16/12/2019 Examples of Inherent Risk

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Examples of Inherent Risk

BY INVESTOPEDIA | Updated Feb 17, 2019

In financial and managerial accounting, inherent risk is defined as the possibility of incorrect
or misleading information in accounting statements resulting from something other than the
failure of controls. Incidents of inherent risk are most common where accountants have to
use a larger than normal amount of judgment and approximation, or where complex
financial instruments are involved. It is often present when a company releases forward-
looking financial statements. 

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Types of Audit Risk

To understand inherent risk, it helps to place it within the context of audit risk analysis. Audit
risk is the risk of error while performing an audit, and it traditionally is broken into three
distinct types.

1. Control risk: Control risk occurs when a financial misstatement results from lack of
proper accounting controls in the firm. This is most likely to surface in the form of fraud or
lazy accounting practices.

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2. Detection risk: It's also possible that auditors simply fail to detect an otherwise easy-to-
notice error in the financial accounts. This is known as detection risk. Normally, detection
risk is countered by increasing the number of sampled transactions during testing.
3. Inherent risk: Considered the most pernicious of the major audit risk components,
inherent risk can't be easily avoided through increased auditor training or creating
controls in the auditing process. Nevertheless, it is one of the risks auditors and analysts
must look for when reviewing financial statements, along with control risk and detection
risk.

Common Examples of Inherent Risk

Inherent risk is common in the financial services sector. The reasons include the complexity
of regulating financial institutions (the large and ever-changing amount of rules and
regulations), the large networks of related companies, and the development of derivative
products and other intricate instruments which require complicated calculations to assess.

Financial institutions often have longstanding and complicated relationships with multiple
parties. A holding company might be involved with several different entities at once, each
controlling special-purpose vehicles and other off-balance sheet entities. Each
organizational structure level might have large numbers of investor and client relationships.
Related parties are notoriously less transparent than separate entities, too.

Business relationships include those with auditors; both initial and repeat engagements with
auditors create some inherent risk. Initial auditors might be overwhelmed by complexity or
new topics. Repeat engagement may cause overconfidence or laxity due to personal
relationships.

Non-routine accounts or transactions can present some inherent risk. For example,
accounting for fire damage or acquiring another company is uncommon enough that
auditors run the risk of focusing too much or too little on the unique event.

Inherent risk is particularly prevalent for accounts that require a lot of guesstimates,
approximations, or value judgments by management. Fair value accounting estimates are
difficult to make, and the nature of the fair value process should be disclosed in accounting
statements. Auditors may have to investigate and interview the firm's decision-makers about
estimation techniques to reduce error. This type of risk is magnified whether it occurs rarely
or for the first time.

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Related Terms
Inherent Risk Definition
The risk posed by an error or omission in a financial statement due to a factor other than a failure of
control. more

Detection Risk Definition

Detection risk is the chance that an auditor will fail to find material misstatements that exist in an
entity's financial statements. more

What is an Audit?
An audit is an unbiased examination and evaluation of the financial statements of an organization.
more

Auditor's Report
The auditor's report contains the auditor's opinion on whether a company's financial statements
comply with accounting standards. more

Transfer Price Definition

Transfer price is the price at which related parties transact with each other, such as during the trade of
supplies or labor between departments. more

A Forensic Audit Could Easily Detect a Padded Expense Report.

A forensic audit is an examination of a firm's or individual's finances to derive evidence that can be
used in a court of law or legal proceeding. more

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