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 include 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 malafide intentions.
Types of Inherent Risk
- #1 – Risk Due to Manual Intervention – Human intervention can undoubtedly lead to errors in processing. No human can be perfect at all times. There are chances of mistakes/errors.
- #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 quickly recorded/reported.
- #3 – Complexity of Organisational Structure – Some organization may form a very complex type of organizational structure which may contain many subsidiaries/holding companyHolding CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies./joint venturesJoint VenturesA joint venture is a commercial arrangement between two or more parties in which the parties pool their assets with the goal of performing a specific task, and each party has joint ownership of the entity and is accountable for the costs, losses, or profits that arise out of the venture. 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 controlInternal ControlInternal control in accounting refers to the process by which a company implements various rules, policies, or procedures to ensure the accuracy of accounting and finance information, safeguard the various assets of the business, promote accountability in the business, and prevent the occurrence of frauds in the company.. If employees collude with mala fide intentions, chances of control lapse increases and leads to fraud, error, misstatement in the financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels..
Examples of Inherent Risk
#1 – Human Intervention
As discussed in the 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 action multiple times. 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 auditors,s which may lead to the creation of personal relationships. This may not be in the interest of the organization. Also, frequent engagement of auditorsEngagement Of AuditorsAn auditor is a professional appointed by an enterprise for an independent analysis of their accounting records and financial statements. An auditor issues a report about the accuracy and reliability of financial statements based on the country's local operating laws. 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 there are still grey areas where organizations have to make an assessment based on judgments, assumptions. This may vary based on organizations that 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 that does not occur in routine or repeatedly. It can lead to an error because of a 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 significant 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 businesses to adopt changes in statutory regulations, norms. Noncompliance with 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 the case of robotic automation, the program needs to be installed once. After that, it performs the same transaction repeatedly 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 is 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 –