Inherent Audit Risks: Definition, Example, Types, Identification

What is Audit Risk?

The primary objective of an audit engagement is for the auditors to provide an audit report. This report must state the auditors’ opinion of whether the financial statements are free from material misstatements. However, they always face the risk of providing an incorrect audit opinion. This risk is known as the audit risk for an audit engagement.

Audit risk may fall into two categories, the risk of material misstatement and detection risk. The former category includes inherent and controls audit risks. Together, these risks constitute the audit risk for an audit engagement. The risk of material misstatement depends on the clients and their operations. Inherent risk is the first audit risk auditors must assess for an audit engagement.

What is Inherent Audit Risk?

Inherent audit risk refers to the likeliness of the subject matter to be materially misstated before considering any related controls. In simpler words, it is the risk that the financial statements may contain material misstatements. However, this risk exists before considering the internal controls in place. Similarly, it does not account for the audit work performed by the auditors.

Inherent audit risk exists due to the nature of clients’ business, operations and transactions. It considers various factors related to those elements. As a part of audit risks, inherent risks are highly crucial in determining the nature of the work performed by auditors. The higher these risks are, the more auditors have to work to ensure they reduce those risks to an acceptable level.

What are the sources of Inherent Audit Risk?

Inherent audit risk may generate from various sources. Some of these are as below.

Complex financial transactions

Complex financial transactions come with a complicated and standardized accounting process. The more complex the nature of those transactions is, the higher the inherent audit risk will be.

Dynamic nature of business

Some clients may operate in industries that involve frequent developments and changes. The more dynamic these businesses are, the higher the inherent audit risks for those engagements will be.

Past misstatements

Clients with a history of misstatements in the past are at a higher likelihood of misreporting again. Therefore, the inherent audit risk for those engagements is higher than for other clients.

Transactions requiring judgment

Sometimes, clients’ management may use its judgment to account for financial transactions. This process complicates the auditing associated with those transactions. Therefore, it can lead to higher inherent audit risk.

Example

An audit firm, Blue Co., gets appointed by a client to audit its financial statements. The client works in a highly dynamic industry with frequent developments. On top of that, Blue Co. studied the previous financial statements reported by the client. The audit firm identifies various instances of restatements in those years.

Blue Co. also audits two other companies in the same industry as that new client. The audit firm has faced issues with audit risk due to the nature of operations for those clients. After considering these factors, Blue Co. identifies the inherent audit risks for the client to be high.

Conclusion

Audit risk is the risk of expressing an incorrect audit opinion despite the financial statements being materially misstated. It includes inherent audit risk relating to the nature of the client’s business, operations, and transactions. As stated above, several factors contribute to this type of audit risk. Inherent audit risk falls before control and detection audit risks.

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