Control Risk Flashcards
Control Risk
Control Risk
Control risk is the risk that a material misstatement in a financial statement assertion will not be prevented, detected, or corrected by an entity’s internal controls.
Control Risk
Control risk is the risk that a misstatement in an assertion about a class of transaction, account balance, or disclosure will not be prevented, detected, or corrected on a timely basis by the entity’s internal control. In other words, it’s the risk that the client’s internal control systems will not prevent or detect material misstatements.
Definition
Control risk is defined as the risk that a misstatement could occur and not be prevented, or detected and corrected, by the entity’s internal control.
Assessment of Control Risk
When preparing an audit plan, the auditor needs to assess control risk for different areas of the audit. This assessment is typically done by evaluating the design and operating effectiveness of the client’s internal controls.
Initial Assumption
The initial assumption is that control risk is very high, and that existing internal controls are insufficient to prevent the risk of material misstatement. This assumption is made to ensure that the auditor is cautious and thorough in their evaluation of internal controls.
Tests of Control
Tests of control are performed to obtain evidence about control risk. These tests may provide sufficient evidence to justify a reduction in the estimated control risk, which can then be used for audit planning purposes.
Example
Suppose we’re auditing a company’s cash receipts process. We identify a control risk that cash receipts may not be properly recorded or deposited. Our initial assumption is that control risk is very high. However, after performing tests of control, such as observing cash handling procedures and reviewing deposit records, we find that the internal controls are operating effectively. As a result, we may reduce our estimated control risk from very high to moderate.
Control Risk Formula
Control risk can be quantified using the following formula:
Control Risk (CR) = 1 - (Control Effectiveness x Control Reliability)
Where:
- Control Effectiveness is the extent to which the control prevents or detects material misstatements (scale: 0-1)
- Control Reliability is the extent to which the control is consistently applied and enforced (scale: 0-1)
For example, if the control effectiveness is 0.8 and control reliability is 0.9, the control risk would be:
CR = 1 - (0.8 x 0.9)
= 1 - 0.72
= 0.28
This means that the control risk is 28%, indicating that there is still some risk that material misstatements may not be prevented or detected by the internal control.
Conclusion
Control risk is an essential concept in auditing, as it helps auditors to identify and assess the risks of material misstatement. By understanding control risk and performing tests of control, auditors can design effective audit procedures to mitigate these risks and provide a higher level of assurance that the financial statements are free from material misstatement.
Key Points
- Control risk relates to the effectiveness of internal controls.
- Auditors assess control risk for different audit areas.
- Evidence on control risk is obtained through tests of control.
- Initial assumption: High control risk, with internal controls insufficient to prevent material misstatement.
- Tests of control may justify reducing estimated control risk for audit planning purposes.
Objective
The auditor’s objective is to assess control risk to determine the likelihood that internal controls will fail to prevent or detect material misstatements.
