Activity Based Risk Evaluation Model of Auditing

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Acceptable audit risk AR*

The acceptable level of audit risk [AR*], is the level of risk of a material misstatement in the audited financial statements, or underlying level of aggregation, that is acceptable to the auditor ^[fn]. It is inversely related to the expected reliance on the financial statements by financial statement users. AR* should not be confused with the achievable level of audit risk [AR], which is based on an evaluation of the various components of AR (inherent, control and detection risks).

The acceptable audit risk AR* is evaluated at different stages of the audit and at different levels of aggregation as shown in the table below:

LEVEL OF AGGREGATION	AUDIT STAGES
	Client acceptance/ retention	Audit planning	Control testing	Substantive testing	Opinion formulation
Financial statement level	AR*1	na	na	na	AR*5
Account balance assertion level	na	AR*2	AR*3	AR*4	na

The acceptable audit risk evaluated in one audit stage may be different to the same risk evaluated during a later audit stage, for two reasons.

Firstly, the evaluation of the acceptable audit risk in the client acceptance /retention stage (AR*₁) is concerned with the evaluation of this risk at the financial statement level. The evaluation of the acceptable audit risk in the substantive testing stage (AR*₄) is concerned with the evaluation of this risk at the account balance assertion level. This will invariably result in a different evaluation (see below).

Secondly, even if both risks are evaluated at the same level of aggregation (as in AR*₁ and AR*₅ or AR*₂ and AR*₄), the second evaluation in each set may differ from the first, owing to the greater knowledge the auditor has of the client's business which may result in the auditor changing the initial evaluation.

AR* at the financial statement level

The evaluation of the acceptable audit risk at the financial statement level is based on the expected reliance by financial statement users on the completeness, validity and accuracy of individual financial statement items. The greater the expected reliance, the lower is the acceptable level of audit risk.

Factors affecting expected reliance on the financial statements as a whole include:

• the size of the client. Generally the larger the size of the client (in total assets or total revenue), the greater the likelihood of reliance,
• the distribution of the ownership. The greater the distribution, the greater the likelihood of reliance, not only by owners, but also by regulators.
• the amount of liabilities. The greater the amount of liabilities, the more likely is it that the financial statements will be relied upon by creditors or potential creditors.
• other factors such as the likelihood of acquisition of the client by another party, additional regulatory requirements, the existence of loan covenants, and the validity of the going concern assumption.

The acceptable risk for each financial statement item, depending on the circumstances, is assessed as VERY LOW, LOW or MODERATE.

For example, for a large, public, listed company with considerable debt, the acceptable level of audit risk for most financial statement items is, owing to the high degree of expected reliance on the financial statements, likely to be VERY LOW. On the other hand, for a small, private, unlisted company with little debt and with two shareholders, both of whom are executive directors, and who are unlikely to rely on or show the audited financial statements to other parties, the acceptable audit risk for the same financial statement items is likely to be MODERATE. In some instances, here may be an increase in the level of acceptable risk relating to some financial statement items.

Factors indicating that financial statement users may place greater reliance on a particular financial statement item include:

• the existence of debt covenants affecting certain financial statement items. This may indicate a lower level of acceptable audit risk for these items, as there may be greater reliance on them by lenders.
• the occurrence in the financial statement item of related party transactions. Thus a different level of acceptable audit risk may be indicated for those items.
• the existence of specific statutory requirements. This may require details of financial statement items to be disclosed which may result in lower levels of acceptable audit risk having to be assigned to those items.
• the amount of the financial statement item. The lower the amount, the less is the likelihood of reliance by financial statement users, thus the higher the acceptable level of audit risk. However, note that where there may be a risk that the financial statement item is understated, this general rule cannot be applied.

AR* at the account balance assertion level

The acceptable audit risk at the account balance assertion level is required during the audit planning and substantive testing stages. Where information affecting its evaluation comes to the attention of the auditor during the control testing stage, it is also evaluated at that time as well.

The acceptable audit risk is evaluated for each assertion relating to an account balance. The definition is similarly based on the expected reliance, by financial statement users, on the individual account balance assertion. The greater the expected reliance, the lower is the acceptable audit risk.

It is evaluated based on the evaluation of AR*₁ for the related financial statement item, adjusted for any expected increased or reduced reliance on the particular account balance assertion.

Factors affecting reliance by users on financial statement items (debt covenants, related party transactions, specific statutory requirements, and the amount of the account balance) may also affect particular account balance assertions.

Again, AR* at the account balance assertion level is evaluated as either VERY LOW, LOW or MODERATE. For example, assume that the expected reliance on the financial statement as a whole was MODERATE. If the auditor expected increased reliance on the validity of an account balance, the auditor may evaluate the acceptable audit risk in relation to the validity of the account balance as LOW.

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