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What is inherent risk?

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Last editedDec 20202 min read

Where there's a possibility of misleading or incorrect information in accounting statements due to factors other than control factors, we say there's an inherent risk. This is a situation where the risk cannot possibly arise as a result of a default in controls, but rather some other factors. Keep reading to gain more insight into the meaning of inherent risk and implications for financial accounting. 

Introduction to Inherent Risk 

Inherent risk may be defined as the risk of an error, omission or misleading information in a financial statement arising from such factors other than a failure of controls. Inherent risk is common in cases involving complex financial instruments or where an accountant has to apply an unusually high degree of approximation or judgement. 

Notable examples of inherent risk can be found in the complex financial transactions made prior to the 2007 financial crisis. These transactions were so complex that even the best finance professionals couldn't crack them. For example, securities such as tranches, which carry varying degrees of risk, yields and maturities, were repackaged several times, making it difficult to audit each tranche. 

The degree of inherent risk varies with factors such as regulatory protocols, level of experience in that business and exposure to complex derivatives. Derivatives, in particular, are naturally complex and hard to value because their value depends on a given underlying asset. So for a company that’s just starting out in a heavily regulated sector like finance and is exposed to complicated instruments like derivatives, inherent risk will be significantly high. But this won't be the case for an established manufacturing company that is run in a stable environment. 

Relationship Between Inherent Risk and Other Audit Risks

Understanding the various audit risks is relevant to knowing how to determine inherent risk. Audit risks exist in three forms: inherent risk, control risk and detection risk. 

Unlike inherent risk, control risk arises in cases where a financial misstatement is caused by a defect in accounting protocols. It is often due to a lack of due diligence in accounting practices or fraud. 

Detection risk is the possibility that auditors are unable to detect a noticeable error in accounts. It is typically reduced when sampled transactions are increased during testing. This is unlike inherent risk, as no amount of sampled transactions can reduce the possibility of inherent risk.

It is worth noting, however, that a detection risk can be set to a lower level where inherent and control risks are high. This is made possible by increasing sample size for testing, and the end goal is to keep the overall audit risk at a reasonable level. 

Factors affecting inherent risks in auditing 

Inherent risks may result from the following factors:

Complexities involved in the sector 

Financial services, for instance, are heavily regulated, the rules are constantly changing, several other companies are involved, and not to mention the complex instruments requiring tough calculations. These factors increase the likelihood of inherent risk.

A network of complicated relationships 

Where a company is involved with several entities controlling diverse aspects of their company, inherent risk is typically high. What's more, separate entities tend to be more transparent than related entities, so this is a significant factor too.

Business' relationship with auditor

Initial relationships with auditors pose as much inherent risk as repeat relationships. New topics or complexities may overwhelm initial auditors, while repeat auditors may become lax or overconfident due to a longstanding supplier-business relationship.

Non-routine accounts 

Non-routine accounts involving an acquisition or a fire damage are quite uncommon. So, inherent risk increases as this type of accounts puts auditors at the risk of misdirecting their focus on material facts. 

Cases involving lots of approximations

Inherent risk is significantly higher for accounts requiring value judgements, approximations and guesstimates. To ascertain and reduce the resulting error, auditors investigate the management about techniques applied in estimation. 

In all, these factors help to demonstrate that far from a failure of controls, inherent risk results most significantly from external factors.

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