Auditing standards indicate that inherent, control and analytical procedures risks may be combined to determine the extent of substantive, detailed testing. The standards depict each component risk individually; however, the audit risk model will not produce proper results unless the components are considered in relation to each other. That is, knowledge about one component of the risk model must be weighed in order to properly assess the risks associated with another (this relationship is known as being “conditionally dependent”).
For example, imagine that firm A and firm B have identical control structures with respect to an audit objective or account, but that firm A is inherently riskier than firm B. If auditors consider only features of the internal controls as the basis to assess control risk, then they will assess A and B control risk as the same. However, to use the risk model properly, the assessed control risk of firm A should be higher than the control risk of firm B. To oversimplify, if there is inherently a higher probability of more material misstatements in firm A than in firm B, then the same control structure has a higher risk of failing to detect/correct misstatements in firm A than in firm B. Assessing these component risks interdependently calls for subtle, highly skilled judgment.
In a series of cases, we looked at inherent, control and analytical-procedures risks from auditors in firms where each of these risks was separately assessed. Our research showed that a client factor or behavior could affect the assessed level of more than one component risk (for example, the aggressiveness of the client firm’s management could influence both the inherent and control risks). Next, we found that auditors did base subsequent risk assessments on the prior risk assessment level, as is necessary for proper use of the audit risk model. The implication is that inherent risk need not automatically be set at a maximum (to offset a possibility that risk components will be assessed independently). Instead, auditors appear to be capable of making combined assessments of the component risks to appropriately plan the extent of substantive testing.
For the full text of the research paper, see Auditing: A Journal of Practice & Theory, Fall 2000, vol. 19, no. 2, “Inherent Risk and Control Assessments: Evidence on the Effect of Pervasive and Specific Risk Factors.”
RICHARD DUSENBURY, PhD, is associate professor of accounting at Florida State University. His e-mail address is firstname.lastname@example.org . JANE REIMERS, PhD, is the KPMG professor of accounting at Florida State University. Her e-mail address is email@example.com . STEPHEN WHEELER is professor of accounting at the University of the Pacific. His e-mail address is firstname.lastname@example.org .