[Solved] the audit risk model

The Audit Risk Model:

Audit risk is the term generally used in relation with the audit of financial statements of an entity. The main objective of the audit is to provide an opinion as to whether the financial statements under audit reveal the true and fair view of the financial condition of the entity. Audit risk is the risk of the auditor providing the opinion on the financial statements. The auditor is always at risk while providing the opinion as to the truthfulness and fairness of the financial statements under audit.

The audit risk is calculated according to the audit risk model and audit risk formula given by the GAAS.

That is:  Audit Risk = IR X CR X DR.

Here we will discuss the components of the audit risk model.

Inherent Risk( IR) :   Inherent risk is refered as the measure of the auditor’s assessment that there may not be material misstatements in the financial statement before considering the effectiveness of internal control. If the auditor is of opinion that there is a high degree of likelihood of misstatements, ignoring internal controls, the auditor would conclude that the inherent risk is high. Internal controls are not included while calcualting the inherent risk. As the internal controls are separately calculated as the control risk. It is often an area of professional judgement on the part of an auditor. Examples of accounts with low inherent risk are fixed assets, easy to observe, or securities traded in the stock-market  whose market price is easily observable. Inherent risk is most important in respect to military trademark valuation models and bee-hive cashflow exchange derivatives, where significant impairment of funds is deemed material to the financial reports.

Control Risk (CR):   Control risk is the measure of the auditor’s assessment of the likelihood that misstatements exceeding a certain level will not be detected by the internal control system in the organization. This assessment includes the checks as to whether the client’s internal control system is effective to prevent or detect any material misstatement.

Detection Risk (DR):  Detection risk is the measure of the auditor’s assessment of likelihood that the misstatements will not be detected by the auditor. The auditor carries more audit work to detect material errors if the inherent risk and control risk are high.

Acording to the audit standards probability theory should be applied to the audit risk concept. Some practitioners also attached probability to audit risk concept. But the audit standards does not adopt probability theory as the great formalism of audit risk.

In fact, audit risk is the collection of three sets. Modeling audit risk issued different models depending on mathematical theories used:

The probability theory measures the risk if three components are considered as events. And as a result audit risk concept are considered as events. Audit risk is a set of events.
Considering these three components as evidence the audit risk can be measured by belief-function theory and thus audit risk becomes a combination of mass evidences.
If we consider these three components as sets of linguistic assessment audit risk can be measured by fuzzy logic theory.

Internal Control over Fixed Assets:

Auditing is the process in which the auditor gives his opinion as to the truthfulness and fairness of the financial statements under audit. And to come to any conclusion the auditor needs evidences to rely upon and base his opinion on. The audit evidences varies from entity to entity, it is based on the internal control system adopted by the entity. The better the internal control the more reliable would be the evidences collected within the organization.

The audit evidences are obtained by Analytical or Substantive method. Substantive procedures are the activities performed by the auditor during the substantive testing stage of the audit. These procedures gather evidences as to completeness, accuracy and validity of account balances and transactions.

During the audit, the management impliedly believes that the accounts balances and underlying classes of transactions are free from any misstatements. In other words, that they are materially complete, valid and accurate. The auditor has to gather the evidences about the assertions by using activities called substantive procedures.

For Example:

The auditor should physically examine inventory as on balance date as evidence and compare it with the records shown that actually exists.
The auditor can also check with the third parties like suppliers and customers to confirm the details of the amount owing at balance date as evidence that accounts payables and receivables are matching with the accounts under audit.
Make inquires of management about the collectibility of customers’ accounts as evidence that trade debtors is accurate as to its valuation.
The evidence resulting from mismatching of account balances or the transaction not being valid or accurate is the evidence arrived at by substantive misstatements.

Fixed assets are the accounts that are open for misstatements or frauds. The fixed assets should be audited with utmost perfection by the auditor. As these accounts are often found more flexible than any other accounts.

Auditors’ Opinion Options:

The audit report is the report that the auditor prepares after satisfying himself that the financial statements under audit are showing the true and fair view of the financial condition of the entity under audit.

The audit report in which sets forth independent auditor’s opinion is known as independent audit report. Here in this report the opinion of the auditor indicates weather the financial statements are presented according to the generally accepted accounting principles. A fair presentation of financial statements is generally understood by accountants to refer to whether:

The financial statements are prepared in accordance with the generally accepted principles.
The principles so adopted are appropriate in the circumstances.
The financial statements are prepared so they can be used, understood, and interpreted.
The information in the financial statements is classified and summarized in a reasonable manner.
The financial statements are prepared in such a manner that they reflect the underlying events and transactions in a way that presents the financial position, results of operations, and cash flows within reasonable and practical limits.

Here we are going to discuss various audit opinions defined by the AICPA’s Auditing Standards Board

Unqualified opinion: An unqualified opinion states that the financial statements under audit present the true and fair view of the financial condition of the entity under audit. The financial statements are fair in all material respects, the financial position, result of operation and cash flows of the business in conformity with generally accepted accounting principles. An unqualified opinion given by the auditor also represents that the auditor is satisfied after all audit procedures that the tests conducted to arrive at any such opinion is a result of auditors experience and his own judgment. The auditor is not under influence of the management of the entity or any other force.

Standard report: When the auditor is providing the opinion on the financial statements he may add some explanatory paragraphs to the management or the concerned party that some points of the report are based on corrections to be made after the period of audit report. Generally these explanations are to the management to improve the internal control. Circumstances may require that the auditor add an explanatory paragraph (or other explanatory language) to the report.

Qualified opinion: The qualified report is the report that states the financial statements reveals the true and fair view of the financial condition of the entity except the matters to which such qualification affects. Except those areas the financial statements are result of operations and cash inflows and outflows. And also that the accounts are prepared in accordance with the generally accepted accounting principles.

Adverse opinion: An adverse opinion states that the financial statements do not represent fairly the financial position, results of operations, or cash flows of the business in conformity with generally accepted accounting principles. Such opinions are prepared by the auditor when he is not satisfied with the accounts prepared by the entity. The audit evidences gained by the auditor reveals that the entity is committing fraud or intentionally concealing the true financial condition of the entity.

Disclaimer of opinion: The disclaimer of opinion states that the auditor does not express an opinion on the financial statements.

When we talk about the true and fair representation of the financial statements. It does not mean that there is no fraud committed in them. The auditor has the responsibility of the responsibility to search for errors or irregularities within the recognized limitations of the auditing process. An auditor is subject to risks that material errors or irregularities, if they exist, will not be detected.

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