Page 75 - CA Inter Bhaskar Vol 1

CA RAVI TAORI RISK ASSESSMENT AND INTERNAL CONTROL

AUDIT BHASKAR CH 03 - PART 01 During the audit of a company if the financial statements of that company are misstated and those
Audit Risk could be simply understood as follows:

misstatements are material in nature, then there will be a risk that audit opinion given by the auditor
regarding audit of that company would be incorrect. Then that risk will be known as Audit Risk.

Example
Strength limited purchased a Plant and Machinery for ₹ 2 Crores in the financial year 2020-2021. The
accountant of strength limited debited ₹ 2 crores in the Repair and Maintenance account in the
statement of Profit and loss instead of taking it to the balance sheet as PPE and claim depreciation on it .
While auditing the accounts of this company the auditor did not notice this and consequently did not
report anything regarding the plant and machinery. Therefore, opinion given by the auditor would be
inappropriate resulting in audit risk.

Audit risk is a function of the risks of material misstatement and detection risk.

om the above, it is clear that –
Audit Risk = Risk of Material Misstatement x Detection Risk------(1)
Further Risk of Material Misstatement= Inherent Risk x Control Risk------(2)
From (1) and (2), we arrive at Audit Risk = Inherent Risk x Control Risk x Detection Risk

What is not included in Audit Risk?
Audit risk does not include the risk that the auditor might express an opinion that the financial
statements are materially misstated when they are not. This risk is ordinarily insignificant.
Further, audit risk is a technical term related to the process of auditing; it does not refer to the
auditor's business risks such as loss from litigation, adverse publicity, or other events arising in
connection with the audit of financial statements.

(CNO--SA315-P1.021) Example

EXAMPLES

i) Complex Accounting Standard, may lead to lack of understanding
and material misstatement. It is inherent risk
a) Inherent Risk
ii) Because of business failures, there may be risk in going concern
because of which asset, liability valuation may go wrong, again it
is inherent risk

Fire extinguishers & smoke detectors may not be
i) Inventory maintained and may not be in working condition.
Related It may lead to heavy loss in inventory
b) Control Risk
Cash & cheque book may not be kept in locked safe
on regular basis
ii) Cash
Petty cash limit is less than 1000 expense but
employees may break expense of 5000 into 10
expenses of 500 and bypass limit of 1000
c) Detection Risk
WIP inventory is material but auditor is still not attending physical
i) Inventory verification is an example of inappropriate / inadequate audit
procedure, and he may miss material misstatement

Auditor may select very small sample of revenue and his conclusion
ii) Revenue may go wrong, which leads to sampling risk which further increases
detection risk

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