explain why inherent risk is set for audit objectives for segments (classes of transactions, balances, and presentation and disclosure) rather than for the overall audit. What is the effect on the amount of evidence the auditor must accumulate when inherent risk changes from medium to high for an audit objective? Provide examples to illustrate your answer.
Inherent risk is the susceptibility of financial statements to material misstatements before considering the effectiveness of internal controls. It is set for audit objectives for segments rather than the overall audit because inherent risk can vary across different areas of an organization's financial statements.
By setting inherent risk at the objective level, auditors are able to focus their attention on specific areas where there is a higher likelihood of material misstatements. This allows for a more targeted and efficient approach to gathering audit evidence.
When inherent risk changes from medium to high for an audit objective, it means that there is an increased likelihood of material misstatements in that specific area. As a result, the auditor must accumulate a greater amount of evidence to address this increased risk.
For example, let's consider the balance sheet audit objective of "valuation and existence of inventory." If the inherent risk is initially assessed as medium, the auditor may plan to perform substantive procedures such as physical inventory counts and revaluation testing. However, if inherent risk for this objective changes to high, the auditor may need to perform additional procedures such as engaging external experts to provide a valuation opinion or conducting more detailed testing of inventory records.
Similarly, for the presentation and disclosure objective of "proper classification of revenue," if the inherent risk is initially assessed as medium, the auditor may plan to perform analytical procedures and review supporting documentation. But if inherent risk for this objective changes to high, the auditor may need to perform more extensive procedures such as inspecting contracts, verifying the accuracy of revenue recognition criteria, and reviewing the appropriateness of revenue disclosures in the financial statements.
In both examples, the increase in inherent risk from medium to high would require the auditor to gather more evidence through additional procedures to ensure the accuracy and reliability of the financial statements in those specific areas.