The Audit Risk Model, the Signal Detection Theory, and the Information Manipulation Theory

Abstract

The Audit Risk Model. The Statement of Auditing Standard (SAS) 99, 107, and International Standards on Auditing (ISA) 240, 315, and 330 require auditors to assess fraud risk factors and materiality level (risk of material misstatement) in a client's financial statements (Bhattacharjee, Maletta, & Moreno, 2016). It further requires auditors to gather sufficient appropriate audit evidences in order to provide reasonable assurance whether the client's financial statements are free of material misstatements (Bhattacharjee, Maletta, & Moreno, 2016). The auditors have to assess the effectiveness of a client’s internal control over the financial reporting, thereby plan the nature, timing, and the extent of their audit procedures to assess the fraud risk in a client's financial statements (Burton, Wilks, & Zimbelman, 2013). The SAS 107 provides a model for audit risk, in which, audit risk (AR) = inherent risk (IR) X control risk (CR) X detection risk (DR). The inherent risk is the susceptibility for an account or assertion to be materially misstated, whereas the control risk is the risk that an entity's internal controls fail to detect financial reporting misstatement. The detection risk is the risk that substantive and analytical audit procedures fail to detect misstatements in the financial reporting. However, this model does not address the influence of sociological, organizational, and ethical factors on the management fraud and does not account for type I and type II audit errors risk, which is the risk to reject fairly presented financial reporting (false negative), and the risk to accept fraudulent audit report (false positive) respectively.