Definition: Inherent risk is the probability that an omission or misstatement will exist in the financial statements due to uncontrollable factors and will not be caught in the audit.
What Does Inherent Risk Mean?
What is the definition of inherent risk? Financial auditing incurs inherent risk, especially when dealing with complex transactions that require a higher degree of attention in financial estimates. For instance, inherent risk when auditing a financial institution with extreme exposure in sophisticated derivative instruments is considerably higher than auditing a manufacturing company in a relatively stable business environment.
Although it can be confused to control risk, inherent risk does not account for the factors that pertain to lack of control, but to the risk that a transaction would incur if no control is applied. Hence, inherent risk provides an indication of the worst-case scenario, in case all controls fail.
Let’s look at an example.
Example
Jonathan represents an auditing firm, and he is asked to audit the financial statements of company ABC, a leading pharmaceutical firm with an extended network of subsidiaries abroad. While performing the audit, Jonathan needs to consider the following external factors that could increase the company’s inherent risk to more than 10%:
Volatile environment: the general level of economic growth in the foreign subsidiaries is volatile as a result of the global financial crisis. The company’s sales in Europe have declined by 6% on average.
Inventory: the company keeps a relatively high level of inventory, which poses a threat of experiencing a high inherent risk.
Interest rates: the level of interest rates is important because it determines the easiness that a firm can finance its operations or not. For example, if a company is facing problems in meeting its short-term liabilities and is in need of a loan, it would be difficult to obtain a line of credit when the interest rates are low. Therefore, it may even default on its obligations and go out of business.
Patents: Pharmaceutical firms incur an inherent risk associated with their expiring patents. When a drug patent is approaching to expiry, the pharmaceutical firm will face high competition from peer companies that will try to market the same drug under a generic label to lower the cost.
All in all, the inherent risk in auditing depends on the type of company and the industry it operates. However, it largely exists in all industries, especially in the highly-regularized sectors with a wide network of subsidies and associate firms.
Summary Definition
Define Inherent Risk: Inherent risk means the chance that auditors will not detect an error in the financial statements.
