DEFINITION OF ‘INHERENT RISK’
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 judgement in regards to financial estimates. This type of risk represents a worst-case scenario because all controls have failed.
INVESTOPEDIA EXPLAINS ‘INHERENT RISK’
Inherent risk is one of the risks auditors must look for when reviewing financial statements, along with control risk and detection risk. When conducting an audit the auditor will try 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.
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 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 cleverest financial professionals to understand. Asset-backed securities, such as collateralised 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 it actually is.