Inherent risk refers to the risk of failure that a business faces due to things that are directly connected to its very existence. However, when applied to a business's financial statement, inherent risks are those financial items that are most likely to signal a potential future failure.
A business’s financial statements are often scrutinized by stockholders and the general public. In fact, what you say in a financial statement could have a direct impact on how your stock performs in the next quarter. Even if your business isn’t public, your financial statements can be obtained at any time by clients, business partners, potential investors and even auditors and reviewed for signs that your business may be at risk. There are a few very specific factors in a financial statement that can point to future risk.
Define Inherent Risk
In business, the term inherent risk refers to the danger of failure that a business faces due to factors that are essential to operations. If nothing changes related to that risk, the business faces failure. When applied to an organization’s financial statements, inherent risk can usually be broken down into fraud and failure risks.
Risks of Fraud
One of the most easily identifiable risks on a financial statement is fraudulent activity. The most dramatic of these involves leadership adjusting numbers to provide a more positive public face. For that reason, it’s best to have someone who has in-depth knowledge of accounting practices review statements on behalf of investors or customers to ensure the integrity of the numbers on the balance sheet.
Another item on a financial statement that can put businesses at an audit risk is a failure to put controls in place. Investors and other interested parties should be able to question a business at any time on its policies and procedures. Without the right controls in place, the business itself can be at risk. If only one person is managing incoming payments, for instance, undetected theft is easier than if one employee is responsible for double checking the other employee’s work.
Risks of Failure
In addition to fraud risk, failure is an inherent risk easily detectable on a business’s financial statements. Often you can get a feel for this risk from the overall tone of the statement itself. Positive leaders who are attuned to what is going on are more likely to have created a good company culture that can not only attract top talent but also retain the great employees already on board. A business with a revolving door will have a much harder time surviving in a competitive marketplace since too much time is spent recruiting and training replacement workers.
The unexpected can also take a business down. Financial statements can reveal how well a business is prepared for a natural disaster. If one fire, earthquake or tornado could put a company out of business in a matter of hours, it’s reason for concern. Perhaps even more common is a business that isn’t monitoring the market and finding ways to adjust behaviors accordingly. A business’s financial statements should show agility and awareness above all else.