Inherent Risk & Control Risk

Instructor: James Blackburn

James has an MBA from Auburn University and a MA in Humanities from Cal State-Dominguez Hills He writes on leadership, business strategy and finance.

In this lesson, we will define risk. We will also identify the various types of risks found in the accounting and finance professions. We will explore the reasons for the risk and provide examples of each type.

Deficient Accounting Controls

In 2014, the total cost of replacing a 53 cent ignition switch for over 2.6 million General Motors cars was over $4 billion. Adding insult to injury, the Security and Exchange Commission (SEC) charged GM with a failure to assess the financial impact of its recall on its financial statements. In January of 2017, General Motors settled with the SEC for $1 million. The Commission cited a general failure to share the recall information with the accountants, resulting in a misstatement of risk in its annual reports.

Risk

Risk is the probability of loss. In business, risk is defined as the probability that either an unexpected event, error or oversight will result in financial loss. Identifying and reporting the risk of a financial loss is required for all publicly traded companies to provide investors with relevant information about the current and future operation of the company.

Regulatory Protection

As investors, we find comfort that the government creates and enforces regulations to protect the financial well-being of those investing in publicly traded companies. The Sarbanes Oxley Act is one of those regulations. Section 404 of this act deals with the internal controls at publicly traded companies that are designed to protect the company and its investors from risks.

Types of Risks

Risks come in many forms. They are normally classified as one of three types: inherent risk, control risk and detection risk. Inherent risks are the natural probabilities that an error will occur in any process or activity. Control risks are the probabilities that a process or activity designed to protect against risk will fail. And detection risks are the probabilities that an auditor will fail to identify a risk during their examination. Our lesson will focus on inherent risks and control risks.

Three types of risk

Inherent Risk

All activities have risk. Through no fault of the employee, an error or event may occur that results in a financial loss. Notice, I mentioned an error or event. An error is normally made by a person. An event occurs unexpectedly, like a storm. Of course, businesses can purchase insurance to protect against natural storms. But, a financial storm, such as the one GM faced because of its faulty ignition switch, is difficult to insure against. The GM scenario is a good example of both types of risks.

The more common form of inherent risk is human error. Everyone make mistakes. When we rush or are under intense pressure, our natural tendency to make errors increase from the accepted 5% to a dangerous 25%. When we are interrupted, we experience error rates higher than normal. We either completely start over or we lose track of where we are in a process and skip a critical step. And, when the task work is complicated and requires significant interpretation and judgement, our tendency to discount the information required creates a higher risk of an error. The failure to share recall information with accounting may have simply been a misjudgment of the impact of the risk by the engineering group.

Another example of an inherent risk is the month end close process. Companies gather and record accounting information all through the month, and at the end of every month, they compile this information into useable reports used for internal decision-making. At the end of the quarter or year, they may prepare similar reports for investors. It's a complicated activity, with many long hours, and very high pressure. Since the information recorded is normally generated elsewhere, accountants rely on information from other areas of the business. During the month, the accountants have time to check if the data is accurate. But, during the crunch time at month's end, it's very easy to miss something that is critical to providing accurate information.

Inherent Risks

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