Risk-based auditing is a style of auditing which focuses upon the analysis and management of risk. ... A traditional audit would focus upon the transactions which would make up financial statements such as the balance sheet. A risk-based approach will seek to identify risks with the greatest potential impact.

2. Risk Based Audit Approach

3. Objectives
 To define audit risks and establish the relationship
between materiality and audit risk
 To discuss the Audit Risk Model
 To explain different kinds of audit risks and the
factors that determine them

4. Audit Risk
 Audit accepts the risk that the audit conclusion may
be wrong and that Audit may have allowed material
error to remain undetected in the account.
 Only a very small degree of audit risk would be
acceptable as otherwise the audit process may lose
its purpose.
 A very high level of assurance (or confidence) is
required when expressing the audit opinion.

5. Relationship between materiality and
audit risk
 Higher the materiality level, lower the audit risk
and vice versa.
 To calculate the level of assurance (or
confidence) required from substantive audit
tests, risk model is employed.

6. Risk Model
 Analytical tool for planning and execution.
 Detects high-risk areas for concentrated audit
efforts.
 Audit can thus focus on areas which are likely to
generate better assurance instead of sampling and
testing of larger but low risk areas.
 Structures the audit procedures and reorganizes the
audit work in terms of risk perception

7. Risk Model
Audit Risk
Inherent Risk Control risk Detection Risk

8. Inherent Risk
 The risk that an error will occur in the first
place.
 Determined by the susceptibility of the
classes of transactions to be audited to
material misstatement, irrespective of the
related internal controls in the organization.

9. Control Risk
 The risk that internal controls will fail to
detect the error
 Determined by the efficacy of internal
control environment in the auditee
organization

10. Detection Risk
 Risk that the audit procedures will fail to
detect the error.
 Risk that auditor’s substantive tests do not
detect a material misstatement in the
transactions audited by him.

11. Overall Audit Risk
 All the three risks are independent of each
other.
 Overall Audit Risk (AR) is defined as:
OAR=CR x IR x DR
 The overall audit risk is defined by the audit
institution and hence is a constant pre-
determined quantity.

12. Objective for the Auditor
 To assess inherent and control risks in the
entity
 To design and perform appropriate
compliance and substantive procedures that
provide sufficient assurance that the product
of the risks identified is less than or equal to
the overall audit risk that the auditor is willing
to accept.

13. Determinants of Inherent Risk
√ The number and significance of audit adjustments and
difference waived during the audits of previous years.
√ Complexity of underlying calculations of accounting
principles
√ The susceptibility of the asset to material fraud or
misappropriation
√ Experience and competence of accounting personnel
responsible for the component
√ Judgment involved in determining amount
√ Mix and size of items subject to the audit test
√ The degree to which the financial circumstances of the entity
may motivate its management to misstate the component in
regard to this assertion
√ Integrity and behaviour of the management.
√ Management turnover and reputation

14. Assessment of Control Risk
 Evaluate the control environment
 Evaluate the control systems

15. Determinants of control environment
√ Management philosophy and operating style
√ The functioning of the board of directors and its
committees, particularly the audit committee
√ Organizational structure
√ Methods of assigning authority and responsibility.
√ Systems development methods
√ Systems development methodology
√ Personnel policies and practices
√ Management reaction to external influences
√ Internal audit

16. Determinants of control
environment (Contd.)
√ Segregation of incompatible functions
√ Controls to ensure completeness of transactions being
recorded
√ Controls to ensure that transactions are authorized
√ Third party controls (e.g. confirmation of events)
√ Control over accounting systems
√ Controls over computer processing
√ Restricted access to assets (only allow access to
authorized personnel)