Controls and Substantive Testing

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. Inherent risk will not be reduced by internal control. 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, yet the financial statements may be materially misstated due to circumstances outside the control of the firm. For example, a customer, on the verge of bankruptcy, has an outstanding Accounts Receivable that is unlikely to be collected. 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. Describe the relationship between tests of controls and substantive testing.

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