Credit Crisis

SUMMARY OF THE AUDIT RISK MODEL Exercise Solution

o What relations exist between component parts of the Audit Risk Model?

Depends on whether auditor is dealing with the model ex post (after evidence has been collected) or ex ante (during the planning stage before evidence is collected). The ex post situation is common in auditor litigation.

Ex Post Situation:

• Assume auditor has collected all audit evidence and that the an alternative dispute resolution professional (e.g., an arbitrator) is using the audit risk model to determine whether actual or "achieved" audit risk, AcAR, is low enough (i.e., to justify issuing an unqualified audit opinion).

• Extent of substantive audit evidence is fixed or "held constant."

So, ex post:

1. As materiality decreases, IR _______UP__________________________.

Explanatory Example:

Suppose Partner B comes from the Chicago office to review the quality of work of Partner A from the Madison, WI office. Partner B reviews work on one client and is convinced that the materiality threshold should have been set at 1% of net income. Partner A had set materiality to 20% of NI.

So, when the audit team under Partner A’s supervision assessed IR (and, for that matter, CR and RMM – risk of material misstatement; also sometimes called ER – engagement risk as well as DR), they were thinking about how likely various risk factors would lead to misstatements that, in the aggregate amounted to 20% of NI. What they should have been thinking about is how likely various risk factors would lead to misstatements that were, in the aggregate much smaller in magnitude – 1% of NI. Obviously the probability of misstatements being greater than or equal to 1% of NI is itself greater than or equal to the probability of misstatements being greater than or equal to 20% of NI.

Pr(Misstatement ≥ 1% of NI) ≥ Pr(Misstatement ≥ 20% of NI).

2. As materiality decreases, CR ________ UP _________________________.

Explanation: See...