In terms of auditing, inherent risk is the risk that some part of a company's accounting process will be faulty or incorrect. This risk is separate from control risk, which is affected by the secondary controls placed on the accounting process by the company. Inherent risk may occur because of human factors like the potential misconduct of employees or unintentional errors made in accounting practices. Also factoring into such risk is the nature of the business in question and the types of accounts being measured.
Auditors in charge of making assessments of the financial practices of a company are concerned with the potential for mistakes in accounting efforts. These mistakes can obviously be extremely detrimental to the overall standing of the company. The company can be affected financially by any tax penalties, and it can be affected through the mistrust false accounting breeds in customers and investors. For these reasons, auditors make an assessment of the inherent risk involved with a company's financial practices at the start of the auditing process.
Inherent risk is the type of risk that is impossible to avoid for any large business. Auditors usually make conservative assessments of such risk because it is impossible to precisely predict how much exists. By contrast, a control risk can be safely assessed by an auditor. Ideally, a company can reduce overall risk to virtually nothing by including internal controls on all accounting practices. Absent of these controls, the control risk would be set at 100 percent, even though it isn't realistic to think that all of the financial practices would be faulty.
Determining inherent risk is often a subjective process for auditors, as it often depends on the reliability of the employees in charge of finances at the company. An auditor must make an assessment on whether these employees can be trusted to deliver proper financial reports. Their reliability can be compromised by time constraints, pressure from upper management to deliver positive results, or even simple ineptitude.
The amount of inherent risk involved with a company's accounting also depends on exactly what kind of business it is and how its wealth is measured. For example, if a company has a majority of its wealth in cash holdings, this would be hard to misrepresent, and the risk would be relatively low. On the other hand, a company whose wealth depends on imprecise holdings like accounts receivable or stock valuations might be more likely to misrepresent such wealth.
