ICAEW ARF · Chapter 3
Planning, materiality and risk assessment MCQs with Answers
13 multiple-choice questions on Planning, materiality and risk assessment for ICAEW ARF Assurance and Risk Fundamentals. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
Which of the following describes control risk?
- A) The risk that the auditor's procedures will fail to detect a material misstatement
- B) The risk that the auditor expresses an inappropriate opinion when the financial statements are materially misstated
- C) The risk that a misstatement that could be material will not be prevented, or detected and corrected, on a timely basis by the entity's internal control
- D) The susceptibility of an assertion to material misstatement before considering any related controls
Show answer & explanation
Answer: C) The risk that a misstatement that could be material will not be prevented, or detected and corrected, on a timely basis by the entity's internal control
Control risk relates to the entity's own internal control failing to prevent or detect and correct a misstatement. The auditor's failure to detect misstatements is detection risk, and expressing an inappropriate opinion is audit risk overall. The susceptibility of an assertion before controls is inherent risk.
Question 2
Which of the following is NOT an objective of planning an audit?
- A) To ensure that the financial statements contain no material misstatements
- B) To help the auditor give appropriate attention to important areas of the audit
- C) To help identify and resolve potential problems on a timely basis
- D) To help assign team members with suitable skills to each area
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Answer: A) To ensure that the financial statements contain no material misstatements
Planning helps the auditor focus on the key risk areas, deal with problems early, organise the engagement and allocate staff with appropriate skills. However, planning cannot ensure that there are no material misstatements; the directors are responsible for the financial statements, and the auditor gives only reasonable assurance.
Question 3
Audit risk is a function of inherent risk, control risk and detection risk. Which of these can the auditor directly influence?
- A) Detection risk
- B) Inherent risk
- C) Control risk
- D) Both inherent risk and control risk
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Answer: A) Detection risk
Inherent risk and control risk are risks of material misstatement that exist within the entity, independently of the audit; the auditor assesses them but cannot change them. Detection risk is the risk that the auditor's procedures fail to detect a material misstatement. The auditor manages it through the nature, timing and extent of substantive procedures.
Question 4
An auditor has assessed both inherent risk and control risk for trade receivables as high. What is the appropriate response?
- A) Plan more extensive substantive procedures on receivables to reduce detection risk
- B) Reduce substantive procedures on receivables, because the risk has already been identified
- C) Rely on tests of controls only, as controls are the main source of risk
- D) Increase materiality for receivables to make misstatements less significant
Show answer & explanation
Answer: A) Plan more extensive substantive procedures on receivables to reduce detection risk
To keep audit risk at an acceptable level, a high risk of material misstatement must be offset by low detection risk. The auditor achieves this through more, and more persuasive, substantive procedures, for example larger samples or procedures closer to the year end. High control risk means controls cannot be relied upon, and raising materiality would be an inappropriate response.
Question 5
An audit firm sets overall materiality at 5% of profit before tax. A client's draft profit before tax is £840,000. What is overall materiality?
- A) £84,000
- B) £4,200
- C) £21,000
- D) £42,000
Show answer & explanation
Answer: D) £42,000
Overall materiality = 5% x £840,000 = £42,000. £84,000 would be 10% of profit, £4,200 would be 0.5% and £21,000 would be 2.5%. The benchmark and percentage are a matter of judgement, and the auditor would revise materiality if the final profit figure changed significantly.
Question 6
Overall materiality for an audit is £60,000. The firm sets performance materiality at 75% of overall materiality and treats misstatements below 5% of overall materiality as clearly trivial. What is performance materiality?
- A) £15,000
- B) £45,000
- C) £3,000
- D) £80,000
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Answer: B) £45,000
Performance materiality = 75% x £60,000 = £45,000. It is set below overall materiality to reduce the risk that uncorrected and undetected misstatements together exceed overall materiality. £15,000 is the 25% difference, £3,000 is the clearly trivial threshold (5% x £60,000) and £80,000 wrongly divides £60,000 by 0.75.
Question 7
Which of the following misstatements is most likely to be material by its nature, even though the amount is small?
- A) A small error in the depreciation charge on office furniture
- B) A minor cut-off error in sales of a few hundred pounds
- C) An understatement of directors' remuneration disclosed in the notes to the financial statements
- D) A small misclassification between two categories of administrative expenses
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Answer: C) An understatement of directors' remuneration disclosed in the notes to the financial statements
Materiality has qualitative as well as quantitative aspects. Directors' remuneration is of particular interest to shareholders and is a legal disclosure, so even small errors may influence users and reflect on directors' stewardship. Small, routine errors in depreciation, cut-off or expense classification are unlikely to be material unless their size is significant.
Question 8
Which of the following is most likely to indicate a high inherent risk?
- A) The client holds a large inventory of fashion clothing whose saleability depends on changing trends
- B) The client does not separate the duties of recording and banking cash receipts
- C) The audit team has no experience of the client's industry
- D) The audit sample sizes have been reduced to meet a reporting deadline
Show answer & explanation
Answer: A) The client holds a large inventory of fashion clothing whose saleability depends on changing trends
Inherent risk is the susceptibility of a balance to misstatement before considering controls. Fashion inventory may become obsolete quickly, making its valuation at the lower of cost and net realisable value subjective. Poor segregation of duties is a control risk, while inexperienced staff and reduced samples increase detection risk.
Question 9
What is the main purpose of performing analytical procedures at the planning stage of an audit?
- A) To help identify unusual changes or relationships that may indicate risks of material misstatement
- B) To provide sufficient appropriate evidence on all account balances
- C) To replace the need for any tests of detail
- D) To confirm the arithmetical accuracy of the trial balance
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Answer: A) To help identify unusual changes or relationships that may indicate risks of material misstatement
Analytical procedures are required as risk assessment procedures because they help the auditor understand the entity and highlight balances that are out of line with expectations. These areas can then be targeted for further work. They are not designed at planning to provide substantive evidence or to check arithmetic.
Question 10
A client's credit sales for the year were £3,650,000 and its trade receivables at the year end were £450,000. Last year receivables collection was 30 days. Assuming a 365-day year, what is this year's collection period and what risk does it suggest?
- A) 45 days; trade receivables may be overstated because of irrecoverable debts
- B) 45 days; trade receivables may be understated because of unrecorded sales
- C) 30 days; there is no change in risk from the prior year
- D) 22 days; the allowance for receivables may be overstated
Show answer & explanation
Answer: A) 45 days; trade receivables may be overstated because of irrecoverable debts
Receivables days = £450,000 / £3,650,000 x 365 = 45 days. The increase from 30 to 45 days suggests customers are paying more slowly, so some balances may not be recoverable and receivables could be overstated if no adequate allowance is made. A longer collection period does not suggest understatement.
Question 11
Which of the following is NOT a risk assessment procedure used to obtain an understanding of the entity and its environment?
- A) Making inquiries of management and others within the entity
- B) Performing analytical procedures
- C) Sending confirmation requests to the client's major customers
- D) Observing operations and inspecting documents such as board minutes
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Answer: C) Sending confirmation requests to the client's major customers
Risk assessment procedures comprise inquiries, analytical procedures, and observation and inspection. External confirmations of customer balances are further audit procedures performed in response to assessed risks, to provide evidence about receivables. They are not used to gain an understanding of the entity.
Question 12
A client's revenue has risen by 10% while its cost of sales is unchanged, so the gross margin has risen from 30% to approximately 36.4%. The business has not changed its pricing or suppliers. Which risk is this most likely to indicate?
- A) Purchases may be incomplete, or closing inventory may be overstated
- B) Revenue may be understated
- C) Closing inventory may be understated
- D) Administrative expenses may be overstated
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Answer: A) Purchases may be incomplete, or closing inventory may be overstated
Check the margin: if last year's revenue was 100 and cost of sales 70 (30% margin), this year's revenue is 110 with cost of sales still 70, so gross profit is 40 and the margin is 40 / 110 = 36.4% (rounded to one decimal place). With unchanged prices and suppliers, cost of sales should rise roughly in line with revenue, so an unchanged cost of sales may mean purchases have been omitted or closing inventory overstated, both of which reduce cost of sales and inflate the margin. Understated revenue or understated inventory would lower the margin, and administrative expenses do not affect gross margin.
Question 13
Which of the following would be included in the detailed audit plan rather than the overall audit strategy?
- A) The overall scope of the engagement and the reporting deadlines
- B) The broad direction of the audit and the areas of highest risk
- C) The specific procedures to be performed on trade receivables, including sample sizes
- D) The resources to be allocated to the audit, including the use of specialists
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Answer: C) The specific procedures to be performed on trade receivables, including sample sizes
The audit strategy sets the scope, timing and direction of the audit and the resources needed. The audit plan is more detailed, setting out the nature, timing and extent of the specific procedures to be performed, such as the tests on receivables and their sample sizes.