The Audit Risk Model under the Risk of Fraud

In this article, we derive an audit risk formula for a simple situation. This formula closely resembles the SAS 47 model when we assume that no material misstatement due to fraud exists. A simple case illustrates how the risk of material misstatement due to management fraud impacts audit risk and how performing special audit procedures to detect such irregularities can decrease overall audit risk. While SAS 53 requires auditors to assess the risk of errors and irregularities and plan the audit to provide reasonable assurance of detecting errors and irregularities, the audit risk model of SAS 47 does not directly address the risk of management fraud. This article develops an audit risk model using the belief-function framework that considers the risks faced by auditors due to random errors, defalcations (employee fraud) and management fraud. We consider two cases. In the first, we consider only affirmative items of evidence and derive an analytical formula for the audit risk. In the second, we consider mixed items of evidence (both affirmative and negative), which models the situation more frequently faced by auditors. We demonstrate that a serious underestimation of audit risk can occur if the audit risk model is used without specifically considering the risks associated with management fraud.