Compotronix Corporation Case Study

1. Professional auditing standards present the audit risk model, which is used to determine the nature, timing, and extent of audit procedures. Describe the components of the model and discuss how changes in each component affect the auditor’s need for evidence.

The audit risk model is used to determine the nature, timing, and extent of substantive audit procedures. According to the model, audit risk (AR) can be decomposed into two component risks: risk of material misstatement (RMM) and detection risk (DR). Specifically, the model relates the components to overall audit risk as follows:

AR=RMM*RD

Risk of material misstatement is the risk that the financial statements are materially misstated prior to audit.[1]It can be further decomposed into two components - inherent risk (IR) and control risk(CR). They can be substituted into the model:

AR=(IR*CR)*RD

Inherent risk (IR) represents the auditor’s assessment of the susceptibility of a management assertion to a misstatement, that could be material, assuming there is no related internal control.

Control risk (CR) represents the auditor’s assessment of the likelihood that a material misstatement in a management assertion will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.

Detection risk (DR) represents the likelihood that the auditor will not detect material misstatements that actually exist in a financial statement assertion. Since it is the only risk that is under the direct control of the auditor, we can rearrange the audit risk model formula to emphasize the role of detection risk in planning substantive testing:

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The revised formula tells us that when Risk of material misstatement (IR*CR) is higher, Detection Risk is lower, which in turn implies the auditor need for more evidence.

2. One of the components of the audit risk model is inherent risk. Describe typical factors that auditors evaluate when assessing inherent...