What are inherent risk factors in identifying and assessing the risks of material misstatement?

Inherent risk factors are characteristics of events or conditions that affect susceptibility of an assertion about a class of transactions, account balance or disclosure, to misstatement, whether due to fraud or error, and before consideration of controls. Such factors may be qualitative or quantitative, and include complexity, subjectivity, change, uncertainty, and susceptibility to misstatement due to management bias or other fraud risk factors.

Inherent risk factors relating to the preparation of information required by the applicable financial reporting framework include:

Complexity ―arises either from the nature of the information or  the way that the information is prepared, for example, complexity may arise  in calculating supplier rebate provisions or when there are many potential data sources, with different characteristics used in making an accounting estimate.

Subjectivity―arises from inherent limitations in the ability to prepare required information in an objective manner. Because of different approaches to preparing the required information, different outcomes could result from appropriately applying the requirements of the applicable financial reporting framework.

Change―results from events or conditions that, over time, affect the company’s business or the economic, accounting, regulatory, industry or other aspects of the environment in which it operates. Such change may affect management’s assumptions and judgments, including as they relate to management’s selection of accounting policies or how accounting estimates are made or related disclosures are determined.

Uncertainty―arises when the required information cannot be prepared based only on sufficiently precise and comprehensive data that is verifiable through direct observation. For example, estimation uncertainty arises when the required monetary amount cannot be determined with precision and the outcome of the estimate is not known before the date the financial statements are finalized.

Susceptibility to misstatement due to management bias or other fraud risk factors insofar as they affect inherent risk―susceptibility to management bias results from conditions that create susceptibility to intentional or unintentional failure by management to maintain neutrality in preparing the information.

 

Examples of events or conditions that may give rise to the existence of risks of material misstatement
Relevant Inherent Risk Factor:	Examples of Events or Conditions That May Indicate the Existence of Risks of Material Misstatement at the Assertion Level:
Complexity	Regulatory:  ● Operations that are subject to a high degree of complex regulation. Business model: ● The existence of complex alliances and joint ventures. Applicable financial reporting framework: ● Accounting measurements that involve complex processes. Transactions: ● Use of off-balance sheet finance, special-purpose entities, and other complex financing arrangements.
Subjectivity	Applicable financial reporting framework: ● A wide range of possible measurement criteria of an accounting estimate. For example, management’s recognition of depreciation or construction income and expenses.  ● Management’s selection of a valuation technique or model for a non-current asset, such as investment properties
Change	Economic conditions:  ● Operations in regions that are economically unstable, for example, countries with significant currency devaluation or highly inflationary economies.  Markets: ● Operations exposed to volatile markets, for example, futures trading. Customer loss: ● Going concern and liquidity issues including loss of significant customers.  Industry model: ● Changes in the industry in which the entity operates. Business model: ● Changes in the supply chain. ● Developing or offering new products or services, or moving into new lines of business Geography: ● Expanding into new locations.  Entity structure:  ● Changes in the entity such as large acquisitions or reorganizations or other unusual events.  ● Entities or business segments likely to be sold. Human resources competence: Human resources competence: ● Changes in key personnel including departure of key executives. IT: ● Changes in the IT environment. ● Installation of significant new IT systems related to financial reporting. Applicable financial reporting framework:  ● Application of new accounting pronouncements. Capital: ● New constraints on the availability of capital and credit.
Uncertainty	Reporting: ● Events or transactions that involve significant measurement uncertainty, including accounting estimates, and related disclosures.  ● Pending litigation and contingent liabilities, for example, sales warranties, financial guarantees and environmental remediation
Susceptibility to misstatement due to management bias or other fraud risk factors insofar as they affect inherent risk	Reporting: ● Opportunities for management and employees to engage in fraudulent financial reporting, including omission, or obscuring, of significant information in disclosures. Transactions: ● Significant transactions with related parties. ● Significant amount of non-routine or non-systematic transactions including intercompany transactions and large revenue transactions at period end. ● Transactions that are recorded based on management’s intent, for example, debt refinancing, assets to be sold and classification of marketable securities