What is an Inherent Risk?
In terms of auditing, inherent risk is the risk that some part of a company's accounting process will be faulty or incorrect. This risk is separate from control risk, which is affected by the secondary controls placed on the accounting process by the company. Inherent risk may occur because of human factors like the potential misconduct of employees or unintentional errors made in accounting practices. Also factoring into such risk is the nature of the business in question and the types of accounts being measured.
Auditors in charge of making assessments of the financial practices of a company are concerned with the potential for mistakes in accounting efforts. These mistakes can obviously be extremely detrimental to the overall standing of the company. The company can be affected financially by any tax penalties, and it can be affected through the mistrust false accounting breeds in customers and investors. For these reasons, auditors make an assessment of the inherent risk involved with a company's financial practices at the start of the auditing process.
Inherent risk is the type of risk that is impossible to avoid for any large business. Auditors usually make conservative assessments of such risk because it is impossible to precisely predict how much exists. By contrast, a control risk can be safely assessed by an auditor. Ideally, a company can reduce overall risk to virtually nothing by including internal controls on all accounting practices. Absent of these controls, the control risk would be set at 100 percent, even though it isn't realistic to think that all of the financial practices would be faulty.
Determining inherent risk is often a subjective process for auditors, as it often depends on the reliability of the employees in charge of finances at the company. An auditor must make an assessment on whether these employees can be trusted to deliver proper financial reports. Their reliability can be compromised by time constraints, pressure from upper management to deliver positive results, or even simple ineptitude.
The amount of inherent risk involved with a company's accounting also depends on exactly what kind of business it is and how its wealth is measured. For example, if a company has a majority of its wealth in cash holdings, this would be hard to misrepresent, and the risk would be relatively low. On the other hand, a company whose wealth depends on imprecise holdings like accounts receivable or stock valuations might be more likely to misrepresent such wealth.
I hope that there is an actual auditor on here somewhere that can explain this concept a little better. It seems like an impossible task, planning for the unknown.
The article mentions that this is a very subjective process. It seems like a lot of it comes down to character judgements. Do the people in charge seem honest and capable? Auditors would need to be judges of character as well as figures. Maybe they even have some psychological training. I'm sure this is a difficult process.
Does anyone on here have any experience measuring inherent risk? How much of a science is this? What are the consequences of mistakes?
@indemnifyme - I don't understand why they don't just use their numbers from past audits. The whole point of an audit is to point out possible weaknesses or mistakes in your accounting. So if you know how incorrect you were the last time around, doesn't it stand to reason your degree of incorrectness will be similar the next time?
I'm surprised there aren't some sort of calculations to determine inherent risk. I know in the insurance industry there are underwriters who decide what is an acceptable risk for the company to take on in terms of customers. They use statistics and calculations to determine these conclusions so I wonder if the same thing could be done in accounting.
Inherent risk seems like a fancy way of saying something that most people already know, which is that people make istakes and no accounting is perfect. The concept of inherent risk seems like it could be applied to almost any project. When you are building something, no matter how careful you and your crew are, there is the very real possibility that something will go wrong or a mistake will be overlooked. If you run a restaurant it is inevitable that something will get burned up in the oven. people are imperfect and mistakes are inevitable. That is just the way that life works
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