Audit Risk

Audit risk(also referred to as residual risk)

Refers to the risk that an auditor may issue unqualified report due to auditors failure to detect material misstatement either due to error or fraud. This risk is composed of inherent risk (IR), control risk (CR) and detection risk (DR), and can be calculated thus:

AR = IR × CR × DR

where... IR is inherent risk, CR is control risk and DR detection risk. IR refers to the risk involved in the nature of business or transaction. Example, where transactions involving exchange of cash may have higher IR than transactions involving settlement by cheques. CR refers to the risk that a misstatement could occur but may not be detected and corrected or prevented by entity's internal control mechanism. DR is the probability that the audit procedures may fail to detect existence of a material error or fraud. While CR depends on the strength or weakness of the internal control procedures, DR is either due to sampling error or human factors.

Solving for DR

Detection risk has to be restricted and occurs when the correct audit procedure is used or the audit procedure is used incorrectly. The auditor assesses the inherent risk and control risk and then solves the audit risk by assigning detection risk to reduce the audit risk to an acceptable amount. The major elements of detection risk are misapplying an audit procedure, misinterpreting audit results, and selecting the wrong audit test method. To solve for the detection risk:

DR = AR/ (IR x CR) or DR = AR/RMM

From the result of solving this equation, it is understood that if the detection risk is low, the auditor must collect additional appropriate evidence and the detection risk is high, the less evidence is needed. Since detection risk is a function of the effectiveness of the audit procedures performed, detection risk is the only risk that is completely a function of sufficiency of the procedures performed by the auditors. The audit evidence that the auditor collects must be...