Examples of Inherent Risk Factors That Are Pervasive in Financial Statements

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Reliance on management assertions can be risky in some firms.
Reliance on management assertions can be risky in some firms. (Image: NA/PhotoObjects.net/Getty Images)

Evaluating risk is a complex topic that is the subject of deep debate within the accounting community. Inherent risk is generally described as a risk that transactions contain material misstatements, regardless of internal controls. A pervasive risk is one that is found throughout the environment and affects several categories or classes of transactions.

Fraud

The largest example of a pervasive, inherent risk is fraud committed by top management. Top-management employees usually have the ability to evade or reduce the effectiveness of financial controls. They usually have the ability to falsify accounting entries and evade detection by auditors. In this way, risk of fraud is inherent in financial statements, and because a fraud can infect all of the accounting entries, it is pervasive as well.

Tone at the Top

Tone at the top is a prime risk factor in evaluating management assertions. The phrase "tone at the top" refers to the atmosphere in the workplace created by the organization's leadership. Whatever that atmosphere is, it will directly affect how employees do their jobs -- and the effects will pervade the financial statements. An emphasis on propping up stock price, for example, may lead the business to pursue strategies that produce short-term gain at the expense of the long-term health of the company. Or if bonuses are based on revenue rather than profit, that may encourage individuals to negotiate deals that generate heavy cash inflows even if the associated expenses make the overall deal a money-loser.

Going-Concern Risk

Going-concern risk is the risk that a business will not operate in the foreseeable future -- the risk, essentially, that a business will fail. A business is generally considered a going concern in the absence of evidence to the contrary, but the risk must be evaluated by auditors in the financial statements.

Estimates

The going-concern risk can be considered inherent and pervasive because it relies on estimates to judge the business's prospects. Audit evidence, by its very nature, comprises records of transactions that have already happened. However, going-concern risk, because it is composed of management's estimates of the future, is susceptible to manipulation and is therefore an inherent, pervasive risk.

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