Inherent risk and control risk are essential concepts in risk management. They’re key parts of the audit risk model, which auditors use to assess overall risk and susceptibility during an external or internal audit process. Inherent risk is the natural risk related to a company’s business activities before considering the internal control environment.
Control risk, on the other hand, is the remaining risk after internal controls are put in place. For example, material misstatements can happen in financial statements if a company does not have proper internal controls to prevent them.
There is a distinct difference between inherent risk and control risk. Inherent risk stems from the nature of the business operation without implementing internal controls. Control risk is from ineffective or inadequate internal control activities to prevent and detect fraud risk and error.
All business activities carry risk, so companies need strong controls to reduce potential losses. However, just implementing an internal control system isn’t good enough.
The third component of the audit risk model is detection risk, which is the risk that auditors won’t detect a material misstatement in an organization’s complex financial instruments.
Three Elements of Audit Risk
Audit risk is the chance that financial statements are materially incorrect, even if auditors do a risk analysis and approve them. The goal is to reduce overall audit risk to an acceptable level by evaluating inherent and control risks.
Since investors, creditors, and others depend on the financial statements, auditors analyze all audit risks carefully to ensure accuracy. A certified public accountant (CPA) firm conducting an audit may face legal consequences if it fails to detect significant errors.
Audit risk is usually considered the product of the various risks. It is :
Audit risk = Inherent risk x Control risk x Detection risk
Inherent Risk
Inherent risk is the fundamental level of risk inherent in a business process or activity before any internal controls are applied.
There are factors that can increase inherent risk. A company that can’t adapt to a rapidly changing business environment could increase the level of inherent risk.Complex transactions, such as consolidating financial data from multiple subsidiaries, have a higher risk of material misstatements. Management integrity issues can lead to unethical business practices.
Examples of Inherent Risk
- Unethical leadership harming the company’s reputation, leading to a loss of business and increasing inherent risk
- Poor past audits that were weak, biased, or auditors intentionally ignored misstatements
- Transactions between the related parties where asset values might be overstated or understated
- Cybersecurity breach due to human error, like lost key passes leading to unauthorized access and creating information security risks
How Do You Identify Inherent Risks?
All businesses face inherent risk, but the level varies. Simple corporate structures typically have lower risk, while more complex organizations or companies in highly regulated industries are more likely to have higher inherent risk.
Auditors identify inherent risk and their potential impact by analyzing risk factors such as:
- Business type
- Data processing methods
- Operational complexity
- Management style and reliability
- Past audits
Control Risk
Control risk is the likelihood of loss if internal controls fail to prevent or detect errors. It arises due to limitations in a company’s internal control system, which may become ineffective if not reviewed regularly.
In a financial environment, control risk is the chance that financial statements may contain errors due to weak internal controls. A major failure could lead to undetected losses despite showing a profit.
Management is responsible for designing, implementing, and maintaining a system of internal controls. However, it’s challenging to ensure they remain effective. Regular reviews and updates are necessary.
Factors That Increase Control Risk
- No segregation of duties
- Approving documents without management review
- Unverified transactions
- Non-transparent supplier selection process
Companies should determine the right controls based on the risk likelihood and financial impact, which can be high, medium, or low. If a risk is highly likely and could cause significant financial loss, strong internal controls are crucial.
Examples of Internal Controls
- The chief financial officer reviews payables at the end of each period.
- The payables manager verifies that all invoices are entered into the system.
- The payables manager checks for unprocessed invoices at the end of the period.
- Department heads regularly review budget-to-actual reports.
Inherent risk exists independent of internal controls. Control risk exists when the design or operation of a control doesn’t eliminate the risk of misstatement.
Even with internal controls, some risk remains. This type of risk is called residual risk—the remaining risk after implementing controls.
Detection Risk
Detection risk is the chance that the auditors fail to detect material misstatements in a company’s financial statements. Auditors use the audit risk model to understand the relationship between detection risk, inherent risk, and control risk.
Although detection risk can’t be totally eliminated, auditors can reduce it to an acceptable level by:
- Assigning skilled auditors to engagements and having the size team
- Adjusting the types of audit procedures, like the degree of substantive procedures compared to the tests of internal controls
- Improve thoroughness of the audit procedures by increasing the sample sizes and duration of the audit engagement
- Strengthening quality control measures within the CPA firm and reviews by qualified personnel outside the audit engagement team
SOC 2 Audit and Risk Mitigation
A SOC 2 audit helps companies strengthen security controls, especially those that handle customer data. It evaluates how well internal controls align with Trust Services Criteria (TSCs), the industry benchmarks for security, availability, processing integrity, confidentiality, and privacy.
How SOC 2 Audits Help Mitigate Risk
During a SOC 2 audit, an independent assessor examines:
- Systems and process vulnerabilities (inherent risk)
- Effectiveness of controls in place (control risk)
- Security policies, procedures, and safeguards
- Any weaknesses that could lead to failures
SOC 2 audits follow a risk-based approach—similar to ISA 315 (revised) standards—and go beyond compliance checklists. They assess real-world security effectiveness, which makes them a powerful tool for improving security sustainably.
Mapping Controls to SOC 2 Criteria
SOC 2 audits map an organization’s controls to the Trust Services Criteria, so security and compliance measures actually work in practice.
Key areas of focus include the following.
- IT controls: How well systems are monitored, updated, and protected.
- SOC 2 control list: Compliance with SOC 2 security standards.
- Access control management: Ensuring only authorized personnel can access sensitive data.
- Audit compliance and audit evidence: Proof that controls are operating effectively.
For example, if a company uses cloud-based storage, an auditor will review encryption policies, access logs, and security monitoring.
Why SOC 2 Audits Matter for Risk Management
SOC 2 audits also provide real value in strengthening security and reducing risk. Some key benefits include:
- Finding security gaps before they become problems. Audits can uncover weaknesses that might otherwise go unnoticed.
- Strengthening compliance across multiple frameworks. Many of the controls in SOC 2 overlap with standards like ISO 27001 and NIST.
- Building customer trust. Being SOC 2 compliant shows clients and partners that data security is a priority.
- Preventing financial and reputational damage. Catching risks early helps avoid costly breaches and regulatory fines.
Understanding the Entity and Its Environment
Before assessing inherent risk and control risk, it’s important to understand the entity and its environment. This context is essential because external and internal factors can significantly impact risk levels.
How the Business Environment Influences Risk Assessment
An entity’s business environment includes factors like industry trends, regulatory requirements, economic conditions, and technological advancements. Events or conditions affecting these areas can directly increase inherent risk by introducing complexities or uncertainties. Some key factors include:
- Industry-specific risks. Some industries, like finance or healthcare, face stricter regulatory scrutiny and higher data security expectations.
- Regulatory and compliance environment. Laws such as SOX, GDPR, or HIPAA add layers of complexity to risk management.
- Economic conditions. Inflation, market volatility, and supply chain disruptions can increase financial risk.
- Operational structure. Companies operating across multiple locations or using third-party vendors may face higher significant risk due to decentralization.
The Role of the IT Environment in Risk Assessment
An organization’s IT environment plays a crucial role in risk management because it governs how financial and operational data is processed, stored, and protected. Consider the following:
- Who has access to sensitive systems and data? Are permissions restricted to authorized users?
- Are periodic reviews done to check that only the right people have access to critical IT systems?
- Are preventative (e.g., firewalls, authentication protocols) and detective (e.g., audit logs, monitoring tools) controls in place?
Weak access controls can lead to higher control risk, increasing the chances of data manipulation or breaches.
Using Analytical Procedures to Understand Risk
Beyond reviewing internal controls, auditors use analytical procedures to assess identified risks by identifying trends, vulnerabilities, or inconsistencies in financial data. This includes evaluating:
- Key ratios. Metrics like debt-to-equity, gross margin, or revenue trends TO spot red flags in financial reporting.
- Historical trends vs. industry benchmarks. Comparing financial performance to industry peers to identify potential risk areas.
- Unusual transactions or fluctuations. Unexpected changes in revenue, expenses, or cash flow signal a significant risk that requires further investigation.
For example, if a company’s revenue suddenly spikes without a clear business explanation, this could indicate an underlying inherent risk factor, such as improper revenue recognition or fraud.
Take Control with ZenGRC
As the business grows, your risk tolerance may shift. Managing risk also becomes more complex. Tracking control, detection, inherent, and residual risks with spreadsheets or traditional methods can be overwhelming.
ZenGRC can help. It is a governance, risk, and compliance platform that can help you create, manage, and track your risk management framework and corrective actions.
ZenGRC’s risk assessment modules provide valuable insight into areas where your documentation falls short, allowing you to take quick action to collect the necessary evidence.
Schedule a demo and get started on the path to worry-free risk management.