Question

Explain why inherent risk is set for audit objectives for segments (classes of transactions, balances, and presentation and disclosure) rather than for the overall audit. What is the effect on the amount of evidence the auditor must accumulate when inherent risk changes from medium to high for an audit objective?

Provide examples to illustrate your answer.

Answer 1

Inherent risk is the risk posed by an error or omission in a financial statement due to a factor other than a failure of control. In a financial audit, inherent risk is most likely to occur when transactions are complex, or in situations that require a high degree of judgment in regard to financial estimates. This type of risk represents a worst-case scenario because all controls in place have nonetheless failed.

Inherent risk is set for audit objectives for segments rather than for the overall audit because misstatements occur at the objective level within a segment. Thereby identifying the misstatment in the segment, Auditor is able to modify audit evidence by analysing the misstatement in the financial statement Acceptable audit risk has an inverse relationship to evidence. If acceptable audit risk is reduced, planned evidence should increase and in case the inherent risk changes from medium to high the auditor should increase the audit evidence gathered to make a conclusion whether there was an actual misstament or not.

An Example for the same would be, Minestone Resources Inc., an oil and gas company, conducted a review of its credit facilities on July 12, 2016, which included the release of forward-looking financial performance.

These forward statements included information on future funds from operations, capital spending, expected debt levels and anticipated oil hedging for 2017. The report openly pointed out that these forward-looking pieces of information have inherent risk because they are based on future estimates. Specifically, the company listed inherent risk arising from future oil prices, estimates in reserve quantities and general economic conditions.