Inherent risk reflects the level of vulnerability of a financial statement to error or fraud prior to the existence of internal controls.
In the world of auditing, risk is one aspect that must be carefully taken into account. One of the main types of risk in an audit is inherent risk.
This risk is a risk inherent in an audit object prior to the existence of internal controls or other mitigation measures. Understanding the inherent risks is essential to help auditor. in assessing the overall level of risk of a process or enterprise.
In this article, we will discuss in depth about inherent risk, starting from its definition, examples, ways of measuring, to the difference with residual risk.
What is inherent risk?
Inherent risk is the possibility of error or fraud in a financial statement or system prior to the existence of internal controls or other mitigation measures. This risk can arise due to external or internal factors that affect the business or audit process.
Some factors that can increase this risk in audits include:
- Transaction complexity – The more complex the financial transactions of an enterprise, the greater its inherent risk.
- Regulatory changes - Changes in accounting or taxation rules may increase this risk.
- Technology and Information Systems – Sistem IT less secure or not up-to-date can lead to higher risks.
- Human factor - Human error or even bad faith in financial reporting can magnify this risk.
Examples of inherent risks in auditing
To understand more deeply, here are some examples of these risks in auditing:
- Companies with complex derivative transactions
Companies that frequently transact with complex financial instruments such as derivatives have a high inherent risk due to the possibility of listing errors or difficult valuations. - Industries with high regulatory change
For example, companies in the financial or insurance sectors often face regulatory changes that could increase these risks in their financial reporting. - Lack of employee experience in accounting
If the staff in charge of the bookkeeping lacks a solid understanding of accounting, the risk will be higher due to the possibility of errors in the recording of transactions.
How To Measure Inherent Risk
Measuring this risk is not an easy task, but there are several commonly used approaches:
1. Qualitative Analysis
- The Auditor assesses risk based on experience, industry insight, and understanding of the client's operations.
- Example: assess whether the company has a history of financial statement errors in the past.
2. Quantitative Analysis
- Using historical data to measure the probability of error or fraud.
- Example: calculate the error ratio in the financial statements of previous years.
3. Risk-Based Approach (Risk-Based Approach)
- Auditors allocate more resources to areas with higher levels of risk.
- Example: a company that experiences frequent audits with material findings will get more attention in the audit process.
See also: Audit Risk: definition, types, examples and how to determine
Difference between inherent risk and Residual risk
Many people often confuse the term inherent risks and residual risk. Here are the differences:
| Aspect | Inherent Risks | Residual Risk |
|---|---|---|
| Definition | Risks that existed before the existence of internal control | Risks remaining after the implementation of internal controls |
| Causes | Natural factors in business, transaction complexity, regulation | Weakness or ineffectiveness of internal control |
| Impact | May cause errors or fraud before mitigation | Errors or fraud that are still possible after mitigation |
| Example of | Error recording of complex derivative transactions | Errors that occur even though the company has a rechecking system |
In auditing, the main purpose of internal control is to suppress inherent risk so that only minimal residual risk remains.
See also: Risk management: definition, objectives and stages
Need a more accurate Audit solution?
Inherent risk is an important element in an audit that reflects the level of vulnerability of a financial statement to errors or fraud before the existence of internal controls.
The Auditor must understand the factors that affect inherent risk, how to measure it, and distinguish it from residual risk in order to provide more accurate recommendations in the audit process.
By understanding these risk concepts, companies can be more proactive in identifying and managing these risks early on, thus minimizing the possibility of errors or fraud occurring in their financial statements.
If you want to improve audit effectiveness and manage risk better, Audithink comes with a technology-based internal audit solution. Contact us via Audithink for more information!
