A. Describe the purpose of the audit risk model and explain the relationship between each component.
The audit risk model helps auditors to assess the
... [Show More] risk of material misstatements in financial statements. It helps auditors to determine to the level of audit procedures that will be performed.
The 3 components that make up the audit risk model are inherent risk, control risk, and detection risk.
1. Inherent Risk: This component represents the risk of material misstatements in the financial statements due to the nature of the client's business or industry, complexity of transactions, changes in accounting policies, or other external factors. Inherent risk is usually assessed by auditors at the beginning of an audit engagement and is based on their knowledge and understanding of the client's business and industry.
2. Control Risk: This component represents the risk that the client's internal controls may not be effective in preventing or detecting material misstatements in the financial statements. Control risk is usually assessed by auditors based on their evaluation of the client's internal control system, including policies and procedures, and testing the effectiveness of the controls.
3. Detection Risk: This component represents the risk that the auditor may not detect material misstatements in the financial statements, even though they exist. Detection risk is usually managed by auditors through the design and performance of audit procedures, including substantive testing, analytical procedures, and tests of controls.
The relationship between these components can be represented by the following equation: Audit Risk = Inherent Risk x Control Risk x Detection Risk
The audit risk model suggests that audit risk can be managed by changing the level of detection risk. For example, if inherent and control risks are high, auditors may decide to perform more extensive audit procedures, which reduces detection risk and increases the likelihood of detecting material misstatements. Conversely, if inherent and control risks are low, auditors may decide to perform less extensive audit procedures, which increases detection risk and reduces the cost of the audit. Ultimately, the goal of the audit risk model is to help auditors provide reasonable assurance that the financial statements are free from material misstatements.
B. Assess the engagement risk (auditor business risk) at high or low, based off the attached “Appendix D: Client Business Risks.” Justify your response using three or more aspects from Appendix D.
The engagement risk for KMHS Manufacturing Company Inc. is assessed as high. Below are the justifications for this assessment:
1. Impact of pandemic, including the temporary and potentially recurring closure of casinos: The pandemic has significantly affected the gaming industry, and KMHS is no exception. The company's financial difficulties, as noted by the audit partner during the brainstorming session, are due to reduced revenue caused by the pandemic. The uncertainty surrounding the duration and impact of the pandemic on the compa [Show Less]