exam style

Audit procedure: obtain copies of the board minutes from meetings held during the year (it involves an action)

Audit evidence: there should be copies of the board minutes on file (there is no action involved in an “evidence” question)

Audit risk is the risk faced by the auditor that an inappropriate audit opinion will be issued

Risk of material misstatement is the product of inherent risk and control risk and, having established material misstatement risk, the auditor can now determine detection risk level that will result in a calculated acceptable level of audit risk

Financial statement risk is the risk facing the company that the financial statements do not faithfully represent the true and fair position of the company or its results / performance

Business risk is the risk facing the business that could lead to the collapse of the business or a marked reduction in the company’s performance levels – for example the company is involved in a sensitive market like breeding animals to be used in scientific experiments. This is very upsetting to animal rights campaigners

Inherent risks have been described as being those that arise because the business is in a business! New ventures, new products, new markets, new personnel, …. are all examples of inherent risks. If you don’t have a business, you don’t face any inherent risks!

OK?

They are NOT the same!

Audit risk is the end result of multiplying risk of material misstatement by detection risk.

Sure, risk of material misstatement is a component element of arriving at audit risk (or put another way, the level of acceptable audit risk is directly affected by the risk of material misstatement) but they are clearly not the same)

We need to pre-determine the level of audit risk that we are prepared to accept.

By enquiry and the application of skill and experience we are able to assess the level of risk of material misstatement.

From the equation (ROMM x Detection Risk = Audit Risk) we are able to determine the level of detection risk.

The lower the detection risk that we can accept, then the lower the materiality level and, conversely, the higher the detection risk that we are able to accept, the higher the materiality level.

Clearer?

Inherent risk is only tangentially related to control risk.

If both inherent risk is perceived to be high and control risk is also perceived to be high then, in order to arrive at acceptable level of audit risk, then detection risk must be low. And if detection risk is low, then materiality level must also be low leading to testing that is more extensive so the risk of non-discovery of material misstatement is lower.

The lower the materiality level, the greater detection risk is reduced.

Ok?

Yes, it is but not in such a simplistic way! You will, in P7, have to analyse a situation and, as a result of that analysis, you could find yourself saying something like “Because of the above points, it’s likely that inherent risk and control risk are both high.

So the risk of material misstatement being high we shall need to set detection risk at a low figure in order to arrive at an acceptable level of audit risk”

Detection risk is a level that WE set and if we want to be ultra cautious we will set the detection risk level very low. Therefore the materiality level will be very low and thus we shall increase the extent of our detailed testing

Is that better?

Nearly! The detection risk is not set low because we believe there are no material errors present. On the contrary, it’s set low because the combination of inherent risks and control risks is so high that we cannot rely on the company’s own systems to detect and prevent material misstatements.

So we have to lower our materiality level in order to carry out a more thorough review / examination / sample giving us a greater chance to discover these material misstatements that more likely have arisen because of the weak systems

Ok now?

That’s good!