Inherent Risk
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
Inherent risk is one of three components of the audit risk model, and a heavily tested concept on the AUD section of the CPA exam.
What is inherent risk?
Inherent risk is the probability that a material misstatement could occur in an account balance or transaction class, assuming there are no related controls in place to prevent or detect the error or fraud. It's the raw, natural risk attached to a specific financial statement area — the susceptibility of an account or disclosure to misstatement before you consider internal controls at all.
What increases inherent risk?
- Complexity of transactions — the more complex the transactions, the higher the inherent risk
- Volume of transactions — more transactions generally mean more risk
- Subjectivity — if an account involves a lot of judgment or estimation, the risk is usually high
Example: You're auditing a pharmaceutical company that spends heavily on R&D. Recognizing R&D expenses involves many estimates and subjective judgments, such as valuing in-process R&D projects. The inherent risk related to the R&D expense account would likely be high, given the level of subjectivity and complexity involved — which should guide how much audit attention that area receives.
Inherent risk exists before you factor in any controls at all. The more complex, high-volume, or judgment-driven an account is, the higher its inherent risk — and the more attention it deserves in the audit.
Want the full AUD framework?
My free CPA 101 course covers the study approach I used to score 90+ on every CPA exam section.
More on audit risk
Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 90 on AUD. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.
