Inherent risk IR

Inherent risk is a component of the audit risk model. In broad terms, inherent risk is the risk of a material misstatement in the unaudited information assuming the absence of internal control procedures. (The Glossary to ISAs defines inherent risk in relation to an account balance assertion as "the susceptibility of an assertion to a misstatement, that could be material, individually or when aggregated with other misstatements assuming that there were no related internal controls.")

Inherent risk includes any risk arising from fraud. As with other risks, inherent risk may be evaluated at various levels of aggregation (e.g. financial statement level, account balance assertion level) and at various stages during the course of the audit (e.g. client acceptance/retention stage, audit planning stage, etc.) as follows:

LEVEL OF
AGGREGATION		 AUDIT STAGES
Client acceptance/
retention		 Audit planning Control testing Substantive testing Opinion formulation
Financial
statement level		 IR1 na na na IR5
Account balance
assertion level		 na IR2 IR3 IR4 na

Auditors first evaluate inherent risk at the financial statement level, then, based on this evaluation, evaluate the risk of each account balance assertion. For example, consider the financial statement item of Inventory. There is a risk that Inventory may be not be complete, it may not be valid and/or it may not be accurate. The auditor evaluates these three risks. The auditor then considers the account balances underlying this financial statement item. This could include, for example, the account balances of Raw materials, Work in progress and Finished inventory. Using the evaluation of the completeness, validity and accuracy of the financial statement item Inventory as the starting point, the auditor evaluates the risk relating to the completeness, validity and accuracy of each of the underlying account balances.

Inherent risk at the financial statement level
Inherent risk at the financial statement level may be defined as the risk of a material misstatement in the unaudited value of a financial statement item, assuming the absence of a positive control environment. It is evaluated in the first and last audit stages, namely in the client acceptance/retention stage, where inherent risk is referred to as IR1, and the opinion formulation stage, where it is referred to as IR5.

See evaluation of inherent risk at the financial statement level.

Inherent risk at the account balance assertion level
Inherent risk relating to a particular account balance assertion may be defined as the risk of a material misstatement of the account balance assertion (including the risk relating to underlying classes of transactions), assuming the absence of internal control procedures directed at that account balance assertion (and underlying classes of transactions).

Inherent risk at the account balance assertion level is evaluated in the second, third and fourth audit stages. In the second audit stage, the audit planning stage, it is referred to as IR2 and is evaluated to assist in determining the audit approach. In the third audit stage, inherent risk at the account balance level may not be evaluated. It is only evaluated if information affecting its evaluation comes to the attention of the auditor during the course of the audit. If it is evaluated, it is referred to as IR3. In the fourth audit stage, the substantive testing stage, inherent risk at the account balance assertion level, IR4, is re-evaluated to assist in determining the extent of misstatements in account balance assertions.

See evaluation of inherent risk at the account balance assertion level.

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