How to Assess Inherent Risk in an Audit
Auditors must determine risks when working with clients. One type of risk to be aware of is inherent risk. While assessing this level of risk, you ignore whether the client has internal controls in place (such as a secondary review of financial statements) in order to help mitigate the inherent risk. You consider the strength of the internal controls when assessing the client’s control risk. Your job when assessing inherent risk is to evaluate how susceptible the financial statement assertions are to material misstatement given the nature of the client’s business. A few key factors can increase inherent risk.
Environment and external factors: Here are some examples of environment and external factors that can lead to high inherent risk:
Rapid change: A business whose inventory becomes obsolete quickly experiences high inherent risk.
Expiring patents: Any business in the pharmaceutical industry also has inherently risky environment and external factors. Drug patents eventually expire, which means the company faces competition from other manufacturers marketing the same drug under a generic label.
State of the economy: The general level of economic growth is another external factor affecting all businesses.
Availability of financing: Another external factor is interest rates and the associated availability of financing. If your client is having problems meeting its short-term cash payments, available loans with low interest rates may mean the difference between your client staying in business or having to close its doors.
Prior-period misstatements: If a company has made mistakes in prior years that weren’t material (meaning they weren’t significant enough to have to change), those errors still exist in the financial statements. You have to aggregate prior-period misstatements with current year misstatements to see if you need to ask the client to adjust the account for the total misstatement.
You may think an understatement in one year compensates for an overstatement in another year. In auditing, this assumption isn’t true. Say you work a cash register and one night the register comes up $20 short. The next week, you somehow came up $20 over my draw count. The $20 differences are added together to represent the total amount of your mistakes which is $40 and not zero. Zero would indicate no mistakes at all had occurred.
Susceptibility to theft or fraud: If a certain asset is susceptible to theft or fraud, the account or balance level may be considered inherently risky. For example, if a client has a lot of customers who pay in cash, the balance sheet cash account is going to have risk associated with theft or fraud because of the fact that cash is more easily diverted than customer checks or credit card payments.
Looking at industry statistics relating to inventory theft, you may also decide to consider the inventory account as inherently risky. Small inventory items can further increase the risk of this account valuation being incorrect because those items are easier to conceal (and therefore easier to steal).
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
