CPA Exam — AUDAssessing Risk and Developing a Planned ResponseMedium
During the planning phase of an audit, an auditor identifies that a client, a pharmaceutical company, is highly dependent on a single, expiring patent for its primary revenue-generating drug. The auditor also notes that significant research and development (R&D) expenditures for new drug candidates have not yet yielded commercially viable products. This situation most likely increases the auditor's assessment of:
- ADetection risk
- BSampling risk
- CInherent risk
- DControl risk
Show answer & explanationAnswer & explanation
Correct answer: C. Inherent risk
The client's high dependency on an expiring patent and unproven R&D pipeline inherently increases the susceptibility of the financial statements to material misstatement, independent of internal controls. This directly relates to inherent risk.
Why the other options are wrong
- A. Detection risk relates to the auditor's procedures failing to detect misstatements, not the client's business environment.
- B. Sampling risk arises from the possibility that the auditor's conclusion based on a sample may be different from the conclusion if the entire population were subjected to the same audit procedure.
- D. Control risk is the risk that a client's internal controls will not prevent or detect a material misstatement.
Inherent Risk Factors
Inherent risk is the susceptibility of an assertion about a class of transaction, account balance, or disclosure to a material misstatement, assuming there are no related controls.
- Exists independently of the audit.
- Affected by business characteristics, industry, and complexity.
- Higher for complex transactions, estimates, or new business lines.
Memory trick: Inherent risks are 'baked in' to the business before controls even start.