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).