Inherent Risk in Auditing

Inherent Risk in terms of Auditing

To better understand the concept of inherent risk in auditing, let me first give you a quick demonstration.

When you plan to ascend a mountain, there’s a risk that you’ll fall down. Even if you fully equip yourself, you cannot completely minimize that risk. In the same way, swimming has the risk of drowning. These risks basically lie in the activity itself and all you can do is gear up, watch out and mitigate the risk to an acceptably low level.

For example, if a business has made a significant amount of credit sales in a year. What might be the risk of increasing receivable balances? Some customers not paying back; thus increasing the bad debt balance. Even if the business has an excellent credit system in place, this inherent risk cannot be completely minimized due to the involvement of external factors like the future financial position of customers or the customers intentionally not paying back.

Now that you know what inherent risk is, let’s talk about why would an auditor be interested in assessing the inherent risk in audit engagements.

Why does inherent risk matter?

Auditors perform audit procedures to look out for evidence that supports their opinion of the financial statements. To make the procedures effective, the auditors need to ensure better half of the procedures are performed on processes/operations that have higher chances of misstatements.

To find those hotspots, it’s important for auditors to find out the intensity of inherent risks in major departments of the client. Let’s say if the client has a significant amount of closing stock, there’s an inherent risk of obsoletion!

Once the auditors overview the entire structure & nature of the client, they would have an idea of the inherent risk of the client and structure their procedures accordingly. It also helps them select sample sizes in audit procedures & testings.

To effectively plan & perform the audit procedures, the inherent risk of the client is assessed in the planning stage of the audit. Once the auditors know what they’re dealing with, it’s easier for them to plan and perform the audit engagement.

Factors that drive the inherent risk

Inherent risk arises due to the following major factors:

• When management has to use a substantial amount of judgment and estimation techniques in recording a transaction.
• Involvement of complex financial instruments, that require advanced accounting knowledge to record.
• The way a business conducts its day-to-day operations. The smoother their operations, the lower the inherent risk and vice versa.
• Weak previous audit: In which the auditor has given a biased opinion and intentionally ignored material misstatements.
• Transactions between related parties (ie parent & subsidiary dealings): It has an inherent risk. The entity could understate/overstate the value of the assets for reasons like tax savings, loan requests etc…

Mitigating the Inherent Risk

Inherent risk lies purely in activities and the company cannot be blamed for its existence. However, the company can reduce it by implementing tight internal control strategies. Having a robust internal control system will decrease the inherent risk to a minimum. So, how does it work?

Let’s say company A has employed Internee Accountants to deal with accounting transactions and their work is not reviewed by senior accountants. On the other hand, company B’s senior accountants review the work of their internees and correct errors & omissions timely. You guessed it right! Company A has a much higher inherent risk as compared to company B.

In the same way, the auditor will assess the controls implemented by the client for different departments and processes during the planning stage of the audit. If the client has weaker controls in place, that would mean higher inherent risk and the auditor would want to investigate the area thoroughly by performing more procedures and keeping bigger sample sizes.