What is Inherent Risk? - Definition & Assessment

Instructor: Usha Bhakuni

Usha has taught high school level Math and has master's degree in Finance

In this lesson, you will learn about the concept of inherent risk in accounting. Then, the lesson explains how this risk is assessed, with the help of an example.

Financial Reporting

A company's financial performance is disclosed to the management, regulators, government and investors periodically. For this purpose, all the financial transactions happening in the company are recorded and reported by accountants.

It often happens that in complex transactions, the information doesn't get recorded accurately. Companies employ many financial controls to prevent these errors.

Inherent Risk

There might be some complex transactions that require an astute accountant's experience, knowledge and judgement in order to be recorded. These transactions are subject to errors, despite the controls put in place. The risk that there might be an omission or error in the financial statements of a company, even after the controls employed, is called inherent risk.

Let's take the case of a global pharmaceutical company, XYZ Pharma, which has subsidiaries in over 10 countries. During the year, the company applied for two new patents on drugs, and its one existing patent expired. It also acquired a company in Asia. It is being audited by Harris. Let's understand how the risk is assessed.

Assessment of Inherent Risk

An independent review and assessment of a company's financial statements and reporting practices is called a financial audit. Its purpose is to ensure that the information captured in the financial reports is accurate. It becomes the responsibility of the auditor to assess the inherent risk in a company. There are several factors that affect the inherent risk level in a company. The assessment of this risk is a subjective process, as the auditor has to assess how susceptible the business is to inherent risk, given its controls.

Now, let's have a look at the major factors that Harris will consider for assessing the inherent risk in this company.

Nature of Business

The nature of business impacts the complexity of transactions that happen. The industries in which goods and services are transacted rapidly are likely to have higher inherent risk. Financial trading companies that deal with risky and complex financial instruments will be more susceptible to these risks. Conglomerates that have a lot of subsidiaries in various industries, with frequent transactions between them, would have higher risks. Also, companies that deal frequently with patents and intellectual property rights have complex transactions.

The company in this case, XYZ Pharma, is a global company with over 10 subsidiaries, so it is subject to more complex transactions. Because it is in the pharmaceutical industry, it deals frequently with drug patents and their expiry. In this year, it had one expiry and two new patents filed. These factors increase the inherent risk.

External Environment

The business transactions are also affected by several external factors, such as general economic condition, currency movements and interest rates. These factors impact the availability of financing for the company.

In this case, XYZ Pharma is a global company, so its financial performance and transactions would be impacted by the condition of the global economy, currency movements, etc. This increases the inherent risk in the company.

Audit History

The auditor needs to review the past audit results of the company for any misstatements. If a company has no auditing history, the auditor puts a higher level of risk in its financial reports. Integrity of the company's management also impacts its risk level.

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