ACCA AA · Chapter 6
Audit risk, materiality and analytical procedures MCQs with Answers
11 multiple-choice questions on Audit risk, materiality and analytical procedures for ACCA AA Audit and Assurance. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
How does ISA 200 define audit risk?
- A) The risk that the entity's internal controls contain significant deficiencies
- B) The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated
- C) The risk that the entity will fail to achieve its business objectives
- D) The risk that the auditor will be sued by a user of the financial statements
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Answer: B) The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated
Audit risk is a function of the risks of material misstatement (inherent and control risk) and detection risk. Business risk relates to the entity's objectives, litigation risk is a separate engagement risk, and control deficiencies are one possible source of control risk.
Question 2
Which component of audit risk can the auditor directly control through the nature, timing and extent of audit procedures?
- A) Control risk
- B) Inherent risk
- C) Business risk
- D) Detection risk
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Answer: D) Detection risk
Inherent risk and control risk exist independently of the audit and are assessed by the auditor. Detection risk, the risk that the auditor's procedures fail to detect a material misstatement, is managed by changing the procedures performed, for example by increasing sample sizes or performing work closer to the year end.
Question 3
The auditor of Sorrel Co assesses inherent risk and control risk for inventory as high. How should the auditor respond?
- A) Reduce detection risk by performing more extensive substantive procedures, such as larger sample sizes
- B) Accept a higher level of detection risk and perform fewer substantive procedures
- C) Rely more heavily on tests of controls over inventory
- D) Set a higher performance materiality for inventory
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Answer: A) Reduce detection risk by performing more extensive substantive procedures, such as larger sample sizes
To keep overall audit risk at an acceptably low level, a high risk of material misstatement must be matched by low detection risk. This means more persuasive substantive evidence, larger samples and procedures closer to the year end. Relying on controls is inappropriate when control risk is high, and performance materiality would normally be lowered rather than raised.
Question 4
Using the audit risk model AR = IR x CR x DR, the auditor wants to restrict audit risk to 5%. Inherent risk is assessed at 80% and control risk at 50%. What is the maximum acceptable detection risk?
- A) 2%
- B) 6.25%
- C) 12.5%
- D) 40%
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Answer: C) 12.5%
Detection risk = AR / (IR x CR) = 0.05 / (0.80 x 0.50) = 0.05 / 0.40 = 0.125, i.e. 12.5%. Multiplying all three figures gives 2%, which confuses the formula. Using 6.25% ignores control risk (0.05 / 0.80), and 40% is simply IR x CR.
Question 5
Cantle Co has profit before tax of $3.6 million. Using a benchmark of 5% to 10% of profit before tax, what range would the auditor consider for overall materiality?
- A) $18,000 to $36,000
- B) $36,000 to $72,000
- C) $180,000 to $360,000
- D) $360,000 to $720,000
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Answer: C) $180,000 to $360,000
5% x $3.6m = $180,000 and 10% x $3.6m = $360,000. The range $18,000 to $36,000 applies 0.5% to 1%, $36,000 to $72,000 applies 1% to 2%, and $360,000 to $720,000 applies 10% to 20%. The auditor uses professional judgement to select a figure within the range based on risk.
Question 6
Why does ISA 320 require the auditor to set performance materiality at an amount lower than overall materiality?
- A) To determine the audit fee for each area of the financial statements
- B) To reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality
- C) To set the level at which the auditor's report must be modified
- D) To identify misstatements that are clearly trivial and need not be accumulated
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Answer: B) To reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality
Testing to overall materiality would leave no margin for undetected misstatements or for individually immaterial misstatements that add up. Performance materiality creates that margin. The clearly trivial threshold is a separate, much lower amount, and modification decisions are made against overall materiality.
Question 7
Overall materiality for the audit of Mullion Co has been set at $420,000. The audit manager sets performance materiality at 70% of overall materiality. What is performance materiality?
- A) $126,000
- B) $294,000
- C) $420,000
- D) $600,000
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Answer: B) $294,000
Performance materiality = 70% x $420,000 = $294,000. $126,000 is 30% of materiality, $420,000 ignores performance materiality entirely, and $600,000 incorrectly divides $420,000 by 0.70.
Question 8
Under ISA 315 (Revised 2019), which of the following is NOT an inherent risk factor?
- A) Subjectivity
- B) Complexity
- C) Susceptibility to misstatement due to management bias or fraud
- D) The effectiveness of the entity's monitoring of controls
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Answer: D) The effectiveness of the entity's monitoring of controls
ISA 315 identifies inherent risk factors including complexity, subjectivity, change, uncertainty and susceptibility to misstatement due to management bias or other fraud risk factors. The monitoring of controls is a component of internal control and therefore relates to control risk, which is assessed separately from inherent risk.
Question 9
Which of the following factors would most likely lead the auditor to set performance materiality at a LOWER percentage of overall materiality?
- A) Profit before tax has increased compared with the prior year
- B) The entity has a strong control environment and no history of misstatements
- C) The finance team is experienced and stable
- D) Significant misstatements were identified in the prior year audit
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Answer: D) Significant misstatements were identified in the prior year audit
Performance materiality reflects the auditor's expectation of misstatements. A history of significant misstatements indicates a higher risk that misstatements will occur again, so the auditor sets performance materiality lower to leave more margin. Strong controls and an experienced team point to a higher percentage, and a rise in profit affects overall materiality rather than the percentage.
Question 10
Draft financial statements of Rivet Co show credit revenue of $10,950,000. Trade receivables were $1,200,000 at the start of the year and $1,500,000 at the year end. Based on year-end receivables and a 365-day year, what is the trade receivables collection period?
- A) 7.3 days
- B) 40 days
- C) 45 days
- D) 50 days
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Answer: D) 50 days
Collection period = closing receivables / credit revenue x 365 = $1,500,000 / $10,950,000 x 365 = 50 days. Using opening receivables gives 40 days and average receivables ($1,350,000) gives 45 days. The figure 7.3 is receivables turnover (10,950 / 1,500), expressed in times, not days.
Question 11
Wimble Co's revenue for the year is $8.0 million. Its gross margin has been stable at 35% for several years and no changes in pricing or costs are known. The draft cost of sales is $5.5 million. Which of the following is the most appropriate conclusion from this analytical procedure?
- A) Cost of sales is $300,000 higher than expected, which could indicate that closing inventory is understated
- B) Cost of sales is $300,000 higher than expected, which could indicate that closing inventory is overstated
- C) Cost of sales is $2.7 million higher than expected, which could indicate unrecorded revenue
- D) Cost of sales is $300,000 lower than expected, which could indicate that purchases are understated
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Answer: A) Cost of sales is $300,000 higher than expected, which could indicate that closing inventory is understated
Expected cost of sales = $8.0m x (100% - 35%) = $5.2m. Actual is $5.5m, so it is $0.3m higher than expected (giving a gross margin of 31.25%). Closing inventory is deducted in arriving at cost of sales, so an understatement of closing inventory would inflate cost of sales; overstated inventory would have the opposite effect.