Relationship Between Audit Risk and Evidence. Auditing Course | CPA Exam

In this video, we explain the relationship between audit risk and evidence.

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Audit Risk and Evidence: An Overview
Audit risk refers to the risk that an auditor may issue an inappropriate opinion on financial statements that are materially misstated. It is a fundamental concept in auditing and directly influences the amount and type of evidence required to support the auditor’s conclusions.

Components of Audit Risk
Audit risk is composed of three interrelated risks:
Inherent Risk (IR)
The risk that a material misstatement could occur in an account or assertion before considering internal controls.
Higher for accounts requiring significant judgment, complex transactions, or areas subject to fraud.

Control Risk (CR)
The risk that a material misstatement will not be prevented or detected by the entity’s internal controls.
Determined by the design and effectiveness of internal control systems.

Detection Risk (DR)
The risk that audit procedures will not detect a material misstatement.
Inversely related to inherent and control risk. When inherent or control risk is high, detection risk must be reduced by gathering more substantive evidence.

Audit Risk Formula:

𝐴𝑅=𝐼𝑅×𝐶𝑅×𝐷𝑅

Audit Evidence: Definition and Importance
Audit evidence consists of the information collected by auditors to support their opinion on the financial statements. It must be sufficient and appropriate:
Sufficiency relates to the quantity of evidence.
Appropriateness relates to the quality, including relevance and reliability.

Types of Audit Evidence
Physical Evidence
Observing tangible assets (e.g., inventory counts).

Documentation
Examining invoices, contracts, and other records.

Confirmations
Direct communication with third parties, such as banks or customers.

Analytical Procedures
Comparing financial data with expectations, trends, or industry benchmarks.

Observation
Watching processes or activities, such as control procedures.

Inquiry
Seeking information from management or staff about specific transactions or procedures.

Recalculation and Reperformance
Verifying mathematical accuracy or reperforming procedures to test controls.
Link Between Audit Risk and Evidence
The level of audit risk determines the extent and nature of evidence required:

High Audit Risk
When inherent and control risks are high, auditors need more substantive evidence, often gathered through detailed testing and external confirmations.

Low Audit Risk
If control risk is low due to effective internal controls, auditors may rely more on analytical procedures and less on substantive testing.

Balancing Detection Risk
Detection risk is managed by designing audit procedures that are robust enough to address the identified risks.

Audit Evidence Quality
Auditors assess the reliability of evidence based on:
Source: Evidence obtained directly by the auditor (e.g., physical counts) is generally more reliable than information provided by the entity.

Nature: Original documents are more reliable than photocopies or electronic versions.

Timeliness: Evidence related to the period under audit is more relevant.
Challenges in Gathering Audit Evidence

Complex Transactions
Transactions with multiple elements or subjective estimates may require specialized expertise.

Volume of Data
Large data sets necessitate the use of data analytics tools to identify anomalies or trends.

Fraud Risks
Intentional misstatements may involve collusion, making evidence less reliable.

Technology
Reliance on automated systems requires auditors to evaluate IT controls and data integrity.

Conclusion
Audit risk and evidence are closely intertwined, as the assessment of risk directly guides the auditor’s approach to gathering evidence. By identifying and addressing risks effectively, auditors can provide a well-supported opinion on the financial statements, ensuring their reliability and compliance with standards. Proper evaluation of evidence also builds stakeholder confidence in the audit process and the organization’s financial reporting.


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