1.

AUDIT RISK
AR is the risk that an auditor expresses an inappropriate audit opinion when a FR is materially misstated (ASA 200).
IR is the susceptibility of an assertion to a misstatement that could be material, either individually or when aggregated with
other misstatements, assuming there are no related controls. (possibility that a MM could occur)
CR is the risk that the client's system of internal controls will not prevent or detect a material misstatement.
DR is the risk that the auditor's testing procedures will not be effective in detecting a material misstatement.

1.1 Define audit risk. Describe the approach the auditors adopt in identifying the accounts and related assertions at risk of
material misstatements. How does this approach help auditors to reduce audit risk to an acceptably low level?
Audit risk is the risk that the auditor gives an inappropriate opinion on the financial report. The auditor tries to keep this risk
to an acceptably low level by planning the audit according to the key risks faced by the client and allocating more audit time
where the risk of material misstatement is highest. This means the auditor tailors the audit work to the client’s characteristics.
If the client characteristics suggest that the risk of material misstatement is greater in a particular account or transaction cycle,
the auditor will plan to do more audit work on that account or transaction cycle than would be done for another client with
different characteristics.
For example, one client may have a greater risk that fictitious credit sales are included in the balance of accounts receivable,
while another client may have a greater risk that accounts receivable balance includes balances that are not likely to be
collected. The first client has ineffective controls over processing credit sales and the second client has ineffective controls
over granting credit to customers. The auditor would spend more time gathering evidence over the validity of credit sales
transactions for the first client, and more time gathering evidence about the collectability of accounts receivable for the
second client.
As the auditors normally work on a sampling basis and during a limited time period, an appropriate focus on the higher risk
areas of the financial statements is essential to help them detect misstatements (if exists), to be able to reduce the risk to an
acceptably low level. On the other hand, if the audit time is spent on lower risk areas, it is likely that insufficient time is spent
on the areas where higher risk of misstatements exist and the auditors will be subject to the risk of not detecting material
misstatements and giving inappropriate opinion on the financial statements.

1.2 Consider this statement: ‘If inherent and control risks are high, to bring the audit risk low, the auditor will set detection
risk low’. Explain how setting detection risk low brings down audit risk.:

The statement is based on the audit risk model. Audit risk (AR), the risk of giving an inappropriate audit opinion, is a
function of the client’s inherent risk (IR), control risk (CR) and the auditor’s detection risk (DR). [AR = IR x CR x DR]
The auditor chooses a desired level of AR. The auditor cannot control IR and CR, so the only way they can achieve the
chosen level of AR is by altering DR. High levels of IR and CR increase AR, so the auditor must plan for a low DR to reduce
AR to the required level. Low levels of IR and CR decrease AR, so the auditor can plan for a higher DR before AR becomes
unacceptable.
The mere act of setting DR low does not reduce actual AR. Normally when the set DR low, they would perform more
effective and extensive the audit procedures.