Audit Risk Model

     This is defined in AUS

402 as ‘the susceptibility of an account balance ... to misstatement that
could be material ... assuming there were no related internal controls’ (AUS

402.09). Estimating the inherent risk (IR) for each account balance or class of
transactions requires the auditor to take into account such factors as the level
of complexity involved in determining the ‘correct’ balance of an account,
the complexity of transactions involving the particular account(s) and the
‘portability’ of the assets involved. The estimation of IR is done as though
no internal controls exist – it looks only at the nature of the account being
evaluated. Control Risk AUS 402 defines this as ‘the risk that misstatements
that could occur in an account balance ... that could be material ... will not
be prevented or detected on a timely basis by the internal control structure’
(AUS 402.06). The evaluation of the level of control risk (CR) requires the
auditor to have a thorough understanding of the internal control structure that
is in place, and practiced (not necessarily the same thing) within the
organisation to be studied. Elements such as the segregation of duties, the
existence of ‘management overrides’, and the level of formalised policies
and procedures in use are among the factors to be considered. Audit Risk Defined
in AUS 402 as ‘the risk that the auditor gives an inappropriate audit opinion
when the financial report is materially misstated.’ (AUS 402.03) The level
that is set as the acceptable audit risk (AR) reflects the degree of certainty
that the auditor and audit subject wish to achieve. An audit opinion can never
be a guarantee (AR = 0), even if every transaction during the year was tested,
due, at least in part, to the interpretive nature of many of the accounting
decisions involved. Detection Risk The final part of the risk model outlined in

AUS 402 is defined as ‘the risk that an auditor’s substantive procedures
will not detect a misstatement...’ (AUS 402.07) This risk relates to the
volume, effectiveness and sufficiency of the audit testing and investigation
undertaken. Both IR and CR are related to the probability that a particular
balance will contain an error, either accidental or fraudulent, while detection
risk (DR) is the probability that the auditor will not detect the error (Graham,

1985, p.15). The audit risk model is ‘a joint probability statement of
independent events’ (Wade, 1996) which attempts to combine these probabilities
and give an overall ‘chance’ of a misstatement existing (IR * CR) and
remaining undetected (* DR) – leading to the auditor giving an inappropriate
audit opinion (AR). B) Armidale Pty Ltd – Year 1 Inherent & Control Risk

Levels In the first year of an engagement the auditor will have gained only a
limited knowledge of the client and their practices. Faced with a poor internal
control structure the auditor may question the level of management experience
and knowledge, which AUS 402.14(b) suggests may be an indicator of high inherent
risk. This, combined with the newness of the engagement, would be sufficient
cause to set IR at a high level at the financial report level, and for most, if
not all, of the assertions below that. AUS 402.32 & AUS 402.34 mandate the
setting of control risk to high ‘unless the auditor is able to identify
internal controls ... likely to prevent or detect and correct a material
misstatement’ (AUS 402.32(a)). Given the conclusion of the auditor that such a
control structure does not exist within Armidale Pty Ltd they would have no
option but to set CR as high – which is a logical choice given our previous
definition of CR. Detection Risk & Evidence Accumulation Assuming that the
auditor wishes to achieve a low level of Audit Risk, especially given the
newness of the engagement and the lack of an effective control structure we can,
by restating the audit risk model as DR = AR / (IR x CR) determine what the
level of detection risk must be set at to achieve the desired level of AR. If,
for example, an AR of 5% is desired with both IR & CR set to 100% the DR
comes out to be: DR = .05 / ( 1 x 1) DR = .05 (5%) This means that the auditor
can only accept a 5% probability that their substantive procedures fail to
detect any material misstatements. Achieving this level of assurance will
require the gathering of a large amount of evidence – large samples will need
to be carefully tested and examined across most assertions. As the accumulation
of evidence is, due to the time and resources required, one of the more
expensive components of an audit the cost of running an audit with high CR &

IR ratings will be greater than ‘normal’. The auditor must balance the costs
and fees of this initial audit against the long term relationship with this new
client – as well as their local competitors. C) Armidale Pty Ltd – Year 3

Setting Audit Risk High With more knowledge and exposure to the client and their
environment the auditor could choose to set the audit risk to a higher level
when, for example, there are few external users of the financial statements
(AFM312, 1999). It can also be set higher when control risk is low due to the
presence of a strong internal control structure and inherent risk is also
assessed as low. IR can be set lower based on the auditors judgement on such
factors as the stability of the company and the environment it operates in, the
level of management expertise, and the complexity and nature of transactions and
accounts involved. What is a ‘low’ level of IR & CR Issuing an
inappropriate audit opinion can be expensive for an auditor, especially in our
increasingly litigious society and with courts having a fairly wide definition
of an auditor’s duty of care. No system of internal controls can guarantee

100% detection of material misstatement – mistakes, whether accidental or
fraudulent, will occur and some will escape detection, again either by deception
or an oversight. Adopting a minimum level of CR of around 30% allows for this
– in effect the auditor says that they believe the internal controls are
sufficient to ensure that a minimum of 70% of misstatements will be detected
and/or corrected. Inherent risk is, by definition, evaluated as though no
internal control system is in place. While it can be set lower as suggested in
the previous section, the relationship between DR, AR, CR & IR as expressed
in the model means that setting it to a lower value increases the allowable
detection risk to achieve a desired level of audit risk. For a 5% AR with CR set
to 30% and IR to 80% we get a DR value of: DR = 0.05 / (0.3 * 0.8) DR = 0.21 If
we lower IR to 30% DR becomes 0.56 – our substantive procedures now need to be
less than 50% effective at detecting misstatements because we ‘trust’ the
client and their systems. Increasing the allowable level of DR could, for
example, lead to a less thorough audit process on ‘old & trusted’
clients. D) The Audit Risk Model in Practice Is the audit risk model as outlined
in AUS 402 a useful tool for helping to plan audit evidence requirements in
practice? Much of the documentation and discussion relating to the assessment of
the various risk elements involved in the model addresses the issue at the
individual account balance or transaction class level. An area of concern
(AFM312, 1999; Lea et al, 1992; Wade, 1996) is the link between these many
individual assessments and an ‘overall’ risk rating at the financial
statement level. As the model uses various independent probabilities it is not
possible to simply ‘sum together’ the assessment for individual areas. There
have been suggestions of methodologies for providing overall aggregation of
assertion level risk assessments (Lea et al, 1992) however these have not been
included in any of the current Auditing standards. This ‘linkage’ problem
limits the value of the model to an auditor as the amount of work required to
derive all of the estimates that AUS 402 suggests could be viewed as excessive
and requiring substantial amounts of duplication of effort. This limitation
appears to have led to the model being largely ignored, or at least
circumvented. Studies such as those by Mock and Wright (1999) have investigated
the effect of different levels of assessed risk on the design of actual audit
programs. These studies have found that, in the majority of cases, auditors
utilise a ‘standard’ set of substantive procedures for all engagements,
regardless of variations in risk factors. Others such as Fitzsimons (1992) and

Jacoby (1995) found that both inherent and control risk are, particularly for
small to medium sized businesses, consistently set to 100%, even with continuing
engagements – reinforcing the use of a ‘standard’ test plan. Reliance on
standard plans may give the auditor a sense of security, whether justified or
not, as they have built a level of confidence in the results and can easily
compare this year to last year. Performing less substantive testing than
‘normal’ may open the auditor to claims of negligence if a material
misstatement escapes detection and a user of the audited statements suffers
damage as a result. The studies assert that the auditor therefore tends to be
conservative and maintain a heavy reliance on substantive testing. If both IR
& CR are automatically set at 100% for all clients, and the auditor relies
on achieving a 5% overall AR, detection risk must, according to the model, also
be set to 5%. Detection risk is made up of two components, sampling risk, and
non-sampling risk. Sampling risk arises from the selection of samples within an
overall population of transactions and accounts. If the samples selected do not
accurately reflect the population the testing may not capture a misstatement.

Sampling risk can be countered by increasing the proportion of the overall
population being tested. Accumulation of evidence, testing the sample, is one of
the high cost areas of an audit and decreasing the sampling risk can, therefore,
be a high cost exercise (Arens et al, 1987). Non-sampling risk derives from the
selection and application of the actual audit procedures to the selected
samples. Inappropriate or ineffective procedures may return misleading
information and lead to incorrect evaluation of results. The audit risk model
assumes that non-sampling risk is negligible and that detection risk is largely
controllable through sample size manipulation. While it is contended by, for
example, Gul et al (1995) that ‘this risk can be reduced to a low level
through effective training, planning and supervision’ the use of
‘standard’ test plans for all clients could lead to ‘blind rote’
application of procedures without any real understanding of the purpose or
relevance of a particular test. In these conditions a series of small
non-sampling errors could rapidly accumulate and reduce the value of the
substantive testing. Where only a small allowance for error exists, due to the
reluctance of the auditor to place more emphasis on the internal control
systems, the desired level of AR could become unachievable. The audit risk model
outlined in AUS 402 as well as many of the overseas auditing standards would
seem to be useful for planning the level of testing required for specific
accounts or account classes. This is particularly so where the auditor believes
internal control systems are in place and effective (low CR) and where the
inherent risk is also medium to low. It appears, however, that, for many
reasons, the auditing fraternity has not rushed to utilise the model in
developing audit plans – preferring to rely on standard series of tests –
although Mock & Wright (1999) did identify some movement towards increasing
use of the model for planning purposes.