How to Assess Inherent Risk and Control Risk for Revenue
After identifying the significant accounts and relevant assertions, the auditor should assess the risk of material misstatement.
The risk of material misstatement is a function of both inherent risk and control risk.
Risk of Material Misstatement = Inherent Risk x Control Risk
The auditor thus needs to:
• Assess inherent risk for revenue accounts
• Assess control risk for revenue accounts
Inherent risk is the risk a material misstatement will occur in the absence of internal controls.
Here are 4 factors that affect the inherent risk for revenue:
• Industry-related factors
• The complexity of revenue recognition
• The difficulty of auditing transactions and account balances
• Misstatements from prior audits
Control risk is the risk a material misstatement would not be prevented or detected by the client’s internal controls.
Assuming the auditor plans to rely on the client’s internal controls, there are 3 steps for setting control risk:
• Understand and document the internal control process
• Plan and perform tests of controls on revenue transactions
• Set the achieved level of control risk
Now that the auditor knows both the inherent risk and the control risk for revenue transactions and account balances, the auditor knows the risk of material misstatement (RMM).
Risk of Material Misstatement = Inherent Risk x Control Risk
RMM is the risk that a material misstatement will occur and not be prevented or detected by the client’s internal controls.
You could also think of RMM as the risk that a material misstatement exists prior to the auditors doing their work. Some people refer to RMM as “client risk” because the auditors have no control over it.
A high RMM means the auditors will need to set detection risk lower to achieve an acceptable level of audit risk.
Audit Risk = Risk of Material Misstatement x Detection Risk
0:00 Introduction
0:29 What is inherent risk?
0:35 Four factors that affect inherent risk for revenue
1:48 What is control risk?
1:58 Three steps for setting control risk for revenue
3:11 The risk of material misstatement
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