Inherent risk is one factor, along with control risk, that an auditor uses to assess the risk of material misstatement associated with a particular financial statement line item or audit area. CPA firms use the assessed level of risk of material misstatement to design the audit procedures applied to the associated accounts.
Inherent risk is considered to be the level of susceptibility to material misstatement that would exist if there were no controls in place. Inherent risk is assessed primarily by the auditor's knowledge and judgment regarding the industry, the types of transactions occurring at a particular company and the assets that the company owns. Usually, an auditor assesses each audit area as either low, medium or high in inherent risk.
Examples of Inherent Risk Factors
For example, financial transactions that require complex calculations are inherently more likely to be misstated than simple calculations. Cash on hand is by nature more susceptible to theft than a large inventory of coal. Rapid technological developments in a particular industry may create a higher risk of inventory becoming obsolete more quickly than in other industries. A company that is struggling financially may inherently have a greater incentive to misstate financial information to meet certain covenants. A company that has improperly reported a particular balance in the past may be inherently more likely to misstate it again. These are the types of factors that auditors consider as they assess inherent risk.
Assessing inherent risk tends to be a more subjective process than other components of the audit. However, there are often clear and observable factors to consider, such as the economy, the industry and previously known misstatements that help the auditor arrive at an assessed level of inherent risk for each audit area.