Video: Audit Risk Formula

In this lesson, Nick Palazzolo provides an overview of the audit risk formula, breaking down its components and explaining how it relates to the inherent risk, control risk, and detection risk. He emphasizes that while the formula is presented like an algebraic equation, it is not used as such in practice but serves a purpose in helping auditors understand the concept. The lesson delves into the definitions of each risk, clarifying that inherent risk is unchangeable and is related to the complexity of a company's operations, while control risk depends on the effectiveness of internal controls in preventing misstatements. Furthermore, detection risk can be reduced by the auditor through additional tests and procedures. Finally, the lesson tackles the idea of risk of material misstatement as an alternative representation of the formula.

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Video Transcript

Instructor: Nick Palazzolo

Nick Palazzolo is head instructor of ExamPrep.ai CPA Review. Nick's teaching style is engaging & upbeat, combining practical Big 4 tax & assurance expertise with years of 1-on-1 coaching. His lessons are concise and emphasize what you need to know to pass. Whether you're a recent grad or working full-time, we’re confident you can conquer your CPA exams with Nick’s review.

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Here's a wonderful, nice little diagram that I made up, and I love it. Thank you to my graphic designer, Mohamed, on that. And then we redid it a few times here. It looks very nice. Now, you're going to see this at the end of the lesson as well. So don't worry about memorizing this. We're just going to go through a nice overview of it. A couple points here. This is really concise. It's really everything you're going to need to know about this audit risk formula. We see here that audit risk is made up of these three other risks, inherent risk, control risk, and detection risk. Awesome, right? Awesome, awesome. I'm just going to break down this diagram. Now we'll go through what these risks are, the definitions of them. A couple points, and again, you're going to have time to memorize this. You'll see this diagram again. Another name for inherent risk and control risk is the risk of material misstatement. If you see a question, you could say audit risk is inherent risk times control risk times detection risk. Or you could say that audit risk is the risk of material misstatement times detection risk. Points to know, these will get you questions right on the exam, making sure you're familiar here. While this is written out like an algebraic equation, and you can follow that, in reality, it isn't really used like that. It's just here for conceptual, to understand how this works. And like that being said, for example, here, if you have a multiple choice question that assigns numbers to these values, you can rewrite it just like any algebra question. So you see audit risk equals the three of these times each other. You could rewrite that, divide detection risk

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