Academic journal article Auditing: A Journal of Practice & Theory

Inherent Risk and Control Risk Assessments: Evidence on the Effect of Pervasive and Specific Risk Factors

Academic journal article Auditing: A Journal of Practice & Theory

Inherent Risk and Control Risk Assessments: Evidence on the Effect of Pervasive and Specific Risk Factors

Article excerpt

SUMMARY

This paper reports on a study that examines the effect of pervasive and specific risk factors on auditors' inherent risk and control risk assessments in an experimental setting. Two hypotheses concerning the significance of inherent and control risk factors on auditors' inherent risk (IR) and control risk (CR) assessments were tested by having 124 senior auditors and managers provide risk assessments on eight cases. The results show that the pervasive and specific risk factors included in the experiment were significant to both the auditors' IR and CR assessments. For the case used in this study, there was a significant positive association between auditors' IR and CR assessments. Taken together, these findings are consistent with Waller's (1993) notion of a knowledge-based dependency between IR and CR assessments. The findings are not consistent with Kinney's (1989) reformulation of the (IR x CR) component of the audit risk model.

Key Words: Audit risk, Inherent risk, Control risk, Auditor judgment.

Data Availability: Data from this study may be obtained from the authors upon request.

INTRODUCTION

The AICPA's audit risk model (AICPA 1996, AU 312) serves as the major conceptual framework for the audit process (Akresh et al. 1988; Cushing et al. 1995), and considerable research has studied various aspects of the model. For example, previous research has examined: (1) analytical properties of the model (Cushing and Loebbecke 1983; Kinney 1983), (2) auditors' assessments of components of the model and how risk factors affect those assessments (Braun 1998; Colbert 1988; Dirsmith and Haskins 1991; Dusenbury et al. 1996, 2000; Haskins 1987; Haskins and Dirsmith 1995; Libby et al. 1985), and (3) auditors' risk assessments in archival studies (Houghton and Fogarty 1991; Mock and Wright 1993; Spires and Yardley 1998; Waller 1993; Zimbelman and Waller 1999).

Researchers and practitioners have criticized the audit risk model because its multiplicative form suggests independence between the components (e.g., Cushing and Loebbecke 1983; Graham 1985; Kinney 1989). If the components are dependent, then use of the model can result in a biased estimate of audit risk. Practitioners have argued that the audit risk model is a good planning tool and that auditors recognize the dependencies between the model's components (e.g., Aldersley 1989; Graham 1985). In this paper, we test for dependencies in the inherent risk (IR) and control risk (CR) components of the audit risk model using an experimental approach. We rely on prior research by Kinney (1989) and Waller (1993) to develop our hypotheses.

The results of the current study show that pervasive and specific inherent and control risk factors were significant in both auditors' IR and CR assessments. We also found a significant positive correlation between auditors' IR and CR assessments for the case used in this study. These findings are consistent with Waller's (1993) analysis of the audit risk model that suggests a knowledge-based dependency between auditors' IR and CR assessments. The significant effect of both pervasive and specific inherent risk factors on the auditors' CR assessments does not support Kinney's (1989) reformulation of the audit risk model that predicts that only the pervasive inherent risk factors will significantly influence auditors' CR assessments.

The remainder of this paper proceeds as follows. The next section presents background information on the audit risk model and develops the hypotheses. This is followed by a section that describes the methodology used to gather and analyze the data. The fourth section reports the results, and the last section presents a discussion of the results, limitations, and concluding comments.

BACKGROUND AND RESEARCH HYPOTHESES

The Audit Risk Model

SAS No. 47 (AICPA 1996, AU 312) defines the audit risk model (1) as AR = IR x CR x DR, where audit risk (AR) is the risk that the auditor may unknowingly fail to modify the opinion on materially misstated financial statements; IR is the susceptibility that material misstatements will occur assuming no related internal controls; CR is the risk that material misstatements that could occur will not be prevented or detected on a timely basis by internal controls; and detection risk (DR) is the risk that the auditors' tests will not detect a material misstatement that exists in the financial statements. …

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