control system:
 Segregation of duties
 Reconciliation procedures
 Existence of internal audit
 Quality of supervision
 Authorisation of transactions
 Physical custody of assets
 Where estimated CR is relatively high, more substantive test of
transactions and balances will be carried out and compliance testing
will cease
Detection risk
 Possibility that auditing test procedures will fail to
detect material error or fraud in the financial statements
 Relates to the substantiative test of transactions and
balances and analytical review – the risk that the
auditors substantive testing will not detect any
misstatements that are not prevented or detected by
the internal control structure
 Determined directly by auditor. Unlike control risk and
inherent risk the auditor can control the actual level of
detection risk by varying the nature, timing and extent
of substantive proceedures to be performed on
managements assertions
Detection risk
 DR can be reduced by:
 Conducting more substantiative testing of
transactions and balances
 Raising materiality levels for various subsystems
– lowering dollar value of what is investigated
during tests of transactions and balances, so that
smaller errors and omissions are seen as
material by the auditor
Audit risk
 There will always be an element of audit risk due to:
 Human error and judgment
 Collusion & fraud
 Scarce resources
 AR = IR * CR * DR
 E.g. Auditor is fine tuning audit plan for sales and accounts
receivable subsystem
 IR = 80% (relatively high risk that material fraud or error occur in
this subsystem)
 CR = 50% ( 50% chance that the clients internal controls will not
prevent material fraud or error)
 DR = 13% (auditor is willing to accept a 13% chance that the
audit tests will not detect material fraud or error in the
subsystem)
 The model looks like this:
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AR = IR * CR * DR
AR = .8*.5*.13
AR = .05
Overall audit risk is 5%
Audit risk
 The auditor generall specifies the desired level of
overall audit risk to be achieved and their
assessed levels of Inherent and control risk and
then solves for detection risk using the following
variation of the model
 DR = AR/(IR*CR)
Audit Risk
 If IR or CR were higher and the auditor
wants to achieve an audit risk of 5% then the
DR would need to be reduced
 DR = AR/ (CR*IR)
 DR = .5/ (.6 *.9)
= .09
Risk of insolvency
 Auditors must assess the risk that the client will not be able to
continue as a going concern
 AUS 708 – Going Concern lists a number of indicators of going
concern:
 Operating Indicators
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Lack of management planning
Lack of management skill
Lack of key management
Loss of significant market, license or franchise
Problems in management information systems
 Financial indicators
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Recent history of net losses
High reliance on borrowed funds
Deferred liabilities approaching maturity
Unfavorable financial ratios such as working capital, gross profit ratio,
interest coverage, stock & debtor turnover
 Lack of operating cash flows
 Inability to pay creditors
 Other indicators
 Non compliance with Corporations Law requirements
 Technological change
 Failure of similar entities in the industry