After identifying the significant accounts, transactions, and assertions for the payroll cycle, the auditor should assess the risk of material misstatement.

The risk of material misstatement is a function of both inherent risk and control risk.

Risk of Material Misstatement = Inherent Risk × Control Risk

Inherent risk is the risk a material misstatement will occur in the absence of internal controls.

Inherent risk is high for payroll accounts and transactions when:
• The company has significant amounts of executive compensation
• The company has significant amounts of sharebased compensation
• The company has high employee turnover
• The company has labor contracts with unions

Control risk is the risk a material misstatement would not be prevented or detected by the client’s internal controls.

Assuming the auditor plans to rely on the client’s internal controls, there are 3 steps for setting control risk:
1. Understand and document the internal control process
2. Plan and perform tests of controls on payroll transactions
3. Set the achieved level of control risk

Once the auditor knows both the inherent risk and the control risk for payroll transactions, the auditor can determine the risk of material misstatement (RMM), which is the risk that a material misstatement will occur and not be prevented or detected by the client’s internal controls.

You could also think of RMM as the risk that a material misstatement exists prior to the auditors doing their work. A high RMM means the auditors will need to set detection risk lower to achieve an acceptable level of audit risk.

Audit Risk = Risk of Material Misstatement × Detection Risk

0:00 Introduction
0:32 Inherent risk
3:06 Control risk
6:35 Risk of material misstatement
7:52 Detection risk
8:10 PDF guide
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