What is Inherent Risk?
Inherent Risk can be defined as the probability of financial statement being defective due to error, omission or misstatement which occur due to factors beyond the control or which cannot be controlled with the help of internal controls. Examples of Inherent Risk can be non-recording of the transaction by an employee, segregating of duties to reduce risk of control but at the same time collusion of employees/stakeholders for mala fide intentions.
Types of Inherent Risk
Inherent risk can be categorized as follows:
- #1 – Risk Due to Manual Intervention – Human intervention can certainly lead to error in processing. no human can be perfect at all times. There are chances of mistakes/error.
- #2 – Complexity of Transaction – Certain accounting transactions may be easy to record/report but the situation is not the same every time. There might occur complex transaction which may not be easily recorded/reported.
- #3 – Complexity of Organisational Structure – Some organization may form a very complex type of organizational structure which may contain many subsidiaries/holding company/joint ventures etc. This may lead to difficulty in understanding and recording of transactions in between.
- #4 – Collusion among Employee – To reduce the risk of fraud, errors organization segregates duties in between multiple employees or other stakeholders. This is a kind of internal control. If employees collude with mala fide intentions, chances of control lapse increases and leads to fraud, error, misstatement in the financial statement.
Examples of Inherent Risk
Let’s understand the examples of inherent risk.
#1 – Human Intervention
As discussed in above-stated points no human can always be perfect like machines. There are chances of error in some activities out of multiple activates performed or the same activity at multiple time. For example, there are chances of non-recording of purchase transaction from a vendor having multiple transactions or recording of the same with the wrong amount.
#2 – Business Relations/Frequent Meetings
Sometimes frequent meetings and repeated engagements may lead to personal relationships with auditor which may lead to the creation of personal relationships. This may not be in the interest of the organization. Also, frequent engagement of auditor may lead to laxity or overconfidence.
#3 – Assumption/Judgement Based Accounting
Although Accounting standards provide detailed accounting methods, policies for recording/ reporting of transactions but still there are grey areas where organization have to make an assessment based on judgments, assumptions. This may vary based on organizations which create a gap for risk.
#4 – Complexity of Organisational Structure
Many organization grows complex in structure due to the formation and existence of a large number of subsidiaries, holdings, joint ventures, associates, etc. This creates the complexity of recording reporting transactions between these companies.
#5 – Non – Routine Transactions
Sometimes it may happen where the organization needs to record a transaction which does not occur in routine or on a recurring basis. This can lead to an error because of lack of knowledge or inaccurate knowledge.
Important Points about Inherent Risk
Due to growing innovations, changes in technology, changing business model chances of inherent risk affecting an organization’s financial statement have also increased. Following are some of the major affecting changes:
- Changing Business Models: Frequent changes in business models create complexities of recording, reporting of new transactions and as a result, there are increased probabilities of the financial statement being misleading due to inherent risk involved in new business models.
- Increased Technology Innovations: Every organization is affected by growing technology. An organization needs to adapt itself according to changes taking place otherwise it is its infrastructure may become obsolete and may lead to the risk of wrong/incorrect/misleading information etc.
- Difficulty in Adopting Changing Statutory Norms: Every day there are growing complexities among business to adopt changes in statutory regulations, norms. Noncompliance of which results in penalties and fines. Every organization needs to be updated about such changes taking place otherwise may face penalties from government departments.
- Reduced Manual Intervention: With the increasing technological interventions, human intervention is reducing. Robotics technology is performing tasks previously performed by human beings. This results in reduced human errors as in case of robotic automation, the program needs to be installed once and thereafter, it performs the same transaction on a recurring basis without any error.
Inherent risk occurs in the financial statement is due to factors beyond the control of an accountant and is the result of error, omission or misstatement of financial transactions. With the changing business models, growing technological innovations, statutory norms inherent risk of the financial statement being misleading are also increasing.
This has been a guide to what is the inherent risk and its definition. Here we discuss types and examples of inherent risk in financial statements along with advantages and disadvantages. You can learn more about accounting from the following articles –