Question

I. For each case, calculate planned [desired] detection risk:

                                                Case 1        Case 2         Case 3         Case 4       Case 5

Audit risk                                 1%              1%               5%               1%              1%

Inherent risk                         40%           60%              40%              20%           20%

Control risk                           60%           40%              60%              20%           40%

II. Define the terms: 1. Audit risk, 2. Control risk, and 3. Inherent risk.   State whether Detection Risk varies directly or indirectly with each risk.

III. Contrast Case 4 with Case 5.

   III A. Would the auditor have to do more or less substantive testing in case 5 compared to case 4?

    III B. Explain, by referring to the audit risk model.

    III C. Now explain, without referring to the audit risk model.

Answer 1

I.

21 3 Detection Risk Audit Risk Inherest Risk* Control Risk 5 So, the detection risk would be as follows - 7 Risk 8 Audit Risk (A) 9 Inherent Risk (B) 70 Control Risk (C) Case 1 Case 2 1% 40% 60% Case 3 Case 4 Case 5 1% 5% 1% 1% 60% 40% 20% 20% 40% 60% 20% 40% 4.167% 4.167% 20.833% 25.000% 12.500% 12 Detection risk 73 (A)/(B)*(C)

II.

1 II It is type of risk wherein the auditor fails to detect the material misstatement despite issuing unqualifed opinion on the financial statements. It is the product of inherent 2 Audit Risk risk, control risk and detection risk. The risk that arises due to lacunae in the entity's internal control mechanism to 3 Control Risk detect the mistatement in the financial statements. Inherent 4. Risk The risk involved in doing the business, which can't be avoided but can be mitigated. 5 6 Corerelation with Detection Risk 7 Risk Type Audit Risk Control Risk Inherent Risk Detection 8 Risk Directly Reverse Reverse Proportional Proportional Proportional

III.

2 Risk 3 Audit Risk (A) 4 Inherent Risk (B) 5 Control Risk (C) 6 Detection Risk Case 4 1% 20% 20% DE Analysis Case 5 Case 4 Case 5 1% Low Low 20% Low Low 40% Low Moderate 13% 25% IIIA Yes, the auditor has to do more substantive testing in case of 5 as compared to case 4. HIB As we can see in Case 4, although the detection risk is higher than case 5, but its inherent and control risk is low, so we would require low level of audit evidences, whereas in case of Case 5, even though its detection risk is lower than case 4, but the control risk is more, we would require moderate level of audit evidences. Without referring to the audit risk model, we would take into consideration the other risks that are associated with the business, say business risk and therefore we would say that case 5 would involve more substantive testing than case 4, as it has IIIC