Control Risk

Control RiskControl risk is the risk that a material misstatement would not be prevented, detected or corrected by the accounting and internal control systems.

Control risk has been defined under International Standards on Auditing (ISA) as following:

“The risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.”

In simple-swords control risk is the probability that a material misstatement exists in an assertion because that misstatement was not either prevented from entering entity’s financial information or it was not detected and corrected by the internal control system of the entity.

Assessment of Control Risk

Assessment of control risk is a measure of the auditor’s expectation that internal controls will neither prevent material misstatements from occurring nor detect and correct them if they have occurred; control risk is assessed for each transaction-related audit objective in a cycle or class of transactions.

After obtaining an understanding of internal control, the auditor makes an initial assessment of control risk.

Assessment of control risk is the process of evaluating the effectiveness of the design and operation of an entity’s internal control structure policies and procedures in preventing or detecting material misstatements in the financial statements.

Control risk assessments are made for individual financial statements assertions of the internal control structure as a whole.

Steps for Assessing Control Risk

Following are the steps are taken by the auditor for assessing control risk:

Step#1: Consider knowledge acquired front procedures to obtain an understanding

The auditor performs procedures to obtain, an understanding of relevant internal control structure policies and procedures for significant financial statements assertions. He/she documents the understanding in the form of completed internal control questionnaires, flowcharts, and narrative memoranda.

For policies and procedures relevant to particular assertions, the auditor carefully considers the Yes, No, and N/A responses and written comments in the questionnaires and the strengths and weaknesses noted in the flowcharts and narrative memoranda.

Analysis of this documentation is the starting point for assessing control risk.

Step#2: Identify potential misstatements

Most audit firms have developed checklists that enumerate the types of potential misstatements that could occur in specific assertions. And some audit firms use computer software for this purpose.

Using either the checklists or the computer software aid and his/her understanding of the entity’s internal control structure, the auditor identifies the potential misstatements applicable to specific assertions given the entity’s circumstances.

Potential misstatements may be identified for assertions about each major class of transactions and assertions about each significant account balance.

Step#3: Identify necessary controls

Whether by using computer software that processes internal control questionnaire responses or manually by using checklists, auditors can identify necessary controls that could likely prevent or detect specific potential misstatements.

In some cases, several controls may pertain to a given potential misstatement. In other cases, a single control may apply.

Also, a single control may pertain to more than one type of potential misstatement. Specifying necessary controls also requires consideration of circumstances and judgment.

Thus, .the auditor must assimilate information about a wide variety of possible control policies and procedures related to any of the ICS components in considering the risk of potential misstatements in particular assertions.

Step#4: Perform tests of controls

In determining the tests to be performed, the auditor considers the types of evidence that will be provided and the cost of performing the test.

The tests include selecting a sample and inspecting related documents, inquiring of client personnel, observing client personnel performing control procedures, and the auditor’s re-performance of certain controls.

The results of each-test of controls should provide evidence about the effectiveness of the design and/or operation of the related necessary control.

Once the tests to be performed have teen selected, it is customary for the auditor to prepare a formal written audit program for the planned tests of controls.

Step#5: Evaluate evidence and make an assessment

The final assessment of control risk for a financial statement assertion is based on evaluating the evidence gained from

  1. procedures to obtain an understanding of relevant, internal control structure policies and procedures, and
  2. related tests of controls.

Based on the nature of the procedures performed, the information obtained might be in the form of any combination of documentary, electronic, mathematical, oral, or physical evidence.

When different types of evidence support the same conclusion about the effectiveness of control, the degree of assurance increases.

Conversely, when they support different conclusions, the degree of assurance decreases.

Additional Considerations in Assessing Control Risk

The auditor typically first assesses control risk for assertions about transaction classes such as cash receipts and cash disbursements.

These assessments are then used in assessing control risk for significant account balance assertions so that the appropriateness of the planned level of substantive tests for the account balances can be determined and specific substantive tests can be designed.

This process is considered next, first for accounts affected by a single transaction class and then for accounts affected by multiple transaction classes.

1. Accounts Affected by a Single Transaction Class

The process of assessing control risk for account balance assertions is straightforward for accounts that are affected by a single transaction class.

For example, sales are increased by credits for sales transactions in the revenue cycle, and many expense accounts are increased by debits for purchases transactions in the expenditure cycle.

In these cases, the auditor’s control risk assessment for each account balance assertion is the same as the control risk assessment for the same transaction class assertion.

For example, the control risk assessment for the existence or occurrence assertion for the sales account balance should be the same as the control risk assessment for the existence or occurrence assertion for transactions.

Similarly, the control risk assessment for the valuation or allocation assertion for many expenses should be the same as for the valuation or allocation assertion for purchase transactions.

2. Accounts Affected by Multiple Transaction Classes

Many balance sheet accounts are significantly affected by more than one transaction class.

For example, the cash balance is increased by cash receipts transaction in the revenue cycle and decreased by cash disbursement transactions in the expenditure cycle.

In these cases, assessing control risk for an account balance assertion requires consideration of the relevant control risk assessments for each transaction class that significantly affects the balance.

Thus, the control risk assessment for the valuation or allocation assertion for the cash balance is based on the control risk assessments for the valuation or allocation assertions for both cash receipts and cash disbursement transactions.