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 internal 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 internal controls in place have nonetheless failed.
Understanding Inherent Risk
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 an acceptably low level to keep the overall audit risk at a reasonable level. To lower detection risk, an auditor will take steps to improve audit procedures through targeted audit selections or increased sample sizes.
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 financially stable than in actuality.
Inherent risk is highest when management has to use a substantial amount of judgment and approximation in recording a transaction, or where complex financial instruments are involved.
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. Forward-looking financials by nature rely on management's estimates and value judgments, which pose an inherent risk. This type of estimation should be disclosed to financial statement users for clarity. (For additional examples of inherent risk, see Examples of Inherent Risk.)