Assessing Inherent Risk Explained. Auditing Course | CPA Exam AUD

In this video, we explain inherent Risk.

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Introduction 0:00
Analogy for Inherent Risk The video starts with a hiking trail analogy to explain inherent risks, such as steep cliffs and unpredictable weather (0:07).

Definition of Inherent Risk Inherent risks are natural vulnerabilities of an account balance, transaction, or financial statement (5:18).

Factors Influencing Inherent Risk Several factors can influence inherent risk: nature of the client's business, prior errors, initial versus repeat engagements, related party transactions, complex transactions, and judgment-based accounting (12:36).

Impact on Audit Approach High-risk areas demand more evidence, rigorous testing, and careful scrutiny (18:58).





Inherent Risk: An Overview
Inherent risk refers to the susceptibility of an account balance, transaction, or financial statement assertion to a material misstatement before considering the effectiveness of internal controls. It arises from factors inherent to the entity, its industry, or the nature of its operations and is independent of the company’s control environment.

Auditors assess inherent risk as part of the overall audit risk assessment to determine the extent and nature of audit procedures needed.

Key Characteristics of Inherent Risk
Natural Susceptibility:
Some accounts or transactions are more prone to errors or fraud due to their complexity or subjectivity (e.g., estimates, valuations).

External Factors:
Industry characteristics, market volatility, or economic conditions can heighten inherent risk.

Independent of Controls:
Inherent risk exists without considering whether the organization has controls in place to mitigate it.

Audit Focus:
High inherent risk areas require more extensive or specialized audit procedures to obtain sufficient evidence.

Factors Contributing to Inherent Risk
Complexity of Transactions:
Accounts with intricate calculations or unusual structures, such as derivatives or foreign currency transactions, often have higher inherent risk.

Subjectivity and Estimation:
Areas requiring management judgment, such as asset impairment or provisions, are more prone to misstatements.

Volume of Transactions:
High-frequency transactions increase the likelihood of errors.

Industry-Specific Risks:
Certain industries, like banking or technology, may have inherent risks tied to regulatory requirements or rapid innovation cycles.

Changes in Operations:
Mergers, acquisitions, or entering new markets introduce unfamiliar risks that can impact financial reporting.

Fraud Risk Factors:
Pressures, opportunities, or rationalizations for fraud can increase the inherent risk in financial reporting.

Examples of High Inherent Risk Areas
Valuation of Intangible Assets:
Intangible assets, like goodwill, require judgment and assumptions, making them vulnerable to errors.

Revenue Recognition:
Revenue may be recognized incorrectly due to timing issues, fraud, or complex contracts.

Inventory Valuation:
Industries with perishable goods or complex production processes face higher risk in inventory valuation.

Deferred Tax Assets:
These rely on assumptions about future profitability, which can be subjective and uncertain.

Inherent Risk in the Audit Process
Risk Assessment:
Auditors evaluate inherent risk during planning to identify areas that require closer scrutiny.

Impact on Audit Approach:
Higher inherent risk leads to more substantive procedures, such as detailed testing or obtaining external confirmations.

Integration with Control Risk:
Inherent risk is considered alongside control risk and detection risk to determine overall audit risk.

Mitigating Inherent Risk
While inherent risk itself cannot be eliminated, organizations can reduce its impact by implementing robust internal controls and enhancing the reliability of financial reporting.

Examples include:
Strengthening policies for estimation and judgment.
Providing adequate training to staff.
Using technology to reduce transaction errors.

Conclusion
Inherent risk is an essential concept in auditing, reflecting the areas of financial reporting most vulnerable to misstatements. By understanding and addressing inherent risk, auditors can design effective procedures to provide assurance over the reliability of financial statements. Identifying these risks also helps organizations improve their financial reporting and mitigate potential issues proactively.









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