Auditing: Assessing Inherent Risk

Inherent risk accounts for one-third of the audit risk, yet it has the least evidence available, meaning that it requires more professional judgement. This article discusses the major factors that an auditor should consider when assessing inherent risk as they prepare their audit plan.

Inherent risk, control risk and detection risk account for audit risk. There is very little documentation and information about inherent risk. This means the auditor has to rely on their professional judgement to assess inherent risk. What are the factors an auditor should consider while assessing inherent risk?

Business Environment

The business environment is an important factor in assessing inherent risk. The higher the competition, the higher the inherent risk. Technology businesses that constantly need to improve to stay relevant and compete with entrants in the marketplace are one such example.

Data Management System

The data management system in a firm is another factor in assessing inherent risk. A poorly managed and maintained Information Technology System increases inherent risk. Such sloppy and poorly maintained systems point to inattentive management that does not consider a well-managed IT system a requirement for conducting business.

The Integrity of the Management

The integrity of the management should be assessed by the auditor. If the management has poor integrity, it can lead to doubtful accounting practices. This can later lead to lawsuits against the auditor for not overseeing and reporting such accounting discrepancies. So a company that has management with poor integrity will have high inherent risk.

Client Motivations

Client motivations determine policy selection and accounting application. Earnings-based bonus plans, financially calculated lending covenants, the decision to sell or go public, and tax minimization schemes can lead to management bias and thereby increase inherent risk.

Historical Accounting Issues

Historical accounting issues are those that have occurred in previous years, may recur and indicate a systemic problem and therefore a source of inherent risk. Auditors can look at previous audits. The pattern from year to year is usually consistent unless the client is vigilant and keen to make the necessary changes.

New Clients

New clients have a higher inherent risk as the auditor is not yet familiar with the business details and previous documentation.