Audit Risk Model
This is defined in AUS

402 as ‘the susceptibility of an account balance ... to misstatement that
could be material ... assuming there were no related internal controls’ (AUS

402.09). Estimating the inherent risk (IR) for each account balance or class of
transactions requires the auditor to take into account such factors as the level
of complexity involved in determining the ‘correct’ balance of an account,
the complexity of transactions involving the particular account(s) and the
‘portability’ of the assets involved. The estimation of IR is done as though
no internal controls exist – it looks only at the nature of the account being
evaluated. Control Risk AUS 402 defines this as ‘the risk that misstatements
that could occur in an account balance ... that could be material ... will not
be prevented or detected on a timely basis by the internal control structure’
(AUS 402.06). The evaluation of the level of control risk (CR) requires the
auditor to have a thorough understanding of the internal control structure that
is in place, and practiced (not necessarily the same thing) within the
organisation to be studied. Elements such as the segregation of duties, the
existence of ‘management overrides’, and the level of formalised policies
and procedures in use are among the factors to be considered. Audit Risk Defined
in AUS 402 as ‘the risk that the auditor gives an inappropriate audit opinion
when the financial report is materially misstated.’ (AUS 402.03) The level
that is set as the acceptable audit risk (AR) reflects the degree of certainty
that the auditor and audit subject wish to achieve. An audit opinion can never
be a guarantee (AR = 0), even if every transaction during the year was tested,
due, at least in part, to the interpretive nature of many of the accounting
decisions involved. Detection Risk The final part of the risk model outlined in

AUS 402 is defined as ‘the risk that an auditor’s substantive procedures
will not detect a misstatement...’ (AUS 402.07) This risk relates to the
volume, effectiveness and sufficiency of the audit testing and investigation
undertaken. Both IR and CR are related to the probability that a particular
balance will contain an error, either accidental or fraudulent, while detection
risk (DR) is the probability that the auditor will not detect the error (Graham,

1985, p.15). The audit risk model is ‘a joint probability statement of
independent events’ (Wade, 1996) which attempts to combine these probabilities
and give an overall ‘chance’ of a misstatement existing (IR * CR) and
remaining undetected (* DR) – leading to the auditor giving an inappropriate
audit opinion (AR). B) Armidale Pty Ltd – Year 1 Inherent & Control Risk

Levels In the first year of an engagement the auditor will have gained only a
limited knowledge of the client and their practices. Faced with a poor internal
control structure the auditor may question the level of management experience
and knowledge, which AUS 402.14(b) suggests may be an indicator of high inherent
risk. This, combined with the newness of the engagement, would be sufficient
cause to set IR at a high level at the financial report level, and for most, if
not all, of the assertions below that. AUS 402.32 & AUS 402.34 mandate the
setting of control risk to high ‘unless the auditor is able to identify
internal controls ... likely to prevent or detect and correct a material
misstatement’ (AUS 402.32(a)). Given the conclusion of the auditor that such a
control structure does not exist within Armidale Pty Ltd they would have no
option but to set CR as high – which is a logical choice given our previous
definition of CR. Detection Risk & Evidence Accumulation Assuming that the
auditor wishes to achieve a low level of Audit Risk, especially given the
newness of the engagement and the lack of an effective control structure we can,
by restating the audit risk model as DR = AR / (IR x CR) determine what the
level of detection risk must be set at to achieve the desired level of AR. If,
for example, an AR of 5% is desired with both IR & CR set to 100% the DR
comes out to be: DR = .05 / ( 1 x 1) DR = .05 (5%) This means that the auditor
can only accept a 5% probability that their substantive procedures fail to
detect any material misstatements. Achieving this level of assurance will
require the gathering of a large amount of evidence – large samples will need
to be carefully tested and examined across most assertions. As the accumulation
of evidence is, due to the