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Wednesday, September 23, 2009

Audit Risk Model

The three components of audit risk (RMMi, 1 - Pr(De), and 1 - Pr(Da)), are referred to respectively as inherent risk [IR], control risk [CR] and detection risk [DR]. This gives rise to the audit risk model of: AR = IR x CR x DR, where
  • IR, inherent risk, is the perceived level of risk that a material misstatement may occur in the client's unaudited financial statements, or underlying levels of aggregation, in the absence of internal control procedures;
  • CR, control risk, is the perceived level of risk that a material misstatement in the client's unaudited financial statements, or underlying levels of aggregation, will not be detected and corrected by the management's internal control procedures 70%;
  • DR, detection risk, is the perceived level of risk that a material misstatement in the client's unaudited financial statements, or underlying levels of aggregation, will not be detected by the auditor.
    In practice, however, auditors evaluate risk components using terms such as LOW, MODERATE or HIGH rather than using precise probabilities.

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