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Audit Risk Assessment (ISA 315): A Simple Explanation

Richard Clarke

Audit Risk Assessment (ISA 315): A Simple Explanation

What is Audit Risk Assessment?

Audit Risk Assessment, per ISA 315, involves identifying and evaluating risks of material misstatement in financial statements. Auditors assess inherent risk (client-specific), control risk (internal controls failing), and detection risk (audit procedures missing errors). In the ACCA AA exam, you’ll analyse risks and plan responses.

Let’s explore assessing risk for a sales process.

Key Components of Audit Risk

Audit risk is the chance financial statements are materially misstated. It’s broken into:

  1. Inherent Risk (IR): Risk due to the nature of the business or transactions (e.g., complex revenue recognition).
  2. Control Risk (CR): Risk that internal controls won’t prevent/detect misstatements.
  3. Detection Risk (DR): Risk that audit procedures fail to catch errors.

Formula

  • Audit Risk = IR × CR × DR
  • Goal: Keep audit risk low by adjusting detection risk based on IR and CR assessments.

Numeric Example

An auditor assesses risk for a retailer’s sales process:

  • Inherent Risk: High (70%)—cash sales are prone to theft or misrecording.
  • Control Risk: Medium (50%)—basic controls exist (e.g., daily reconciliations), but staff turnover weakens them.
  • Target Audit Risk: 5% (acceptable level for material misstatement).

Step 1: Assess Combined Risk (IR × CR)

  • Combined Risk = 70% × 50% = 35% (or 0.7 × 0.5 = 0.35)

Step 2: Calculate Acceptable Detection Risk

  • Audit Risk = IR × CR × DR
  • 5% = 35% × DR
  • DR = 5% ÷ 35% = 14.29% (or 0.05 ÷ 0.35 ≈ 0.143)

Step 3: Interpret Detection Risk

  • DR = 14.29%: Auditor must design rigourous procedures (e.g., extensive sampling) to limit detection risk to 14.29%, ensuring overall audit risk stays at 5%.

What Does This Mean?

  • High IR (70%): Cash sales are risky due to fraud potential.
  • Medium CR (50%): Controls help but aren’t foolproof.
  • Low DR (14.29%): Auditor needs robust testing (e.g., vouching sales records) to compensate.

The auditor might recommend stronger controls (e.g., segregation of duties) or increase sample sizes.

Why It Matters for ACCA AA

Audit Risk Assessment tests your ability to:

  • Identify risks using ISA 315 (e.g., significant risks like revenue).
  • Quantify and link IR, CR, and DR to plan audits.
  • Justify procedures to mitigate risks.

Practice with scenarios (e.g., inventory, payroll) to pass the AA exam!