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 share-based 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 …
