Activity Based Risk Evaluation Model of Auditing

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Evaluation of inherent risk at the account balance level

Inherent risk at the account balance level is evaluated in the second, third and fourth audit stages. This evaluation is of considerably greater depth than the evaluation of inherent risk at the financial statement level as it focuses on individual account balance assertions, and underlying classes of transactions, rather than the financial statements as a whole. Its evaluation requires a detailed knowledge of the client's business and a continuing consideration of the possibility of fraud.

Auditors evaluate IR₂ for a particular account balance assertion based on the earlier evaluation of IR₁ for the related financial statement item assertion, adjusted for any increased or reduced inherent risk attaching to the unaudited value of the account balance assertion (including classes of transactions affecting the account balance assertion), assuming there are no internal control procedures in place that relate to either the account balance assertion or underlying classes of transactions. In addition, auditors evaluate the inherent risk for an account balance assertion net of any provisions that relate to the account balance.

The evaluation of IR₃ and IR₄ for a particular account balance assertion is based on the previous evaluation of IR₂ adjusted for the far more detailed and up to date knowledge the auditor has obtained during the course of the audit. At the end of the fourth audit stage, it is likely that most misstatements will have been detected and corrected by either the auditor and/or management, in which case IR₄ for any account balance assertion is likely to have a lower value than the value of IR₂ for the same account balance assertion previously evaluated in the audit planning stage. Inherent risk is evaluated as LOW, MODERATE or HIGH.

Inherent risk factors

There are a number of factors, which if present, indicate that there is s a significant risk that an account balance (or underlying class of transaction) may be misstated. In each audit engagement, an auditor determines whether these factors are present or absent. These factors include:

• management discretion over the value of the account balance: The inherent risk relating to the accuracy [of valuation] of an account balance that involves a high degree of management judgment, or that is difficult to compute, is evaluated as high. (However, see Journal of Accountancy article Top 10 Audit Deficiencies.) For example, trade debtors is normally subject to a provision for bad debts. This may involve a high degree of management discretion. In such instances, the inherent risk is evaluated as high. (Note that risk factors relating to an account balance assertion are evaluated net of any related provision.) The inherent risk for account balances that are based on management estimates is always evaluated as high.
• for account balances that represent assets, a high susceptibility of the asset to obsolescence. The susceptibility of an asset to obsolescence, as well as changes in consumer demand or technological change that could affect their value, increases the risk of the accuracy [of valuation] of the account balance, relative to those account balances that are not so susceptible. For example, if IR₁ for a computer retailer is evaluated as low, the inherent risk relating to the accuracy [of valuation] of the finished goods inventory would be evaluated as moderate (or even high), as the value of the inventory is susceptible to technological change.
• for account balances representing assets, a high susceptibility of the asset to misappropriation. The susceptibility to loss or misappropriation of an asset underlying an account balance affects the inherent risk relating to the completeness of the account balance. For example, cash at bank is an asset that is highly susceptible to misappropriation. If cash in the form of currency is misappropriated, then cash receipt transactions would not be complete and the asset would be understated (or not be complete). However, if the misappropriation is concealed, by, for example, including a fictitious outstanding deposit in the bank reconciliation, then not only would cash at bank not be complete, but the recorded value of the account balance would also not be valid. In this instance, (and depending on prior evaluations of IR₁), IR₂ in relation to both the completeness and validity of cash at bank is evaluated as high. (Similarly, IR₂ relating to the completeness of cash receipt transactions and validity of cash disbursement transactions is generally evaluated as high.)
• the presence of unusual transactions affecting the account balance assertion. (However, see Journal of Accountancy article Top 10 Audit Deficiencies.) If an account balance contains unusual transactions, inherent risk is evaluated as high. An example would be the account balance "purchases” where the entity is a company and the purchases are made from related parties. If related party transactions are required to be disclosed, then there is an increased risk, compared to account balances that contain either only related party transactions or no related party transactions, that all reportable transactions will not be disclosed. In other words, an increased risk relating to the accuracy [of description] of the account balance. Note that the inherent risk relating to transactions for which the business rationale is not obvious (see substance over form) as well as significant general journal transactions, is considered to be high.
• a susceptibility of the account balance to adjustment. If an account balance is susceptible to adjustment (for example, in prior years the account balance was found to be misstated and required adjustment), the inherent risk for the particular account balance assertion is increased ^[fn].

All the above factors increase inherent risk for a particular account balance assertion. Inherent risk is evaluated as LOW (when few of the above inherent risk factors are present), MODERATE, or HIGH (when a significant number of inherent risk factors are present).

In the audit planning stage, where the evaluation of IR₂ for an account balance assertion is MODERATE or HIGH, auditors regard this as a significant risk requiring special audit attention. In particular, auditors evaluate CR₂ for these account balance assertions to determine whether there will be some amelioration of the overall risk of misstatement.

Note that auditors who are industry specialists may evaluate inherent risk differently to auditors who are non-industry specialists^[fn].

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