# Inherent Risk: Definition, Examples, and 3 Types of Audit Risks

> **Definition**
>
> Inherent risk arises from the possibility of committing an error or omission in a financial statement for reasons other than a failure of internal controls.

When auditors examine financial statements, they start with a crucial question: How likely are these statements to contain material misstatements, even before considering any internal controls? This is inherent risk—the natural susceptibility of [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp) to errors or misstatements because of the complexity of transactions, the judgment required in accounting estimates, or the nature of the business itself.

Businesses, too, face inherent risks. For instance, a tech company developing the newest apps has more inherent risk than a corner grocery store simply because of the complexity involved. For this article, though, we focus on the inherent risks relating to financial statements.

### Key Takeaways

*   Inherent risk concerns the vulnerability of financial statements to material misstatements without considering the effects of internal controls.
*   It's a fundamental aspect of audit risk assessment, alongside control risk and detection risk.
*   Auditors evaluate inherent risk by assessing transaction complexity, accounting estimates, and financial reporting requirements.
*   Different financial statement areas carry varying levels of inherent risk.
*   For example, complex revenue recognition calculations have a higher inherent risk than simple cash transactions.  
    

![Inherent Risk](https://www.investopedia.com/thmb/hUGsmh5WQYmcc-z50F3xwkDuc_M=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/InherentRisk_V2-3455cf2e80a64af9a07d730f6794cf46.jpg)

*— Investopedia / Jake Shi*

## What Is Inherent Risk?

Every financial statement has sections where misstatements are more likely to occur—that's just the nature of accounting. Some transactions and account balances are inherently more susceptible to material misstatement than others. For example, calculating [depreciation](https://www.investopedia.com/terms/d/depreciation.asp) expenses is trickier to audit accurately than simple cash transactions since you're dealing with estimates and technical accounting judgments.

A common misconception is that just because a business seems "easy to audit," it has a low inherent risk. For example, with a cash-heavy business, you might think, "Well, we can verify the bank balance easily, so the risk must be low." But that's actually about audit evidence and controls, not inherent risk. The natural susceptibility of cash accounts to misstatement (inherent risk) is independent of these verification methods.

The level of inherent risk in financial statements may be influenced by the following:

*   **Complexity of financial reporting**: Areas like revenue recognition for multiple-element arrangements, [derivative](https://www.investopedia.com/ask/answers/060315/how-price-derivative-determined.asp) valuations, or pension obligations where accounting requirements are complex. The more complicated the [accounting standards](https://www.investopedia.com/terms/a/accounting-standard.asp) and calculations, the higher the inherent risk of misstatement.
*   **Judgment and subjectivity in accounting**: Whenever accounting estimates enter the picture, especially in areas like loan loss provisions, warranty reserves, or fair value measures, inherent risk increases. Management needs to make significant judgments about these estimates, and each judgment carries the risk of misstatement.
*   **External environment**: Changes in accounting standards, regulations, or economic conditions can affect the complexity and judgment required in financial reporting. For example, high inflation periods might increase the risk of misstatement in inventory valuation.
*   **Nature of transactions**: Complex financial instruments, related party transactions, or unusual one-time events tend to have a higher inherent risk because of their accounting requirements and potential for misstatement.
*   **Human factors in financial reporting**: Even with clear accounting standards, the risk of human error in applying them remains. This includes misunderstanding the accounting requirements, turnover in accounting staff, or pressure to meet financial targets.
*   **Information systems**: Complicated accounting systems, multiple data sources, or system changes can increase the risk of processing errors in financial reporting.

> **Tip**
>
> Inherent risks are not just qualitative. If there's a high transaction volume and variety, inherent risk increases. In addition, one-off transactions typically carry more inherent risk than recurring, standardized ones.

## Examples of Inherent Risk

Let's look at how inherent risk typically appears in different financial statement areas and industries:

### Financial Services

Financial services companies face high inherent risk in several key financial statement areas. For example, the valuation of complex financial instruments like [derivatives](https://www.investopedia.com/terms/d/derivative.asp) and structured products involves multiple assumptions and complicated [fair value](https://www.investopedia.com/terms/f/fairvalue.asp) calculations. These inherently increase the risk of material misstatement before any controls are considered.

In addition, loan loss provisions require significant judgment about future economic conditions and borrower behavior, making them naturally susceptible to misstatement.

### Manufacturing

Manufacturing companies typically have a higher inherent risk in their inventory and cost accounting. The valuation of work-in-progress inventory involves complex [cost accounting methods](https://www.investopedia.com/terms/c/cost-accounting.asp) and estimates. When manufacturers operate globally, they face additional inherent risks in areas like these:

*   Foreign currency translation of financial statements
*   Transfer pricing between subsidiaries
*   Capitalization of manufacturing overhead costs
*   Revenue recognition for long-term contracts

### Health Care

Health care organizations face unique inherent risks in their revenue recognition and receivables. The complexity comes from the following:

*   Multiple payment arrangements with different insurers
*   Estimates of contractual adjustments
*   The gap between service delivery and final payment
*   Complex regulations affecting revenue recognition and

### Technology Firms

Technology firms often have high inherent risk in several financial statement areas:

*   Revenue recognition for multiple-element arrangements (like software plus services)
*   Capitalization of software development costs
*   Valuation of [intellectual property](https://www.investopedia.com/terms/i/intellectualproperty.asp)
*   Recognition of deferred revenue

## Types of Audit Risk

Let's examine how inherent risk fits into the bigger picture with two other forms of audit risk:

1.  **Control risk**: This is the probability that a company's internal controls will fail to identify or prevent errors or fraudulent activities even after implementation. When internal controls are either weak or improperly done, they lead to a higher control risk. Unlike inherent risk, which is about natural difficulties, control risk is directly related to the management practices and systems put in place.
2.  **Detection risk**: This is the possibility that significant errors will remain undiscovered throughout an auditing process. Thus, it's a risk from within the audit process itself. A poorly designed audit procedure can lead to detection risks, no matter how low the other two risks are.

Together, these three risks determine the overall audit risk. While they are independent, they can often build on one another. A higher inherent risk often leads [auditors](https://www.investopedia.com/terms/a/auditor.asp) to implement more extensive testing procedures (reducing detection risk) and companies to establish stronger controls (reducing control risk).

## The Bottom Line

Understanding inherent risk helps auditors identify which financial statement areas need more attention, design appropriate audit procedures, determine the extent of testing needed, and focus on areas most susceptible to important misstatements.

While strong internal controls can help mitigate risks, they don't change the underlying inherent risk in complex accounting areas like revenue recognition, fair value measurements, or significant estimates. Hence, auditors must first assess inherent risk independently of controls—it forms the basis for how audits are done.

> **Article Sources**
>
> 1.  _Journal of Accountancy._ "[Inherent Risk and SAS No. 145: New Concepts and Requirements.](https://www.journalofaccountancy.com/news/2022/oct/inherent-risk-sas-no-145-new-concepts-requirements.html)"