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Using the Audit Risk Model

When you audit a company, your main goal is to provide assurance to the users of the company’s financial statements that those documents are free of material misstatement. You use the audit risk model, which consists of inherent, control, and detection risk, to help you determine your auditing procedures for accounts or transactions shown on your client’s financial statements. These financial statements consist of these three documents:

  • Income statement: Shows a company’s operating performance (revenues, expenses, and net income)

  • Balance sheet: Shows a company’s assets, liabilities, and owners’ equity

  • Statement of cash flows: Shows the company’s sources of cash and cash payments

In addition to these three statements, owner’s equity can be further broken out into a statement of changes in owner’s equity (balance sheet), which details items such as the effect net income and dividends have on owner’s equity. Your client may also have footnotes to the financial statements which reports additional information left out of the main reporting documents, such as the balance sheet and income statement, for the sake of brevity.

Unfortunately, you can’t just trust that a client’s financial statements are complete and accurate. You have to work hard to come to that conclusion — or to determine that certain information is incomplete or inaccurate. And you may encounter situations in which your ability to assess the financial statements is impeded by the client itself. That situation increases your audit risk. Audit risk has two faces:

  • *You issue an adverse opinion when it’s not warranted. An adverse opinion indicates that the financial statements don’t present the financial data in accordance with generally accepted accounting principles (GAAP). The bottom line is that your client must follow these accounting standards when preparing its financial statements.

    How can this type of error happen? Maybe you’re not up to speed with recent changes in GAAP, or you misinterpret a specific accounting principle, leading you to find fault where none exists.

  • You issue an unqualified opinion when it’s not warranted. An unqualified opinion is the best you can issue. It means the financial statements present fairly, in all material respects, the financial position of the company under audit. Making this mistake means that your client’s financial statements contain material misstatements from either unintentional errors or intentional fraud, and you didn’t catch the problems through your audit procedures.

There are three specific components of audit risk — inherent risk, control risk, and detection risk.

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