The Audit Risk Model, Business Risk, and Audit Planning Decisions

Abstract

This study identifies conditions under which the audit risk model does, and does not, describe audit planning (investment and pricing) decisions. In an experiment, audit partners and managers examined one of two cases where a material misstatement ? error or irregularity ? was discovered. The auditors assessed the elements of the audit risk model, assessed business risk, and provided recommendations for the audit investment and fee. When the likelihood of an error was high, the audit risk model dominated business risk in the explanation of the audit investment, and the fee did not contain a risk premium. When the likelihood of an irregularity was high, the results were reversed. Business risk dominated the audit risk model in the explanation of the audit investment, and the fee contained a risk premium. These results suggest that both the ability of the audit risk model to describe auditor behavior and the inclination of auditors to charge a risk premium depend upon the nature of the risks present in the audit. In the presence of errors, the audit risk model adequately described audit-planning decisions; in the presence of irregularities it did not.

JEL Classification: M40, M49