1. Audit Risk
The risk that an auditor will give an inappropriate audit opinion when the financial statements are materially misstated

2. 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

3. Audit risk Audit risk has 3 components Inherent risk Control risk
Detection risk

4. Inherent risk
Inherent risk is the possibility that material misstatements are contained in the financial statements
In estimating inherent risk the focus is on:
The nature of transactions & resultant balances eg cash is more susceptable to misappropriation than are plant assets
The clients operating environment eg foreign exchange dealings

5. Inherent risk 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

6. Inherent risk The clients operating environment
Matters to be considered
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

7. 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

8. 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

9. 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

10. 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:
AR = .8*.5*.13
AR = .05
Overall audit risk is 5%

11. 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)

12. 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

13. 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
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
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