Inherent audit risks are the risks that the material misstatements could happen in financial statements due to other reasons rather than the failure of internal control over financial reporting as well as detection risks. Many reasons lead to increased inherent risks in the audit of financial statements.
Those include the complexity of elements being reported in financial statements while those elements involved many justification and adjustments from the management of the company.
The high degree of involvement from management could increase the inherent risks and subsequently lead to material misstatements due to the leak of experiences on dealing with complexity element being evaluated or managements’ intention.
There are many other factors that auditors need to pay serious attention to when assessing or dealing with inherent risks. In other words, auditors should consider reviewing or modifying the current auditor procedures to ensure that the detection risk is as low as possible so that the inherent risk and audit risk are subsequently decreased to the acceptable level.
The following are the detailed explanation and examples:
As we mentioned above, inherent risks are the risks that the financial statements could contain material misstatements on an account or group of accounts that are pervasive in financial statements.
Inherent risks cause by external factors rather than internal factors. There are examples:
- Judgment: If the elements of financial statements involve a high judgment or justification from management, the degree of incorrect judgments is likely to increases. This is because of inexperience or intention from the involved management.
- Estimates: There are larges or significant accounting estimated in the financial statements may increase the inherent risks. The auditor needs to make sure that the accounting estimate complies with the accounting principles and accounting standards.
- The complexity of the business might affect certain items in the financial statements. For example, complex contracts with many different kinds of terms and conditions as well as variability.
- A rapid change of business could make certain financial assets or financial liability obsolete. These changes increase the inherent risks and critical assessment is required.
Inherent Risk Assessment:
Normally, the auditor performs a risk assessment on the financial statements that they are auditing. This usually happens at the planning stage of financial statements auditing. Audit risks need to be assessed, identified, and managed.
Three major audits risks are normally assessed and calculated. Inherent Risk is one out of three including control risks and detection risks.
As mentioned above, most of the factors that affect the inherent risks are from external factors rather than internal factors.
Therefore, when assessing the inherent risks that could materially affect the entity’s financial statements, auditors should assess how those factors could affect the entity’s financial statements.
The assessments should also be depending on the experiences and expertise of the industry that auditors have.
If the entity being audited is in a complex environment or fast-changing, then expert auditors in those industries should be part of the team. These could decrease the audit risks by decreasing detection risks.
It is important to understand that assessing inherent risks is a subjective process. This is due to each entity may have completely different external factors.
However, the best approach to perform this assessment is to take a look at the external environments that could potentially affect the quality of financial statements.