The Audit Risk Model

The audit risk model shows audit risk (the risk the auditor will issue an incorrect opinion when the financial statements are materially misstated) as a function of 3 factors: (1) inherent risk, (2) control risk, and (3) detection risk. Inherent risk is the susceptibility of an account to material misstatement in the absence of internal controls; inherent risk is based on the business environment, the nature of the transactions, and the integrity of the client's management. Control risk is the likelihood that a material misstatement will not be caught by the client's internal controls. Inherent risk and control risk, taken together, are referred to as the risk of material misstatement. The risk of material misstatement (sometimes called client risk) is the risk that the financial statements will contain a material misstatement before the auditor gets involved. The auditor has no control over the risk of material misstatement, but must assess the risk of material misstatement in order to set detection risk accordingly. Detection risk is the risk that the auditor will fail to catch a material misstatement that is not caught by the client's internal controls. When the risk of material misstatement is high, the auditor should set the detection risk to a low level to ensure that audit risk remains low. The auditor reduces detection risk by conducting more substantive tests. Thus, the higher the risk of material misstatement, the more testing the auditor needs to conduct. There is therefore an inverse relationship between the risk of material misstatement and detection risk.
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