In this lecture, 4.02 – Audit Risk, Financial Statement Level and Assertion Level – Lesson 3, Roger Philipp, CPA, CGMA, provides a quick summary of the the Audit Risk, Financial Statement Level and Assertion Level discussion and provides a big picture view.

Audit Risk equals inherent risk (IR) times control risk (CR) times detection risk (DR). In solving for DR, audit risk is divided by IR times CR equals DR. Control risk is high when reliance on the operating effectiveness of controls is low, which drives up DR. DR consists of AP – the risk that the auditor’s analytical procedures will not detect material misstatements and TD – the risk that the auditor’s tests of details (Roger mnemonic: ICORRIIA) will not detect material misstatements.

Why do we care about audit risk, substantive testing, financial statement level assertions and management assertions regarding account, transactions and balances? Because the auditor’s objective is to obtain sufficient, appropriate audit evidence in order to substantiate or confirm the assertions management is making in the form of financial statements. And in order to do so, the auditor performs substantive tests: the nature, timing, and extent of which are determined by the auditor’s assessment of the risk of material misstatement (RMM) and the acceptable level of detection risk (DR) for the engagement.

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Video Transcript Sneak Peek:

Now, all this stuff wasn't that fascinating, but let's summarize. What did we just say? We said audit risk equals, we'll do it right here. Audit risk equals IR times CR times DR. In solving for DR, audit risk over IRCR equals DR. We also said if reliance is low, this goes up. We want our acceptable level low. We better do more substantive testing.

We said that we're concerned with DR because DR relates to both test of details risk and analytical procedures risk, the risk that you, the auditor, do not detect the problem while you're doing test of details of accounts, transactions and balances, or analytical procedures which is, again, ratio analysis. I haven't defined these for you yet. We're going to talk about them in detail in a few minutes. Those are called the audit procedures, the actual substantive test. This is the dee-da.

So while you're doing your inquiry, confirmations, observations, recalculations and so-on, you don't detect the problem, or analytical procedures, we talked about in the planning phase and as a substantive test, as a review phase, that study of that in comparisons relationships like inventory, turnover receivable, turnover ratios, gross profit percentages and so-on, that's analyzing the numbers themselves, you don't detect the problem. That's what your analytical procedures or your AP risk actually talks about as well. So we're looking at both the different levels, that's what we're heading into.

Now why do we care about this? Because management assertions ties to the objectives, ties to the audit procedures. Here's how it all ties together. We're going to go out and pick up these statements. Whose statements are these? Management. What are the assertions they're making? Those are these things.

Out of the assertions grows our objective. Out of the objective grows the actual audit procedures or substantive tests. These are the tests we're going to do, test of details and analytical procedures. These are the tests to meet our objective which you'll see in a minute. What is our objective? To corroborate or substantiate all of these assertions that management is making in the form of financial statements.

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