All organisations in all industries face a certain amount of inherent risk. Inherent risk is the amount of risk that exists when some threat goes untreated or unaddressed. This also means that the less an organisation tries to manage risk, the more inherent risk it has.
Auditors analyse inherent risk as part of their effort to assess the risk of material misstatement in financial reporting or the risk of non-compliance with regulatory obligations.
They also analyse control risk, which is the risk that a control you put in place to reduce inherent risk won’t work.
An understanding of inherent risk is crucial for organisations as they build systems of internal control to keep the organisation’s risks at acceptable levels.
So, what are the components of inherent risk?
Inherent risk is an assessed level of raw or untreated risk. It is the natural level of risk inherent in a process before applying controls to prevent and mitigate the risk. Inherent risk should not be confused with residual risk.
Residual risk is the level of risk that remains after implementing a set of controls to reduce the inherent risk.
Inherent risk has several components that auditors can use to identify potential risks, the probability of occurrence, and the potential impacts. These are:
- Business type
How the company conducts its day-to-day business operations is a primary factor for inherent risk. The amount of inherent risk increases if the organization displays an inability to adapt to external factors and cannot cope with a dynamic environment.
- Execution of data processing
Data processing refers to a company’s capacity to use technology and computers to convert raw data into usable information. When a company uses weak it infrastructure to drive and analyze data, that increases its inherent risk.
- Complexity level
This characteristic focuses on how a company records complicated transactions and operations. A company that performs highly complex work will usually also have a higher chance of completing the work improperly, increasing the amount of inherent risk. For example, gathering information from multiple subsidiaries to report them at a single, globally level is a highly complicated task that may contain significant misstatements. That can drive up inherent risk.
- Poor management
Management that is oblivious to the everyday actions of employees can increase the levels of inherent risk. If leadership is not engaged, significant errors emerging from general operation of the business may be missed, giving rise to inherent risk.
- Integrity of management
Poor integrity of management is a decisive factor resulting in inherent risk. A senior management team pushing unethical business practices will continually degrade the organisation’s reputation and its ability to meet regulatory compliance obligations, leading to a loss of business and raising the inherent risk.
- Previous results on compliance audits
If past audits were inadequate, discriminatory, or purposefully disregarded serious misstatements, such events might introduce inherent risk. These incidents or events tend to recur.
- Transactions among related parties
Transactions among related parties are likewise fraught with inherent risk because of the potential for conflicts of interest. Checks and balances are diminished, and there is an increased risk of misstatement in financial transactions or the risk of other regulatory compliance violations (say, corruption).
As your business grows, you’ll find that your risk tolerance varies. After all, running a business is your job, and you may be bolder in certain areas now than you were a year ago.
Still, keeping track of your inherent, control, detection, and residual risks may be too tricky for spreadsheets or traditional approaches.
That’s where compliance consultant can help you.
LS Consultancy can assist you in establishing, managing, and tracking your risk management and controls framework and corrective tasks.
The risk assessment audit conducted by LS Consultancy can give significant insight into where your controls are lacking, enabling you to take immediate action.
Call LS Consultancy 020 8087 2377 or email us
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