Assessing

Inherent Risk

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 Inherent Risk – Identification

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 Inherent Risk – Identification
Risk identification involves:
• Performing risk assessment procedures to identify
sources (causes) of risk through understanding the entity;
• Determining the possible effects of the risk sources
identified – potential misstatements in the financial
statements, including the possibility of fraud; and
• Relating the effects of risks to the financial statement area
and assertions affected, or determining that the risks are
pervasive to the financial statements as a whole and
potentially affect many assertions.

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 Factors Affecting Inherent Risk
Nature of Client’s : • Industry practices
Business • Non-routine transactions
• Makeup of the population

Culture : • Related parties

• Factors• related topractices
Industry fraudulent financial
• Non-routine transactions
reporting
• Factors• related
Makeup toofmisappropriation
the population of assets

Audit Experience : • Prior audit results

• Initial vs. repeat engagement
• Audit judgment required to correctly record
balances and transactions

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 Factors Affecting Inherent Risk
Inherent Risk at the Financial Statement Levels
1. Business risk
2. Fraud risk.

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 Factors Affecting Inherent Risk
Inherent Risk at the Accounts and Assertions Level
The account balance :
• represents an asset that is relatively easily stolen
• is made up of complex transactions
• requires a high level of judgment or estimates to value
• is composed of a high volume of non-routine transactions
• is subject to adjustments that are not in the ordinary
processing routine, such as year-end adjustments

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 Business Risk
Business risks can be resulted from
• Significant conditions, events, circumstances, actions, or
inactions that could adversely affect the entity’s ability to
achieve its objectives and execute its strategies.
• Setting inappropriate objectives and strategies.
• Change, complexity, or the failure to recognize the need for
change.
- The development of new products that may fail;
- An inadequate market, even if new products are successfully
developed; or
- Flaws in the products that may result in liabilities and
damage to the entity’s reputation

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 Fraud Risk
The term “fraud” refers to an intentional act by one or more
individuals among management, those charged with
governance, employees, or third parties involving the use of
deception to obtain an unjust or illegal advantage.
• Management fraud – involving member(s) of management
and those charged with governance;
• Employee fraud - involving only employees of the entity.

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 Fraud Risk

Types and characteristics of fraud :

Error
RMM
Fraud

• Fraudulent (Manipulation of
Financial Statements)

• Missappropriation of Assets

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 Fraud Risk

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 Fraud Risk

How
Much

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 Fraud Risk
Major conditions that create an environment for fraud include:
• Ineffective corporate governance;
• Lack of leadership by management and poor “tone at the top”;
• High incentives provided for financial performance;
• Taxes or other expenses that are considered very high or
onerous;
• Complexity in the entity’s rules, regulations, and policies;
• Unrealistic expectations from bankers, investors, or other
stakeholders;
• Downward and unexpected shifts in profitability;
• Unrealistic budget targets for staff to attain; and
• Inadequate internal control, especially in the presence of
organizational change.

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 Fraud Risk
• Fraud risk relates to events or conditions that indicate an
incentive or a pressure to commit fraud or provide an
opportunity to commit fraud.
• In conducting risk assessment procedures, audit team
members need to consider the existence of the three
conditions that often provide clues to the existence of fraud
(“fraud triangle”).
 When all three conditions are present, it is highly likely
that fraud may be occurring.

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 Fraud Risk
The Fraud Triangle :

Generated by Rationalization is
immediate needs the belief that a
that are difficult fraud has not really
to share with been committed
others

A poor corporate culture and

a lack of adequate internal
control procedures can often
create confidence that
a fraud could go undetected
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 Risk Factors for
Fraudulent Reporting
Pressures/Incentives
• Financial stability or profitability is threatened by economic,
industry, or entity operating conditions
• Excessive pressure exists for management to meet targets
or debt requirements
• Personal net worth is materially threatened by the entity’s
financial performance

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 Risk Factors for
Fraudulent Reporting
Opportunities
• There are significant accounting estimates involve
judgments that are difficult to verify
• There is ineffective board or audit committee oversight
over financial reporting
• High turnover or ineffective accounting, internal audit, or
information technology staff exists

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 Risk Factors for
Fraudulent Reporting
Rationalization/Attitude
• Inappropriate or inefficient communication & support of
the entity’s values is evident
• A history of violations of laws is known
• Management has a practice of making overly aggressive
or unrealistic forecasts

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 Risk Factors for
Missapropriation of Assets
Pressures/Incentives
• Personal financial obligations create pressure to
misappropriate assets
• Adverse relationships between management and
employees motivate employees to misappropriate assets

Opportunities
• There is a presence of large amounts of cash on hand or
inventory items
• There is an inadequate internal control over assets

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 Risk Factors for
Missapropriation of Assets
Rationalization/Attitude
• Disregard for the need to monitor or reduce risk of
misappropriating assets exists
• There is a disregard for internal controls by failing to
correct known deficiencies
• Management is tolerant of some employee thefts (no
disciplinary action is taken when an employee is caught
stealing)
• Management does not enforce the entity’s values or
ethical standards

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 Responses to Fraud Risk
Maintain an attitude of professional skepticism at all time during
the engagement.
 Recognizing that management can commit fraud;
 Make critical assessments about the validity of audit evidence
obtained;
 Being alert on the reliability of documents and responses to
inquiries and othe information obtained form management;
 Being careful – avoid :
• Overlooking unusual circumtances
• Overgeneralizing when drawing conclusions
• Accepting less than persuasive audit evidence in a belief
that management and those charged with governance are
honest and have integrity

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 Inherent Risk – Assessment

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 Inherent Risk – Assessment
Risk assessment involves consideration of two attributes
about the risk:
1. What is the likelihood of a misstatement occurring as a
result of the risk?
2. What would be the magnitude (monetary impact/
materiality) if the risk did occur?

• Use subjective/non-quantitative measurement.

• The auditor could evaluate the likelihood of simply as high,
medium, or low, or could assign a numerical score, such as 1 to 5.

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 Inherent Risk – Assessment

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 End

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