1. Define Audit Risk.

 Audit risk is the risk that, when reviewing a client's financial records, an auditor may not
find mistakes or fraud. It refers to the risk that financial records are materially
inaccurate, even though the audit judgment notes that the financial reports are free of
any factual misstatements. The aim of an audit is to reduce the audit risk to an
acceptable low level by proper testing and sufficient evidence.

2. What are the components of the risk of material misstatement? What are the components of
audit risk model?
 The risk of material misstatements is defined as the risk that the financial statements
are significantly incorrect prior to the audit. It consists of two elements: the inherent
and control risks.
The inherent risk is 'the vulnerability of an assertion about a transaction class, account
balance or exposure to a mistake that may be material, either individually or when
combined with other mistakes, before any associated safeguards are taken into
account.’
The control risk is ‘the possibility that a mistake that could arise in a statement about a
transaction class, account balance or declaration and that may be material, either
separately or when combined with other errors, would not be avoided or identified and
corrected by the internal management of the company on a timely basis.'

 The audit risk model is an instrument used by auditors to consider the relationship
between different risks resulting from an audit commitment that helps them to manage
the overall audit risk. The audit risk model shows that an engagement 's total audit risk
is the result of the following three component risks: Inherent Risk, Control Risk &
Detection Risk.

 Inherent risk exists due to the essence of an item's vulnerability to misrepresentation.

For instance, since they require judgment, there is an implicit danger of
misrepresentation of estimates. Control risk is the risk that a company's internal
controls, which avoid or track and fix errors, malfunction and therefore the things in the
financial statement are mistaken. Detection risk occurs because all the misstatements
are not identified by the auditor's standards and strategies, to test balances and
transactions for factual errors.

3. How is the audit risk model used to plan the audit?

 The aim of the auditor is to reduce the potential risk of an audit to an appropriate
amount. They would first determine the amounts of each variable vulnerability of the
model in order to do so. However, the risk values are not easily quantifiable and
auditors use expert discretion to determine the hazards. This suggests that, as most
mathematical calculations are normally used, the above equation is not usually used to
quantify threats. Nevertheless, the auditors will measure the risk values in some
manner, mostly through descriptive means. In order to create a relationship between
the risks, the auditors then use the model to take steps to reduce the total audit risk to
 an appropriate level. This could be of great help for them to come up with an effective
audit result.

4. What is the primary difference between a material misstatement due to fraud or error?
 If the underlying conduct that resulted in the misrepresentation of the financial report is
deliberate or accidental is the primary consideration that separates fraud from mistake.
Misstatements resulting from false financial reports are deliberate error or omission in
financial records of sums or disclosures intended to mislead consumers of financial
statements where the effect allows the financial statements not to be presented in all
relevant ways in compliance with GAAP. A vital aspect of an auditor's credential
engagement is the evaluation and reaction to threats of content misrepresentation due
to mistake or fraud. Auditors must provide an effective approach to their measured
threats of material misrepresentation due to control override management fraud,
including checking journal entries for evidence of potential material misrepresentation
due to fraud.

5. What is the auditor’s responsibility regarding fraud risk?

 Paragraph 02 of AS 1001, Responsibilities and Functions of the Independent Auditor,
states, "The auditor has a responsibility to plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement, whether caused by error or fraud. The audit committee is expected to
address the likelihood of a material error in the financial statements related to theft
before and after the evidence collecting process through a discussion or brainstorming
activity.

6. Identify the three different categories of fraud risk factors. Next, for each category what are
some of the conditions that can help contribute to a higher likelihood of financial statement
fraud?
 Under the audit fraud risk lies the three categories namely: 1) incentive/pressure to
perpetrate fraud; 2) opportunity to carry out the fraud and 3) attitude/rationalization to
justify the fraudulent action.
o INCENTIVE/PRESSURE: The plan holds employer securities and the employer is
in an industry in which the value of the securities is subject to significant
volatility or is not readily determinable & Recurring negative cash flows
combined with an underfunded position or a threat of regulatory intervention
to the plan

OPPORTUNITY: Significant related-party transactions not in the ordinary course

of business or with related plans not audited or audited by another firm & Non-
readily marketable investments where valuation is based on significant
estimates that involve subjective judgments or uncertainties that are difficult to
corroborate, such as unregulated investments (hedge funds or "alternative
investments") or real estate
ATTITUDE/RATIONALIZATION: Ineffective communication, implementation,
support, or enforcement of the plan sponsor or plan's values or ethical
standards by management or the communication of inappropriate values or
ethical standards & Management failing to correct known operational
deficiencies, prohibited transactions, or reportable conditions on a timely basis