Audit Risk Explained: Inherent, Control & Detection Risk with Real Examples
Overview: Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the opinion on financial statements that are materially misstated. This risk must be reduced to an acceptably low level before the auditor issues an opinion.
✅ What is Audit Risk?
Audit Risk (AR) is defined by the equation:
AR = RMM x DR
Where:
- RMM (Risk of Material Misstatement): The risk that the financial statements are materially misstated before the audit. RMM = Inherent Risk (IR) x Control Risk (CR).
- Detection Risk (DR): The risk that the auditor’s procedures will not detect a misstatement that exists.
✅ Inherent Risk (IR)
Inherent Risk is the susceptibility of an assertion to a material misstatement before considering controls. High IR is linked to complex transactions, estimates, or areas with significant judgment.
✅ Control Risk (CR)
Control Risk is the risk that a material misstatement will not be prevented or detected (and corrected) by the entity’s internal control system. Ineffective controls mean higher CR.
✅ Detection Risk (DR)
Detection Risk is the only element the auditor can directly influence by adjusting the nature, timing, and extent of audit procedures. When RMM is high, DR must be set low by doing more effective, extensive, or closer-to-year-end testing.
📌 Inverse Relationship Between RMM and DR
There is an inverse relationship between RMM and DR:
- If RMM is high ➔ DR must be low ➔ More persuasive evidence, larger sample sizes, and more substantive testing.
- If RMM is low ➔ DR can be higher ➔ Less testing needed.
✅ Types of Misstatements
- Factual Misstatements: Clear misstatements with no doubt.
- Judgmental Misstatements: Differences in estimates or policies.
- Projected Misstatements: Auditor’s estimate of misstatements in a population based on samples.
📝 Real Example: Derivative Transactions
Imagine an auditor assesses an investment account involving complex derivatives:
- IR is high because derivatives are complex and subjective.
- CR is high because controls for derivatives are ineffective.
- Therefore, RMM is high, so DR must be low.
- The auditor must obtain more persuasive evidence — e.g., test closer to year-end, increase sample size, and rely on external confirmations.
✅ Audit Risk and Materiality
Audit risk and materiality must be considered together. The higher the risk of material misstatement, the more substantive procedures and persuasive evidence the auditor needs to obtain.
🔗 Helpful References
👉 Master the audit risk model and keep your opinions clear and compliant!
