Compute the overall Audit Risk if looking at the nature of business there are chances that 30% bills of services provided would be defalcated,…

According to SA 200, “Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Standards on Auditing”, the Audit Risk is a risk that Auditor will issue an inappropriate opinion while Financial Statements are materially misstated. Audit Risk has two components: Risk of material Misstatement and Detection Risk. The relationship can be defined as follows. Audit Risk = Risk of Material Misstatement X Detection Risk Risk of Material Misstatement: - Risk of Material Misstatement is anticipated risk that a material Misstatement may exist in Financial Statement before start of the Audit. It has two components Inherent risk and Control risk. The relationship can be defined as Risk of Material Misstatement = Inherent risk X Control risk Inherent risk: It is a susceptibility of an assertion about account balance; class of transaction, disclosure towards misstatements which may be either individually or collectively with other Misstatement becomes material before considering any related internal control which is 30% in the given case. Control risk: It is a risk that there may be chances of material Misstatement even if there is a control applied by the management and it has prevented defalcation to 60%. Hence, Control risk is 40% (100%-60%) Risk of Material Misstatement: Inherent risk X Control risk i.e., 30% X 40% = 12% Chances of Material Misstatement are reduced to 12% by the internal control applied by management. Detection risk: It is a risk that a material misstatement remained undetected even if all audit procedures applied, Detection Risk is 100% - 75% = 25% In the given case, overall Audit Risk can be reduced up to 3% as follows: Audit Risk: Risk of Material Misstatement X Detection Risk = 12% X 25% = 3%