What is Inherent Risk
Inherent risk is the risk posed by an error or omission in a financial statement due to a factor other than a failure of control. In a financial audit, inherent risk is most likely to occur when transactions are complex, or in situations that require a high degree of judgment in regard to financial estimates. This type of risk represents a worst-case scenario because all controls in place have nonetheless failed.
Inherent risk is one of the risks auditors and analysts must look for when reviewing financial statements, along with control risk and detection risk. When conducting an audit or analyzing a business, the auditor or analyst tries to gain an understanding of the nature of the business while examining control risks and inherent risks. If inherent and control risks are considered to be high, an auditor can set the detection risk to a lower level to keep the overall audit risk at a reasonable level.
BREAKING DOWN Inherent Risk
The Underlying Reasons for Inherent Risk
Companies operating in highly regulated sectors, such as the financial sector, are more likely to have higher inherent risk, especially if the company does not have an internal audit department or has an audit department without an oversight committee with a financial background. The ultimate risk posed to the company also depends on the financial exposure created by the inherent risk if the process for accounting for the exposure fails.
Complex financial transactions, such as those undertaken in the years leading up to the financial crisis of 2007-2008, can be difficult for even the most intelligent financial professionals to understand. Asset-backed securities, such as collateralized debt obligations (CDOs), became difficult to account for as tranches of varying qualities were repackaged again and again. This complexity may make it difficult for an auditor to make the correct opinion, which in turn can lead investors to consider a company to be more, or less, financially stable than in actuality.
An Example of Inherent Risk
Inherent risk is often present when a company releases forward-looking financial statements, either to internal investors or the public as a whole. For example, BlackPearl Resources Inc., an oil and gas company based in Alberta, Canada, conducted a semiannual review of its credit facilities on July 12, 2016, which included the release of forward-looking financial performance.
These forward statements included information on future funds from operations, capital spending, expected debt levels and anticipated oil hedging for 2017. The report openly pointed out that these forward-looking pieces of information have inherent risk because they are based on future estimates. Specifically, the company listed inherent risk arising from future oil prices, estimates in reserve quantities and general economic conditions.