MCQ

Q1. For a given assertion, the relationship between the level of detection risk (DR)
and assessed control risk (CR) and inherent risk (IR) is shown correctly in which
of the following, where + means increase, - means decrease:
a. +DR if +CR and +IR.
b. +DR if -CR and -IR.
c. +DR if +CR and -IR.
d. +DR if -CR and +IR.

Q2. If inherent risk and control risk are both assessed as low, detection risk will be:
a. low.
b. high.
c. the same as audit risk.
d. medium.

Q3. Inherent risk is defined in terms of:

a. a total absence of controls.
b. an ideal set of controls.
c. the existing controls.
d. the standard controls for the client's industry.

Q4. For a particular assertion, control risk is the risk that:

a. a material misstatement will occur in the accounting process.
b. audit procedures will fail to detect a weak control system.
c. control procedures will not detect a material misstatement that occurs.
d. the prescribed control procedures will not be applied uniformly.

Q5. When the lower assessed level of control risk approach is used, the final
assessment of control risk is made after completing:
a. the procedures to obtain an understanding.
b. the documentation of the understanding.
c. all the planned tests of controls.
d. all the above.

Q6. Professional standards recognise that a misstatement that is quantitatively

immaterial may be qualitatively material. In regard to these items, professional
standards require the auditor to:
a. plan the audit to search for them.
b. design explicit procedures to detect them.
c. be on the alert for them.
d. report them directly to client management.

Q7. In making judgements about materiality at the account balance level, the auditor
must consider the relationship between it and overall materiality. This should lead
the auditor to plan the audit to detect misstatements that:
a. are individually material to the statements taken as a whole.

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 b. are individually immaterial to the statements taken as a whole.
c. bring the cumulative total of known misstatements to the level of materiality
established by management.
d. may be immaterial individually, but may aggregate with misstatements in
other accounts to a material level

Q8. All else being equal, as the level of materiality decreases, the amount of evidence
required will:
a. increase.
b. decrease.
c. remain the same.
d. change in an unpredictable fashion.

Short Essay questions

1) Discuss the component of the audit risk model and its limitation of audit risk
model. How the model may be used in planning and audit?

Pointers:
Audit risk is defined as the risk that the auditor may give an inappropriate OR
wrong opinion when he financial statements are materially misstated. The auditor’s
standard report states that the audit provides only reasonable assurance that the
financial statements do not contain material misstatements. The term “reasonable
assurance” implies that there is some risk that a material misstatement could be
present in the financial statements and the auditor will fail to detect it. For eg. Audit
Risk of 5% means that the is 5 chances in 100 of giving the wrong opinion.

Audit Risk Model:

Audit Risk(AR)= Inherent Risk (IR) X Control Risk(CR) X Detection Risk (DR)

Inherent Risk is the susceptibility of an assertion to material misstatement assuming

no related internal controls.(Risk or likelihood of material error being present in the
financial statement if there were no internal control operating) This types of risk
derives from 3 sources:

 Management integrity –mgt ‘s moral and ethical stance,

 Account risk-the level of uncertainty or degree of judgement involved in an
account (eg provision of doubtful debt),
 Business risk –External and Internal eg the extent to which the client biz is
vulnerable to changes in the economy, competition and or technological
advancement.(Refer to the lecture notes for more examples)

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Internal control Risk is the risk that material misstatement that occur will not be
prevented or detected by the internal controls. Some internal control risk will always
be present because any system of internal control has inherent limitations (eg
collusion)
Note: IR and CR are not under the direct control of Auditor, but with the
Auditee to certain extent.

Detection Risk- Detection Risk is the risk that the auditor will not detect a material
misstatement that exists in the financial statements. This risk can be influenced by the
auditor. Inherent risk and control risk differ from the detection risk in that they exist
independently of the audit of financial statements whereas detection risk relates to the
auditor ‘s procedures and can be changed at the auditor’s discretion. Detection risk
has and inverse relationship to inherent and control risk. Given the desired AR, if
IR and CR are assessed to be high, then, the amount of Substantive test will be
increased.
Note: DR can be decomposed further into Analytical Procedures risk (APR) and
Substantive test of details risk

The use of the model in planning the areas of the audit on which to concentrate (the
areas of greatest risk of material misstatement) and in planning the amount of detailed
testing should then follow.

The limitations of Audit Risk Model are as follows:

 First: the model assumes that its component are independent of one another
while they are likely to be dependent in the real world.

 Second: since the auditor assesses IR and CR, such assessments may be
higher or lower than the actual IR and CR that exist for the client

 Last, the audit risk model does not consider the possibility of non sampling
risk.
(An aspect of audit risk that results from an incomplete examination of the
available data. It is the failure of an auditor to catch a mistake or a
misstatement. This may be caused by either misinterpreting the evidence or
misapplying procedures that are inappropriate)

Indicate which of these components is under the control of the auditor and
indicate the relationship of this component to the other components of audit
risk.

Answers

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 The component that is under the control of the auditor is detection risk. There is an
inverse relationship between inherent and control risks and the level of detection
risk that the auditor can accept for an assertion.

Question 2
Distinguish between the terms tolerable misstatement and preliminary judgement
about materiality. How are they related to each other?
Answers:
A preliminary judgment about materiality is set for the financial statements as a
whole. Tolerable misstatement is the maximum amount of misstatement that would
be considered material for an individual account balance. The amount of tolerable
misstatement for any given account is dependent upon the preliminary judgment
about materiality. Ordinarily, tolerable misstatement for any given account would
have to be lower than the preliminary judgment about materiality. In many cases, it
will be considerably lower because of the possibility of misstatements in different
accounts that, in total, cannot exceed the preliminary judgment about materiality.

Question 3
Explain briefly what is meant materiality in the context of financial reporting and
discuss why this concept is important to the auditors.

Answers:

Materiality MFRS 101 Definition: Information is material if non disclosure could

influence the economic decisions of users taken on the basis of the financial
statements. Materiality depends on the size of the item or error judged in the
particular circumstances of its omission or misstatement. The concept of materiality is
reflected in the wording of the auditors ‘standard audit report through the phrase “the
financial statements give true and fair view or present fairly in all material
respects.”This is the manner in which auditor communicates the notion of materiality
to the users of auditor’s report

Materiality is considered a relative concept because an amount such as RM 10K

might be considered highly material for a small entity but would be clearly
immaterial for a large multinational company with assets in billions. The is why the
calculation of the preliminary judgement is based on the relative size (eg total assets
or total revenues) of the entity. There is no specific guidance and it is a matter of
Professional Judgement

Qualitative and Quantitative factors that may affect the assessment of materiality
must be taken into consideration.

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 Qualitative factors include: fraud and irregularities, small amounts that might
violate covenants in the contract, on compliance with laws or regulations,
amount that might affect the trend in earning.

Quantitative factors: Total Assets, total revenues, Net Income before tax, Gross
Profit, average of 3 year income before tax.
According to ISA 320 the auditor should consider materiality and its relationship
with audit risk when conducting audit (Inverse relationship).

This concept is important to the auditors for the following reasons:

a) Determining the nature(compliance/substantive testing),extent (amount of audit
evidence)and timing (year end and interim audit)of audit procedures

b) Evaluating the effect of misstatement.

It is accepted that financial statements may give a true and fair view even if they
include errors or misstatements so long as the errors or misstatement are not material.
The responsibility of the auditor is to detect material errors and misstatement (the
audit will be impossible if the auditor were to responsible for detecting all the errors.

Question 4
Identify the two levels of materiality that are important in audit planning and indicate the
reason for each level.

Answers:

Level 1 ─ Financial statement level (overall materiality), because the auditor expresses an
opinion on the financial statements taken as a whole.

Level 2 ─ Account balances and class of transactions level (account balances level),
because the auditor verifies account balances in reaching an overall conclusion on the
fairness of the financial statements.

The relationship between materiality for planning purposes and materiality for
evaluation purposes

The auditor's judgment about materiality for planning purposes may be different from
materiality for evaluation purposes because the auditor, when planning an audit, cannot
anticipate all of the circumstances that may ultimately influence judgment about

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materiality in evaluating the audit findings at the completion of the audit. If
significantly lower materiality levels become appropriate in evaluating the audit
findings, the auditor should re-evaluate the sufficiency of the audit procedures already
performed.