. Given the following facts: (11 points) The auditor would like to keep his over
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Question
. Given the following facts: (11 points) The auditor would like to keep his overall audit risk at 5%. Internal control over accounts receivable is very poor. The A/R balance is composed of a large volume of large balance in an economy that has recently experienced a downturn. a. Show the audit risk model (4 points) b. Use the audit risk model and the above facts, and your own (quantitative) estimate of each of the components of the audit risk model to calculate detection risk. You must come up with an estimate of detection risk (i.e., a percentage) as your answer. (6 points) c. What does the level of detection risk you came up with suggest relative to how much testing the auditor will need to do in the next stage of the audit? (1 points)Explanation / Answer
Solution :
a. Audit Risk model :
This model is used to manage the overall risk of an audit engagement & also describes how this risk can be managed.
Audit Risk = Inherent Risk * Control Risk * Detection Risk.
In order to keep the overall acceptable risk below the acceptable limit, the auditor must assess the level of risk pertaining to each component of the above formula.
Inherent Risk : This risk is caused by error or omissions arising from factors other than control failures.Generally, Inherent risk is considered high when high degree of judgement is involved in a transaction, when transactions are highly complex.
Control Risk : This risk is usually caused in case of poor controls. It is a risk of material misstatement arising due to absence or failure in the operation of controls of the entity.
This risk is high in the case of lack of good internal controls to identify frauds and errors. This may lead in in preparation of incorrect financial statements.
Detection Risk : It is a risk where auditors fails to detect material misstatement that exists in the financial statements. An auditor should be alert during audit. He should perform additional evidences in order to obtain sufficient appropriate audit evidence.
b. Audit Risk Model based on above facts :
In the above case, it is seen that there are poor internal controls established over Accounts Receivable. The A/R has recently experienced a downturn. Which means our risk of audit of not to form an inappropriate opinion has also increased.
Model formulation :
We assume our control risk to be 50 % as proper internal controls are not established & also because of down turn as it may lead to fraud ; Inherent risk to be 40% as there is a decline in A/R, reason needs to be found out as wholly it may not be due to controls ; the balance shall be detection risk :
0.05 = 0.5* 0.4 *Detection Risk.
The answer comes out to be 25 % detection risk in order to set the overall risk at 5 %.
c. Detection risk is the risk that an auditor's substantive procedures will not detect a misstatement that exists in the transactions that could be material. The higher the assessment of internal & control risk, the more audit evidence should be obtained by performing substantive procedures. If this is the case, the auditor should consider whether the procedures to be performed can provide him with sufficient appropriate audit evidence in order to reduce detection risk. The auditor should plan and perform the procedures in such a way that his overall audit risk is reduced to an acceptable level.
The detection risk arrived in this case is 25 %. Basically, one point needs to be kept in mind that the Risk of material misstatement (RMM) & Detection Risk (DR) are inversely related. It means lower RMM, higher DR implies, lower risk and further limit the audit procedures. In our case, our DR is 25% which is lower. It means the entity is required to increase its substantive procedures to a certain extent based on its knowledge obtained throughout the audit in order to reduce RMM.
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