SECTION A CASE QUESTIONS (Total: 50 marks)

SECTION A CASE QUESTIONS (Total: 50 marks) Answer ALL of the following questions. Marks will be awarded for logical argumentation and appropriate presentation of the answers. CASE Background Angel Limited ( Angel ) is an integrated fine jewellery manufacturer and original design provider with a well-established operating history in Hong Kong. Angel is primarily engaged in designing, manufacturing and trading of jewellery products. The company has its financial year end at 31 December. Angel offers a wide range of fine jewellery products in karat gold, including rings, earrings, pendants, necklaces, bracelets, bangles, cufflinks, brooches and anklets. Angel s customers are mainly wholesalers and retailers of jewellery products. Since 2013, Angel has started operating its own retail chain stores in Hong Kong selling its own jewellery products. Angel s major suppliers include suppliers of raw materials and processing services. The principal raw materials purchased by Angel are gold, diamonds and gem stones. Angel engages sub-contractors with jewellery manufacturing facilities to handle certain steps of the production process such as casting, filing, stone setting, polishing and electroplating. Semi-finished products are sent back to Angel s production facilities located in Hong Kong for the final processing. Organisation structure of Angel Limited The organisation chart of Angel Limited is set out below: Angel Limited Subsidiary A ( Sub A ) (Wholesale) Subsidiary B ( Sub B ) (Manufacturing) Subsidiary C ( Sub C ) (Retail) Module C (December 2015 Session) Page 1 of 9

Angel has three wholly-owned subsidiaries namely A, B and C (represented as Sub A, Sub B and Sub C respectively) which are all incorporated in Hong Kong. Angel and its subsidiaries hereafter are collectively referred to as the Angel Group. Angel is an investment holding company but also responsible for product design. It has a team of designers who undertake research and provide their own designs for fine jewellery products. During 2015, Angel was successfully listed on the Hong Kong Stock Exchange. After listing, approximately 65% of its shares are owned by the An family. The control environment of Angel is similar to other small and medium-sized entities ( SMEs ) where a lot of Angel s activities are controlled by a few family members of the controlling shareholders. Activities engaged in by the subsidiaries Sub A Wholesale Sub A is responsible for the sales and marketing activities and sells goods to external customers and Sub C. It sources supplies from Sub B solely. Sub A will place a production order to Sub B to commence the production. When production is completed, Sub A will purchase the finished goods from Sub B and arrange sales and delivery of the finished goods to the respective customers. The gross margin that Sub A normally earns ranges from 15% to 30%. Sub A will not keep any inventory except when the goods are in transit during delivery to the customers. Sub B Manufacturing Sub B has only one customer, which is Sub A. Each sales order is assigned with a production order. When a production order is received, Sub B will commence the production plan comprising raw materials sourcing and job order scheduling. Sub B will then engage the third party sub-contractors in Shenzhen China to provide the sub-processing services. Once completed, the semi-finished goods will be sent back to Sub B in Hong Kong for the final production process. Sub B will sell the finished goods to Sub A. Sub B will charge Sub A at a mark-up of 10% based on the related costs incurred. Sub B keeps a significant amount of inventories which comprises raw materials, work-in progress, and finished goods. Sub C Retail Sub C operates a few chain stores in Hong Kong. The majority of its customers are tourists. Sub C only sells Angel s own products, accordingly it sources jewellery products from Sub A solely. The normal gross margin that Sub C can earn ranges from 50% to 60%. However, Sub C has incurred a significant amount of selling and promotional expenses which resulted in a net profit margin of 15% during recent years. Module C (December 2015 Session) Page 2 of 9

Extracted financial information of Angel Group for the years ended 31 December 2014 and 2015 and as at those dates: HK$ million 2015 2014 (Unaudited) (Audited) Revenue 500 300 Gross margin ( GP ) 175 84 Profit before tax 90 43 Net profit (note 1) 75 36 GP% (GP/Revenue) 35% 28% Net profit/revenue% 15% 12% Trade receivables 50 30 Inventories (note 2) 100 60 Total assets 300 120 Net assets 180 55 Notes: 1. Net profit in 2015 was mainly contributed by Sub A (80%) from the sales of jewellery products to third party wholesalers and retailers, and Sub C (20%) from the retail sales in Hong Kong. 2. Inventories as at the end of 2015 mainly comprised raw materials including gold, diamonds, and gem stones, work-in-progress (i.e. semi-finished jewellery products) and finished goods. Approximately 70% of the inventories were kept by Sub B which were located at its warehouse and sub-contractors premises. The remaining 30% of the inventories were kept by Sub C which were located at its retail stores. Recent economic environment Towards the end of 2015, the government announced that the total number of tourists visiting Hong Kong had dropped by 8% when compared to the previous year. This affected the overall performance of the retailing business in Hong Kong. Scope of engagement You were the audit engagement partner of Angel for the financial year ended 31 December 2014. After Angel became a listed company, you continue to act as Angel s audit engagement partner. You are now required to perform the audit of Angel s consolidated financial statements for the financial year ended 31 December 2015. Module C (December 2015 Session) Page 3 of 9

Question 1 (12 marks approximately 22 minutes) Assess the risks of material misstatements at the financial statement level. You should write down the specific circumstances of Angel that you have considered and your judgment about the overall risk at the financial statement level. (8 marks) Your audit engagement manager has consulted you as to which one of the following methods to determine the materiality of Angel s financial statements is appropriate. Advise and explain to your audit engagement manager which method should be adopted. (i) (ii) Total assets (HK$300 million) x 0.5% = HK$1.5 million; or Profit before tax (HK$90 million) x 5% = HK$4.5 million. (4 marks) Question 2 (16 marks approximately 28 minutes) Angel s accounting policy for inventories is that inventories are stated at the lower of cost and net realisable value. Cost is determined on the first-in-first-out basis and in the case of work-in-progress and finished goods, comprises direct materials, direct labour and an appropriate proportion of overheads. Net realisable value is based on estimated selling prices less any estimated costs to be incurred to completion or disposal. Angel captures the related direct and overhead costs incurred for each of the production orders. No standard costing has been applied. Evaluate and explain the risks of material misstatements relating to the valuation assertion of Angel Group s inventories. (8 marks) Suggest and discuss the audit procedures you would perform on inventories in response to the assessed risks of material misstatements relating to the valuation assertion in Question 2. (8 marks) Module C (December 2015 Session) Page 4 of 9

Question 3 (12 marks approximately 22 minutes) In obtaining an understanding of the process of recording the wages and salaries of the designers employed by Angel during the audit planning stage, what are the key internal controls that you would expect Angel should take place? List four key internal controls in your answer. (4 marks) During the audit, you noted that one of the designers is also a director of Angel. This director received salaries which are comparable to other designers within Angel. As a listed company in Hong Kong, what are the requirements as set out in the Code on Corporate Governance Practices for Angel to determine the remuneration payable to this director and the related disclosures in the annual report? (8 marks) Question 4 (10 marks approximately 18 minutes) As a listed company in Hong Kong, Angel is required to publish an interim report for its half yearly results for the period ending 30 June 2016. Angel would like to engage you for the review of its interim financial information and is now exploring with you the plan for such a review. Describe the procedures that you will undertake for the review of Angel s interim financial information. Your answer should cover the procedures for the different stages of "Planning", "Execution" and "Completion". (10 marks) * * * * * * * * Module C (December 2015 Session) Page 5 of 9

End of Section A

SECTION B ESSAY / SHORT QUESTIONS (Total: 50 marks) Answer ALL of the following questions. Marks will be awarded for logical argumentation and appropriate presentation of the answers. Question 5 (10 marks approximately 18 minutes) External confirmation is reliable audit evidence in the audit of trade receivables. Provide reasons to support the above statement. (2 marks) You are the audit engagement manager auditing a garment trading company (the company ) which transacts with various customers mainly in Europe and America. As at 31 December 2014, the company has significant outstanding trade receivables due from its customers. You have agreed with the audit engagement team that external confirmation procedures should be performed. The audit engagement senior reports to you the audit confirmation results and would like you to advise the follow up audit procedures in response to each of the following scenarios: Scenario (i) The audit engagement team noted that there was a new customer from India who started trading with the company in November 2014. 10% of the outstanding trade receivables as at year end was contributed by this new customer. However, the finance manager of the company strongly refused the audit engagement team s request to send a confirmation request to this new customer. (4 marks) Scenario (ii) One of the confirmation replies was mailed directly to the company. The finance manager passed to the audit engagement team the confirmation reply without opening the sealed envelope containing the confirmation. (2 marks) Scenario (iii) One of the confirmation replies had only a minor difference (i.e. below the materiality level) and therefore the audit engagement senior decided no follow up procedure was required. (2 marks) Suggest and explain the appropriate follow up audit procedures for each of the above scenarios. Module C (December 2015 Session) Page 7 of 9

Question 6 (10 marks approximately 18 minutes) Two years ago, Melon Limited acquired Lychee Limited. Melon Limited and Lychee Limited are both fruit distributors. Both companies use Enterprise Resource Planning ( ERP ) computer software for daily operations and bookkeeping. However, the system specifications and the ERP modules used are very different in the two companies. In order to enhance the operational efficiency, it was decided that Lychee Limited will switch to the ERP system of Melon Limited and scrap its own ERP system this year. You are the auditor of Lychee Limited and in the process of understanding the change of system with the management. Suggest the possible factors that may lead to material misstatements in the financial statements of Lychee Limited as a result of the change of system. (3 marks) In response to the possible factors identified in Question 6, suggest audit procedures to address the possible risks of material misstatements in the financial statements relating to the above change of system. (7 marks) Question 7 (11 marks approximately 20 minutes) Fashion Limited is a garment manufacturer based in mainland China and listed in Hong Kong. Audit Partner A and Manager C have been assigned as the audit engagement partner and audit engagement manager of Fashion Limited for 5 years and 10 years respectively. The audit engagement team maintains a very good relationship with Fashion Limited s management team. During the year, the performance of Fashion Limited deteriorated significantly as Fashion Limited lost several major customers. There may be a risk of impairment of Fashion Limited s fixed assets. However, both the management and audit engagement team believe that no impairment of fixed assets should be made in the year. Partner B has been newly assigned as the engagement quality control reviewer of the audit of Fashion Limited for the current year. HKSA 220 (Clarified) Quality Control for an Audit of Financial Statements sets out the requirements and provides guidance regarding quality control of individual audits. Explain the differences in the roles and responsibilities of Partner A and Partner B in Fashion Limited's audit. (5 marks) In response to the facts and circumstances above, what would you recommend Partner B doing to discharge his role and responsibilities as an engagement quality control reviewer? (6 marks) Module C (December 2015 Session) Page 8 of 9

Question 8 (19 marks approximately 34 minutes) Solar Energizer Limited ( Solar ) is a company incorporated in the Cayman Islands and listed in Hong Kong. Its principal activities are the manufacturing and trading of devices which convert solar energy directly into electricity using special cells and modules. It also participates in large scale construction projects providing solutions to companies switching to solar energy. Many share market analysts have placed very high expectations on Solar s upcoming result announcement. Solar s recent share price has increased 10 times compared to a year ago. Alan is the audit engagement partner of Solar. Two days before Solar s current year results announcement, the management told Alan that they had just identified a product defect in one of their major products and planned to announce a large scale product recall immediately after the results announcement. The audit engagement team has substantially completed the 31 December 2014 year-end audit. The only outstanding piece of work was the review of the product recall and its financial and disclosure impact on the financial statements. After learning from the management about Solar s product recall, Alan explained to the management that he needs more information to understand the financial impact of the product recall. Solar s management estimated that additional costs of HK$10 million would be incurred in response to the product recall programme but refused to recognise such a provision in the financial statements for the year ended 31 December 2014. The pre-tax profit of Solar for the year ended 31 December 2014 before the adjustment of the provision is approximately HK$100 million. On the same night, Alan attended a reunion event with his university classmates. One of his classmates, Michael, asked for Alan s view of Solar s business performance. Michael plans to invest HK$5 million in Solar as he strongly believes in Solar s business model and the management team. (c) Assume you are Alan, would you tell Michael about the plan for the product recall? Explain your answer and suggest an appropriate response to Michael. (6 marks) The product recall has been identified as a significant subsequent event after the end of the reporting period by the audit engagement team. What are the audit responsibilities of the audit engagement team in assessing the impact of the product recall on the financial statements? What would be the possible material misstatements on the financial statements in view of the product recall? (7 marks) Based on the information given in the case, advise an appropriate audit opinion in response to such a situation and draft the auditor's report. You are only required to draft two paragraphs including basis of opinion and your proposed audit opinion. (6 marks) * * * END OF EXAMINATION PAPER * * * Module C (December 2015 Session) Page 9 of 9