Audit Risk Model (Audit, Inherent, Control & Detection Risks)

Summary

In this educational video, CPA expert Savant from the CPA Recipe channel delves into the audit risk model, explaining how auditors provide a reasonable level of assurance, which is less than 100%. He discusses the components of audit risk, including inherent risk, control risk, and detection risk, and how they contribute to the overall audit strategy. Savant uses the audit risk model formula to illustrate how auditors aim to minimize risk to an acceptable level, ensuring the financial statements are materially correct and reducing the chance of issuing an incorrect opinion.

Takeaways

• 😀 The video discusses the audit risk model, which is crucial for understanding how auditors approach financial statement audits.
• 🔍 The speaker, a certified public accountant and former auditor, emphasizes the importance of minimizing audit risk to an acceptable level.
• 📊 Audit risk is defined as the risk that an auditor may issue an incorrect opinion on the financial statements.
• 📈 The audit risk model is represented by the formula: Audit Risk = Risk of Material Misstatement (Inherent Risk x Control Risk) x Detection Risk.
• 📋 Inherent risk is the susceptibility of financial statements to material misstatement due to factors like the nature of the business and accounting treatments.
• 🛡️ Control risk is the risk that material misstatements will not be prevented or detected by the entity's internal controls.
• 🔎 Detection risk is the risk that the auditor's procedures will not detect material misstatements that exist in the financial statements.
• 🔑 The auditor's objective is to express an opinion with a minimal risk of being wrong, aligning with the acceptable audit risk level.
• 🔍 The video explains that auditors use professional judgment to assess inherent and control risks, which are influenced by the client's business environment and internal controls.
• 📝 The speaker provides examples of how to assess risk components, such as revenue recognition and complex accounting measurements like pension liabilities.
• 🎯 The video concludes with a focus on the overall audit strategy, which involves determining the nature, timing, and extent of audit procedures to achieve the desired level of assurance.

Q & A

What is the main topic discussed in the video?

The main topic discussed in the video is the audit risk model, which is a framework used by auditors to assess and minimize the risk of providing an incorrect opinion on financial statements.

Who is the presenter of the video?

The presenter of the video is Savant from the CPA Recipe, a certified public accountant and former external auditor.

What does the acronym 'CPA' stand for?

CPA stands for Certified Public Accountant, a professional credential for accountants who have met certain qualifications and passed a rigorous examination.

What is the level of assurance an auditor provides during an audit?

An auditor provides a reasonable level of assurance, which is less than absolute or less than 100 percent. This means there is always some degree of risk that the financial statements might be materially misstated.

What is the significance of the phrase 'legend wait for it dairy' used in the video?

The phrase 'legend wait for it dairy' is used as a humorous and catchy way to engage the audience and create a memorable moment in the video. It does not have a direct relation to the content of the audit risk model discussion.

What are the three factors affecting audit risk according to the audit risk model?

The three factors affecting audit risk are the risk of material misstatement (Inherent Risk and Control Risk) and Detection Risk. These factors are used in the formula: Audit Risk = Inherent Risk x Control Risk x Detection Risk.

What is meant by 'Inherent Risk' in the context of the audit risk model?

Inherent Risk refers to the susceptibility of an account or financial statement to material misstatement due to factors such as the nature of the account, the complexity of the accounting treatments, and the volume of transactions.

How is 'Control Risk' defined in the audit risk model?

Control Risk is the risk that a material misstatement that could occur in a financial statement will not be prevented or detected on a timely basis by the entity's internal controls.

What is 'Detection Risk' and how does it relate to the audit process?

Detection Risk is the risk that the auditor's procedures will not detect a material misstatement in the financial statements. It is influenced by the nature, timing, and extent of the audit procedures performed by the auditor.

Why is it important for auditors to minimize audit risk?

Minimizing audit risk is important because it helps to ensure the credibility and reliability of the audit opinion. Reducing audit risk to an acceptable level minimizes the chances of issuing an incorrect opinion, which could damage the auditor's reputation and potentially lead to legal consequences.

How does an auditor determine the overall audit strategy to reduce audit risk?

An auditor determines the overall audit strategy by assessing the inherent risk, control risk, and planning the nature, timing, and extent of the audit procedures to address the detection risk. This involves professional judgment and may include analyzing financial trends, performing tests of controls, and conducting substantive testing.

Outlines

00:00

🎓 Introduction to the Audit Risk Model

The video begins with an introduction to the audit risk model by a certified public accountant and former external auditor named Savant. He explains that auditors provide a reasonable level of assurance, which is less than absolute or 100%. The video aims to make accounting topics engaging and easy to understand. Savant emphasizes the importance of subscribing and engaging with the content for viewers who are new to the channel. He outlines that the audit risk model will be discussed in detail, highlighting the concept that auditors aim to minimize audit risk to an acceptable level due to the impossibility of achieving 100% assurance.

05:01

🔍 Components of Audit Risk

This paragraph delves into the components that affect audit risk according to the audit risk model. It explains that audit risk is influenced by the risk of material misstatement, which can be further broken down into inherent risk and control risk. Inherent risk refers to the susceptibility of financial statements to material misstatement due to factors like the complexity of accounting treatments, volume of transactions, and the use of estimates and judgments. Control risk pertains to the possibility that internal controls will not prevent or detect material misstatements. The video also touches on the concept of detection risk, which is the risk that the auditor will not detect a material misstatement during the audit.

10:02

📊 Understanding Inherent and Control Risks

The video continues by discussing inherent risk in more detail, explaining that it exists due to the nature of the business and its accounting treatments. Examples are given, such as revenue recognition and complex accounting measurements like pension liabilities. Control risk is then explored, emphasizing that even if internal controls are in place, they may not be effective in preventing or detecting errors or fraud. The video suggests that auditors must assess the design and implementation of internal controls to determine their effectiveness in reducing control risk.

15:03

🕵️‍♂️ Assessing Detection Risk and Audit Strategy

Detection risk is the focus of this paragraph, which is the risk that the auditor will not detect material misstatements even if they perform audit procedures. The video explains how auditors use various audit procedures to mitigate detection risk, including sampling and the selection of appropriate audit techniques. It also discusses how auditors assess the acceptable level of audit risk and how they plan their audit strategy to ensure that the overall audit risk is reduced to an acceptable level. The importance of professional judgment in setting inherent risk and control risk assessments is highlighted.

20:03

📈 Audit Evidence and Risk Assessment

The final paragraph emphasizes the role of audit evidence and the assessment of inherent, control, and detection risks in the audit process. It discusses how auditors use various audit procedures, such as analytical procedures and tests of details, to gather evidence and assess risks. The video concludes by reiterating the importance of understanding the audit risk model and how auditors use it to form their opinion on the fairness of financial statement presentation. It also encourages viewers to engage with the content and provides a call to action for feedback and questions.

Keywords

💡Audit Risk Model

The Audit Risk Model is a framework used by auditors to assess and manage the risks associated with the audit process. It helps in determining the level of assurance an auditor can provide on the financial statements. In the video, the model is central to understanding how an auditor plans and conducts an audit to minimize the risk of issuing an incorrect opinion.

💡Reasonable Assurance

Reasonable assurance refers to the level of confidence an auditor provides on the fairness of the financial statements, which is less than absolute or 100%. The video emphasizes that audits are designed to provide a high, but not perfect, level of confidence, as indicated by phrases like 'less than absolute' and 'less than one hundred percent'.

💡Material Misstatement

Material misstatement is a term used to describe errors or omissions in financial statements that could significantly affect the decisions of users relying on that information. The video discusses how auditors assess the risk of material misstatement as part of the audit risk model, using examples like revenue recognition and complex accounting measurements.

💡Inherent Risk

Inherent risk is the susceptibility of financial statements to material misstatement due to factors inherent in the business, such as the nature of the company's operations. The video explains that inherent risk exists before considering the effectiveness of internal controls, and it is assessed based on the complexity of accounting treatments and the volume of transactions.

💡Control Risk

Control risk is the risk that a material misstatement will not be prevented or detected on a timely basis by the entity's internal controls. The video script mentions how auditors assess control risk by evaluating the design and implementation of internal controls, such as bank reconciliations, to determine their effectiveness in preventing or detecting errors or fraud.

💡Detection Risk

Detection risk is the risk that the auditor's procedures will not detect a material misstatement. It is influenced by the nature, timing, and extent of audit procedures. The video discusses how auditors plan their audit procedures to minimize detection risk, such as by using sampling techniques and choosing appropriate audit procedures.

💡Acceptable Audit Risk

Acceptable audit risk is the level of risk that an auditor is willing to accept when expressing an opinion on the financial statements. The video uses the example of setting an acceptable audit risk at one percent, which means the auditor aims to be 99% sure that the financial statements are free from material misstatement.

💡Audit Evidence

Audit evidence is the information obtained by the auditor during the audit process to afford a reasonable basis for an audit opinion. The video script refers to audit evidence in the context of testing internal controls and conducting substantive tests to support the auditor's opinion on the financial statements.

💡Audit Strategy

Audit strategy refers to the overall plan that an auditor develops at the start of the audit to address the assessed risks and to guide the audit process. The video emphasizes the importance of determining the overall audit strategy to reduce audit risk to an acceptable level, which includes decisions about the nature, timing, and extent of audit procedures.

💡Professional Judgment

Professional judgment is the application of relevant knowledge, experience, and professional standards in making informed decisions. The video script mentions that auditors use professional judgment in assessing inherent risk, control risk, and in planning the audit, which is crucial for the effective application of the audit risk model.

💡Sampling

Sampling is a technique used by auditors to examine a portion of a population to make inferences about the whole. The video discusses sampling in the context of testing the occurrence of sales transactions, where the auditor cannot examine every transaction and thus relies on a sample to assess the risk of material misstatement.

Highlights

Introduction to the audit risk model by a certified public accountant and former external auditor.

Emphasis on the reasonable level of assurance in auditing, which is less than absolute.

Discussion on the implications of issuing an incorrect audit opinion and the associated risks.

Explanation of how auditors aim to minimize audit risk to an acceptable level.

Introduction to the audit risk model formula: Audit Risk = Risk of Material Misstatement × Detection Risk.

Breakdown of the risk of material misstatement into inherent risk and control risk.

Definition and examples of inherent risk, including the complexity of accounting treatments and volume of transactions.

Explanation of control risk and its relation to the effectiveness of internal controls.

The role of detection risk in the audit process and how it affects the audit strategy.

Importance of professional judgment in assessing inherent risk and control risk.

Methods auditors use to assess control risk, including observation, inspection, and interviews.

The impact of internal controls on the audit process and the auditor's assessment of their effectiveness.

How auditors determine the nature, timing, and extent of audit procedures to manage detection risk.

The objective of auditors to express an opinion with minimal risk of issuing a wrong opinion.

Strategies for auditors to manage audit risk, including the assessment of inherent risk and control risk.

The concept of acceptable audit risk and how it influences the overall audit strategy.

Conclusion summarizing the audit risk model and its components.

Transcripts

[Music]

in this video i'm going to discuss

the audit risk model and we're starting

right now

what's up my name is savant from the cpa

recipe and i'm a certified

public accountant and also a former

external auditor

if this is your first time in this

channel and if you're looking for fun

engaging and easy to understand

tutorial videos about accounting and

related topics you've come to the right

place so start now

by hitting the like button sharing this

video on your timeline and hitting the

subscribe button and bell notification

icon

so you won't miss anything now as i've

said earlier in this video

i'm going to discuss go anub auditivist

model and this is gonna be

legend wait for it dairy

[Music]

[Music]

as i have said in the previous episode

of this auditing theory series

an auditor only gives a reasonable level

of assurance

meaning brought the level of assurance

is less than absolute

or less than one hundred percent an

audit of bro

for instance i unqualified opinion

in fact the financial statements are

materially mistaken

remember sabinate and the level of

assurance is less than 100 percent

ebik's a b in bro for instance if the

level of assurance is 98 percent

ebik's

now if an auditor would be issuing an

incorrect opinion

it was a reputation or public image

especially since hindi

so there is a risk of a lawsuit against

the auditor

or possible or involved litigation case

and is an auditor and of course

payment of damages but wait there's more

etho

not impossible achieve a 100 percent or

absolute assurance

then the best way to go for an auditor

is to minimize the audit risk to an

acceptable level

so now bro how can an auditor minimize

risk to an acceptable level

of anti-natal audit risk model

now to illustrate assurance

to mata advice versus a bro

now the objective of the auditor bro is

to have that level of assurance

no confidence in an audit report

this of course will depends a

professional judgement thanks an auditor

acceptable level let's say for instance

an acceptable level of assurance for me

is 95 percent

in such case we have around five percent

acceptable audit risk

kapagnam an acceptable assurance level

by 90 percent

the acceptable audit risk is 10 so

theoretically

they equal 100 percent however bro

the problem is that the audit risk is

not immediately equal to the acceptable

audit risk by default

the objective of the auditor here is to

determine the overall audit strategy

in order to reduce the audit risk to an

acceptable level

which is untina tawangana acceptable

audit risk

now there are three factors affecting

the audit risk according to the audit

risk model

ato and formula audit risk all the trace

equals risk of material misstatement

times detection risk ebik sabihin bro

in opinion auditor are influenced by two

things

material statements financial statements

either due to error or fraud

or a risk of material misstatement or in

short

rom or rom

ability

[Music]

a decision making non-users and

statements nato

now bucket magazine material statements

financial statements well either due to

error

or fraud now the risk of material

misstatement can still be broken down

into two components

annual two components

in heaven control risk so now

we can express the formula for audit

risk as audit risk equals inherent risk

times control base times detection risk

so let's discuss these two components of

risk of material misstatements

one by one

so now una

the risk exists due to the very nature

of the cause of

risk for example accounts at accounting

treatments that by their very nature

a prone to material statements now

bucket cell prone to material

statements an example for instance

revenue especially if making it even

recognition practice and is an

entity for instance human construction

revenues

percentage of completion another example

you mean a complex accounting

measurement kagayanang pension liability

another example bro you make a recurring

transaction or one-time transaction

kagaya for instance bro kevin and fire

lost during the covered period

so going back definitely bro estimate

yan

hindi monument pueden expect no amount

the process of estimation is an estimate

is an

estimate so anupabaya among accounting

treatments or accounts

not possibly may mata asana inherent

risk investments especially the ones

that measured using fair value

so depends a business and entity so

again to reiterate

an inherent risk a young risk of

material misstatement

natural financial statements due to

reasons like complexity of accounting

treatments

use of estimation and judgments and

significant volume of transactions

prior to consideration of internal

controls

so next anonymous natalognati no control

risk

and risk i young risk now although my

internal controls in place not designed

and

implemented by management a hindi na

tomape prevent

madido attack or mako correct an errors

or fraud

no potentially magnus material

misstatement

financial statements an internal

controversibro hindi nominee and 100

percent

prevent technology

making all considering constraints when

designing and implementing internal

controls

for instance bro let's say not to ensure

that the cash inbound

balance of the entity is correct they

perform monthly bank reconciliation

now in this case the performance of the

bank reconciliation is an internal

control

now i'm seeing a service control risk

although medium internal control

and possibly a internal control nato i

invented prevent my detect or makovec a

material misstatement

this is highly likely especially broken

and pinagoo-uzapanatin afrod

since there is an intention to deceive

okay

the control is inadequately designed or

not properly implemented

for instance bank reconciliation

record keeping functions

reconciliation so there are really cases

that all do my internal controls in

place

and eventually material statement

so now the last factors of the twist

model

detection risk anonymous detection risk

a tournament bro young listener do not

perform audit

[Music]

for instance a company has 100 000 sales

transactions during the year

and you want to verify if this sales

transactions actually occurred

hindi mo ichick sales invoices nyan bro

invoice sampling basis

from the population and i'm sure the

encounter moon

and sampling young studies takes the

subject now

auditor there is that likelihood

or young fraud transactions or invoices

now for the non-sampling risk the man

bro papa supplemented for instance

selection of inappropriate procedures

for instance broner according initial

assessment of risks asap

analytical procedures

must detail the audit procedures okay

at coagulation and audit risk inherent

risk

control risk at detection risk now

balika nathaniel formula nathan kannina

which is audit risk equals inherent risk

times control risk

times detection

three risks namely young inherent risk

or the natural western

melissa financial statements due to

complexity of accounting treatments

volume of transactions reliance on

estimates and judgments etc

next

internal controls and significant errors

or fraud

some financial statements and lastly

young detection risk no

although not performing audit procedures

the fairness of the presentation of the

financial statements

now dahil dito the objective of the

auditor is to express his opinion

at a point in which the risk of a wrong

opinion being issued is minimal

or at an acceptable level now pa'ano

united gagavin auditor bro let's say for

example

kung akoyo auditor bro definitely i

would want the audit risk to be as

minimal as possible

so for instance i want to be 99 percent

sure

99 but i am 99

germs except one person he makes a bean

for me bro

the acceptable audit risk is one percent

or there is not one percent chance

soda bro a platinum it was all the twist

model

so the acceptable audit risk is now set

at one percent

now as discussed earlier the audit risk

is influenced by the risk of material

misstatement

which is broken down further into the

inherent risk and the controlled risk

now it don't inherently risk and control

the basics bro

there is nothing that the auditor can do

about them because they are a function

of the audit client anubian business

environmental business yeah and

therefore and bio accounting standards

applicable as well as the laws and

regulations

anubian internal controls designed and

implemented

by the audit clients management lahat

language bro

hindi in hawaii auditor now

congratulations

formula it will depend on the

preliminary assessment of the auditor

and in heaven

the auditor can only assess

with management and other key personnel

now audit client

young analytical procedures for instance

analyzing trend from the previous year's

financial statements

versus the current year's trial balance

significant changes

of sales and many more also puerto karen

mcpher former observational operations

the audit

performed inspection and documents and

the records nila

makhikita mojan bro if maven bank

segregation of duties

and also you can verify if you manage

in interview mode actually daily

operations

so now let's say in an assessment at

control risk

so let's assume that based on your

assessment there is a 90 percent chance

that the financial statements are

materially mistaken

so if platinum and under inherent risk

7.9

now of course hindi ito basta pak plat

lamong ng percentages bro

kailang and now well documented the

manga among risk assessment procedures

in order to support your assessment that

the inherent risk is at 90 percent

now of course obviously bro the auditor

needs to use his professional judgment

in this assessment

now for the control risk bro here is the

catch

on control risk i assess jan brew at 100

[Music]

internal controls magnifi-like has

internal controls meaning bro

based on your assessment of the controls

relevant to the financial reporting

appropriately designed consistently

implemented

at operating effectively on internal

controls

ebig's a begin based on your assessment

nani niwalaka nakayama prevent

internal controls and errors or fraud my

material impacts the financial

statements

now bro a tongue assessment monotone

control risk below 100 percent

so

[Music]

[Music]

[Music]

banana audit evidence and test of one

transaction definitely brew him there

so young design control at consistent

implementation

the test of operating effectiveness of

controls

now it'll bro sampling

testing and controls

[Music]

uncontrolled less than 100 percent

test of design and implementation or

todi

a test of operating effectiveness or

t-o-e

assessment one hundred percent by

default

documentation understanding non-internal

controls

now acceptable audit risk inherent risk

at control risk

and detection risk now detection risk

bro

nature timing and extent of audit

procedures

acceptable audit risk for instance in

our example

the hill 7.99 inherent risk at let's say

the controller sky one

patama maintaining auditorium audit

risks a level acceptable

now in this case which is one percent

ebik's ability detection

timing and extent of audit procedures

nature meaning bro

and bank classes and procedure and

gagawin analytical

or test of details or kailangan mixture

of both

timing ibxabihin timing ibxabihin

so for instance

level from the audit procedures

and procedures of details

tap was closer to here in bush again at

lastly madame can sample size

don't worry must idi discuss in detail

but even audit approach in a separate

video

for now unconcerned audit risk model

overview overall audit strategy

size more amount of evidence

and that's it for this video bro i hope

madame gangna tunan

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and see you in another episode for

legend

wait for it dairy

you