S11_RiskBasedAuditApproach

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S11: Risk Based Audit

Approach

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Session Objectives

To define audit risks and establish the relationship

between materiality and audit risk

To discuss the Audit Risk Model

To explain different kinds of audit risks and the

factors that determine them

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Audit Risk

Audit accepts the risk that the audit conclusion may

be wrong and that Audit may have allowed material

error to remain undetected in the account. Only a very small degree of audit risk would be

acceptable as otherwise the audit process may lose

its purpose.

A very high level of assurance (or confidence) is

required when expressing the audit opinion.

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Relationship between materiality and

audit risk Higher the materiality level, lower the audit risk

and vice versa.

To calculate the level of assurance (or

confidence) required from substantive audit

tests, risk model is employed.

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Risk Model

Analytical tool for planning and execution.

Detects high-risk areas for concentrated audit

efforts.

Audit can thus focus on areas which are likely to

generate better assurance instead of sampling and

testing of larger but low risk areas. Structures the audit procedures and reorganizes the

audit work in terms of risk perception

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Risk Model

Audit Risk

Inherent Risk Control risk Detection Risk

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Inherent Risk

The risk that an error will occur in the first

place.

Determined by the susceptibility of the

classes of transactions to be audited to

material misstatement, irrespective of the

related internal controls in the organization.

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Control Risk

The risk that internal controls will fail to

detect the error

Determined by the efficacy of internalcontrol environment in the auditee

organization

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Detection Risk

Risk that the audit procedures will fail to

detect the error.

Risk that auditors substantive tests do not

detect a material misstatement in the

transactions audited by him.

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Overall Audit Risk

All the three risks are independent of each

other.

Overall Audit Risk (AR) is defined as:

OAR=CR x IR x DR

The overall audit risk is defined by the audit

institution and hence is a constant pre-

determined quantity.

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Objective for the Auditor

To assess inherent and control risks in the

entity

To design and perform appropriate

compliance and substantive procedures that

provide sufficient assurance that the product

of the risks identified is less than or equal tothe overall audit risk that the auditor is willing

to accept.

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Determinants of Inherent Risk

The number and significance of audit adjustments anddifference waived during the audits of previous years.

Complexity of underlying calculations of accountingprinciples

The susceptibility of the asset to material fraud ormisappropriation

Experience and competence of accounting personnelresponsible for the component

Judgment involved in determining amount

Mix and size of items subject to the audit test The degree to which the financial circumstances of the entity

may motivate its management to misstate the component inregard to this assertion

Integrity and behaviour of the management.

Management turnover and reputation

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Assessment of Control Risk

Evaluate the control environment

Evaluate the control systems

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Determinants of control environment Management philosophy and operating style

The functioning of the board of directors and itscommittees, particularly the audit committee

Organizational structure Methods of assigning authority and responsibility.

Systems development methods

Systems development methodology

Personnel policies and practices

Management reaction to external influences

Internal audit

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Determinants of control

environment (Contd.)

Segregation of incompatible functions

Controls to ensure completeness of transactions being

recorded Controls to ensure that transactions are authorized

Third party controls (e.g. confirmation of events)

Control over accounting systems

Controls over computer processing

Restricted access to assets (only allow access toauthorized personnel)

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Case Study