Inherent Risk: Recognizing the Nature of a Client’s Business
One component of audit risk is inherent risk. The term refers to the likelihood that you’ll arrive at an inaccurate audit conclusion based on the nature of the client’s business. While assessing this level of risk, you ignore whether the client has internal controls in place (such as a well-documented procedures manual) 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 here is to evaluate how susceptible the financial statement assertions are to material misstatement given the nature of the client’s business.
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. For example, any business that manufactures computer or video games has inherent risk because its products become obsolete very quickly. No matter how recent your computer purchase, you can rest assured that the release of a quicker and smaller version with a better operating system is just around the corner.
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.
This increased competition may sharply reduce the company’s future earnings and sales, raising the issue of going concern (whether the company can continue operating for at least one more year beyond the date of the balance sheet). In addition to lower future sales, the patent expiration increases the potential for excess inventory, which may become obsolete as the expiration dates of the inventoried drugs come due.
State of the economy: The general level of economic growth is another external factor affecting all businesses. Is the company operating in a recession or a growth period? You can certainly make this evaluation during your pre-planning activity. If the economy is bad and employment is low, a trickledown effect hurts most areas of commerce, even demand for basic needs such as food, housing, and medical care.
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.
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 whether you need to ask the client to adjust the accounting records for the total misstatement.
Here’s an example: Suppose you’re in charge of auditing the client’s accounts receivable balance. Going through prior-period workpapers, you note accounts receivable was understated by $20,000 and not corrected because your firm determined any misstatement under $40,000 was immaterial. In the current period, you determine accounts receivable is overstated by $30,000. The same $40,000 benchmark for materiality is in place. Do you have a material misstatement?
The answer is yes. Standing alone, neither the $20,000 from last year nor the $30,000 from this year is over the $40,000 limit. However, adding the two misstatements together gives you $50,000, which is in excess of the tolerable level of misstatement.
You add the two figures together in this example because the difference was understated in one year and overstated in the next. If the differences had been in the same direction, you would have subtracted one from the other.
So if the prior year had been overstated by $20,000 instead of understated, the aggregate of your differences would be $10,000 ($30,000 – $20,000), which is well under the tolerable limit of $40,000, and so the misstatement wouldn’t be material.
You may think an understatement in one year compensates for an overstatement in another year. In auditing, this assumption isn’t true. Here’s a real-life auditing example that explains why:
Suppose you’re running the register at a local clothing store. Your ending cash register draw count is supposed to be $100. One night your register comes up $20 short, a material difference. The next week, you somehow come up $20 over your draw count. That’s good news, right? Well, yes and no.
Although your manager is happy to hear that the store didn’t actually lose $20, he doesn’t buy into the notion that the second mistake erases the first. As he sees it, you made two material mistakes. 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.
Additionally, the fact that the two mistakes counterbalance each other doesn’t negate the fact that a material misstatement of your register count occurred on two different occasions, indicating a significant recurring breakdown in controls.
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 are 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).