Lesson: Audit Risk Relationships

Instructor: Nick Palazzolo

In this lesson, the relationship between the different facets of audit risk - inherent risk, control risk, and detection risk - is examined in depth. Through various examples, it is demonstrated how these factors are inversely related to one another and how altering one can maintain or change the overall audit risk. The concept of interim testing is also discussed, highlighting its usage and implications on detection risk. With a concrete understanding of these relationships, viewers will be better equipped to tackle multiple choice questions on the CPA exam related to audit risk.

Updated: June 22, 2023 Create an account

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Audit Risk Overview

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Introduction to Audit Risk

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Inherent Risk, Control Risk, and Detection Risk

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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We're going to go over a couple other points here for our relationship between the items within audit risk. Now, an increased risk of material misstatement, meaning we just later on discover that internal controls are not operating effectively as much or there's just more inherent risk that we discovered. So that's an increased risk of material misstatement would require you to decrease the detection risk, also known as the synonym here of a lower acceptable level of detection risk. So you would need to decrease detection risk because let's say, right before we said 30 is made up of 2, 2 is inherent risk, 5 was control risk and 3 was our detection risk. Right, so we've got that. Now let's say this inherent risk we just discover actually goes up to 3. We say, uh oh, that's a problem, right? This is now 15 is the risk of material misstatement times 3 is 45. So our overall audit risk is now 45. What can we do here? Well, we can test more, which reduces our detection risk now to maybe 2, balancing us out again, saying 3 times 5 is going to get us 15 times 2, which is 30. We see what we did there. If we discover later on that for whatever reason, the risk of material misstatement is higher than originally thought out, we need to lower detection risk because this is the one we have actual control over, bringing us back to our original audit risk of 30. Satisfied by performing more tests of detail. Let's play around with this formula again. A decreased risk of material misstatement would allow for an increase to detection risk in order for audit risk to remain the same. Playing around with these numbers again, let's say that

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