Distinguish between inherent risk and control risk. How do internal controls and detection risk fit in?

Answer 1

Inherent risk is associated with the unique characteristics of the business or industry of the client. Firms in declining industries are considered to have more inherent risk than firms in stable or thriving industries. Control risk is the likelihood that the control structure is flawed because internal controls are either absent or inadequate to prevent or detect errors in the accounts. Internal controls may be present in firms with inherent risk, yet the financial statements may be materially misstated due to circumstances outside the control of the firm, such as a customer with unpaid bills on the verge of bankruptcy. Detection risk is the risk that auditors are willing to accept that errors are not detected or prevented by the control structure. Typically, detection risk will be lower for firms with higher inherent risk and control risk.