SECTION A CASE QUESTIONS (Total: 50 marks) Answer 1(a) The balance of trade receivables as at 30 June 2014 significantly increased when compared to that of 31 December 2013, which did not match with the half-year performance of the entity. The debtors turnover period for the interim period increased significantly to 88 days when compared to 68 days for the year ended 31 December 2013. The debtors turnover period for the interim period was much longer than the normal credit term granted to its customers. The risk of material misstatement relating to the existence and valuation assertions of trade receivables is high. The risk of material misstatements may be caused by: Amounts posted to trade receivables were not related to valid sales. Cut-off error receipt from debtors before report date but not recorded; or recorded sales but actual delivery was made after the reporting date. The reconciliation between the trade receivables sub-ledger and the general ledger may contain un-reconciling items which could result in a misstatement of trade receivables. The trade receivables were not recoverable. Trade receivables were misstated due to the use of an incorrect exchange rate for the foreign currency sales. Inputting error. Answer 1(b) Cherry Group s external auditors can perform the following: circularise year end trade receivable balances to targeted debtors which were identified as having large outstanding balances; follow up the replied confirmations with disagreements and the non-replied confirmations; review post reporting date cash receipts by inspecting bank statements and cash receipts documentation; for balances not yet settled after the reporting date, examine their respective invoices, sales order from customers or despatch documentation, etc; Module C (December 2014 Session) 1 of 12
for specific invoices concerning their validity, examine the customer's account or customer correspondences to confirm their validity; and apply substantive analytical review procedures to test the reasonableness of the outstanding balance including comparison of prior year outstanding amounts. Answer 1(c) (i) Computer-assisted audit techniques ( CAATs ) are the application of auditing procedures using the computer as an audit tool. (ii) Use of CAATs in the substantive testing of accounts receivables includes the followings: Check addition accuracy and inter-ledger agreement of accounts receivable control and sub-ledgers. Select random sample for circularisation. Select targeted sample for circularisation e.g. major customers or customers satisfying particular selection conditions. Perform detailed substantive analytical review e.g. debtors turnover by product or by segment. Search for unusual items e.g. related party for general audit considerations and disclosure. Answer 2(a) Ways to obtain an understanding of the component auditor In order to obtain an understanding of the component auditor who will be involved in the group audit, the group engagement team may consider to: evaluate the results of the quality control monitoring system where the group engagement team and component auditor are from a firm or network that operates under the common monitoring policies and procedures; hold discussions with the component auditors; perform site visits of the component auditors; request the written confirmation from the component auditor; request the component auditor to complete questionnaires; Module C (December 2014 Session) 2 of 12
hold discussions with other individuals familiar with the component auditors; obtain confirmations from the professional body or bodies to which the component auditor belongs, the authorities by which the component auditor is licensed, or other third parties; reflect on prior experience with the component auditors, if applicable; and review relevant documentation as it relates to the component auditors. Answer 2(b) Component auditor s understanding and compliance with the ethical requirements The group engagement team would normally obtain the acknowledgment from the component auditor as to their understanding and compliance with ethical requirements and properly file it in the working papers. If a component auditor does not meet the independence requirements that are relevant to the group audit, or the group engagement team has serious concerns about the component auditor's ability to comply with ethical requirements, professional competence and regulatory environment, the group engagement team is required to obtain sufficient appropriate audit evidence relating to the financial information of the component without requesting that component auditor to perform work on the financial information of that component. Answer 2(c) Component auditor s professional competence The group engagement team s understanding of the component auditor s professional competence should include whether or not the component auditor: possesses an understanding of auditing and other standards applicable to the group audit that is sufficient to fulfil the component auditor s responsibilities in the group audit; possesses the special skills (e.g. industry specific knowledge) necessary to perform the work on the financial information of the particular component; and possesses an understanding of the applicable financial reporting framework that is sufficient to fulfil the component auditor s responsibilities in the group audit (instructions issued by group management to components often describe the characteristics of the applicable financial reporting framework). Module C (December 2014 Session) 3 of 12
The group engagement team can obtain an understanding of their professional competence through discussions with the component audit team. The group engagement team can request the component audit partner s résumé of their relevant experience which will assist in enhancing understanding of the component auditor. If necessary, further discussions may be held between the group engagement partner and the component audit partner for a thorough understanding of the competence and expertise of the component auditor. Answer 3(a) HKSA 570 (Clarified) Going Concern should be referred to when the auditor considers the going concern assumption affecting his/her audit opinion. Under the going concern assumption, an entity is viewed as continuing in business for the foreseeable future. General purpose financial statements are prepared on a going concern basis, unless the entity management either intends to liquidate the entity or to cease operations, or has no realistic alternative but to do so. Before the auditor expresses his/her opinion, he/she should consider the mitigating factors on the casting of significant doubt on Cherry Group s ability to continue as a going concern. The auditor should: request management to make its assessment about the entity s ability to continue as a going concern; or evaluate management s plans for future actions in relation to its going concern assessment, whether the outcome of these plans is likely to improve the situation and whether management s plans are feasible in the circumstances. Answer 3(b) The auditor has to evaluate Cherry Group s Management assessment on preparing the financial statements on a going concern basis. Vietnam Co contributes 20% of the Group s revenue and 8% of the net profit before tax. Vietnam Co is regarded as material and is obviously significant in the financial reporting of the Group. Vietnam Co is the defendant of a legal claim. If the claim is successful, Vietnam Co should become insolvent (or be subject to a court order of winding up) and its assets value would have diminished after making the claim. However, the impact of the demise of Vietnam Co on the Group as a whole may not be pervasive although material, because both the profit contribution and net assets value contributed to the Group are less than 10%. Nevertheless, it will cast significant doubt on the Group s operating under a going concern should the limited liability protection not being available and hence the Hong Kong companies are required to pay compensation. The auditor should consult Cherry Group's lawyer as well as its legal advisor to seek written advices. Module C (December 2014 Session) 4 of 12
With only a few months away from the year end date, it is not certain if the legal claim against Vietnam Co would succeed. It is also not certain if any judgement obtained in Vietnam could be enforced in Hong Kong against the resident companies especially when more than one jurisdiction is involved. Under the general principles relating to separate legal entity of limited companies, it offers initial comfort preventing the claims against a subsidiary company from reaching the holding company. Therefore, it should still be appropriate for Cherry Group s Management to use the going concern assumption to prepare their financial statements when a material uncertainty exists, at least for the next 12-month period. According to HKSA 706 (Clarified) Emphasis of Matter Paragraph and Other Matter Paragraphs in the Independent Auditor s Report, if the auditor agrees that it is still appropriate for the Management to use the going concern assumption, the auditor shall express in his report an unmodified opinion and include an Emphasis of Matter paragraph to disclose the legal claim and its impact. The Emphasis of Matter paragraph must also draw the user s attention to the related disclosure note in the financial statements and indicate that the auditor s opinion is not modified in respect of the matter emphasized. In Cherry Group s case, the auditor should issue an unmodified opinion and include an Emphasis of Matter paragraph in his report. Answer 4(a) The main role and responsibilities of the Audit Committee on financial statements and external audit should include: to assist the Board by carrying out their own independent review of financial reports, including any other reports or statements on behalf of the Board. Such reviews should focus on the integrity of the financial statements and on the adequacy and fairness of disclosure; to make recommendations to the board on the appointment, reappointment and removal of the external auditors, to approve the remuneration and terms of engagement of the external auditors and any questions or resignation or dismissal of the external auditors; to monitor and review the external auditor s independence, objectivity and effectiveness of the audit process in accordance with applicable standards; to develop and implement policy on engagement of the external auditor to supply non-audit services; to meet the external auditor and discuss accounting and auditing issues; to review the external auditor s management letter; and to ensure that the board provides a timely response to the issues raised in the external auditors' management letter. Module C (December 2014 Session) 5 of 12
Answer 4(b) In this context, the review process would normally encompass consideration by the Audit Committee of the areas discussed below. The appropriateness of significant accounting policies: The Audit Committee should consider whether the accounting policies adopted by the company are in accordance with accounting principles generally accepted in Hong Kong or any other applicable accounting principles. They should consider carefully instances where the company s policies are not in accordance with Hong Kong Financial Reporting Standards and whether the justification for any departure is reasonable. The Audit Committee should consider whether the accounting policies adopted are appropriate to the circumstances of the company and whether alternative policies would be more appropriate. Judgmental issues and accounting: Estimates in preparing financial statements which give a true and fair view, management frequently has to make estimates, for example, where the outcome of a particular matter is uncertain. Accounting estimates fall outside the scope of traditional internal accounting controls applied to systematically processed, recurring transactions. The Audit Committee should review accounting estimates carefully to satisfy themselves that the judgements made by management are reasonable. The adequacy and usefulness of disclosures: Members of the Audit Committee should satisfy themselves that all relevant items have been properly disclosed in the financial statements. The disclosure of related party transactions and any unusual items should receive particular attention. Material, non-recurring items which may be considered unusual: The treatment and disclosure of unusual items which occurred during the year should be considered by the Audit Committee. Any material, non-recurring items may be considered unusual and may require greater prominence in the financial statements. Examples of unusual items would include asset acquisitions and disposals, contingent liabilities and litigation. * * * END OF SECTION A * * * Module C (December 2014 Session) 6 of 12
SECTION B ESSAY / SHORT QUESTIONS (Total: 50 marks) Answer 5 Situation (i) You should refuse the tickets. Unless the value of the ticket is trivial and inconsequential, a member of an engagement team should decline any offers which may be seen to be intended to influence the judgement of a professional accountant. It is difficult to be convinced from the independence perspective that a concert ticket worth HK$8,000 be regarded as trivial and inconsequential and the acceptance of the tickets will likely to create self-interest threat. Situation (ii) Your team may or may not accept the dinner invitation. hospitality will create a self-interest threat. It depends on whether the The engagement team should refuse any extravagant dinner as it will fall into a grey area as to whether the offer would be an inducement or downright bribery. However, the engagement team can accept any dinner offer that is part of business life. Situation (iii) You should refuse the contingent fee arrangement proposed by the Chairman. The bonus arrangement creates self-interest threat to the audit engagement team as the auditor s remuneration would be based on the outcome of a potential IPO. A firm should not enter into a contingent fee arrangement for any assurance engagement as payment arrangements based on outcomes create self-interest threat which cannot be reduced to acceptable levels through the application of suitable safeguards. Situation (iv) The tax team can maintain a close working relationship with the audit client in the normal business context and as long as no familiarity threat is created. They can continue with the tax advisory work and the audit support work as long as there are proper safeguards to prevent the tax team auditing their own work. Auditing its own work will create a self-review threat for the team. Safeguards can include appointing separate teams for the tax advisory and tax audit. Module C (December 2014 Session) 7 of 12
Answer 6(a) The internal control system can only provide reasonable assurance but not absolute assurance as there are inherent limitations such as: (a) the cost of control not outweighing the benefits; (b) the potential for human error; (c) collusion between employees; (d) possibility of controls being by-passed or over-ridden by management; and (e) controls being designed to cope with routine but not unusual transactions. Human error and potential for fraud are the most serious challenges to any internal control system, as any control system is only operating effectively as long as the people operate it. If employees decide to commit fraud by collusion, or management commit fraud by overriding systems, they probably do so in the knowledge that they can manipulate the accounting system to conceal their fraudulent activity. Answer 6(b) Situation (i) A test of details audit approach is suggested. Though the branch seems to have a good control environment that is subject to a good tone at the top, the branch s lack of segregation of duties due to a limited number of staff could be a problem. There is no accounting control that can be relied on as all books and records are kept by the same accounting staff which indicates no review and approval process. Situation (ii) A combination of both test of controls and test of details audit approach is suggested. The principal subsidiary seems to have effective controls in place. The engagement team may be able to rely on the accounting controls. The auditor should test the management s representation to validate any change of process and key personnel during the year. Test of details are also required for areas that are designated as significant risk. There is a rebuttable presumption that management override of controls and fraud risk in revenue recognition are significant risks so that certain test of details should be performed. Module C (December 2014 Session) 8 of 12
Situation (iii) A combination of both test of controls and test of details audit approach is suggested. The engagement team should perform a walkthrough test to understand the processes changes in the purchase and payable cycle, identify and evaluate the key controls. The engagement team should also perform a validation test to ensure the key controls are effective during the year. Test of details should be performed to address the significant risk in account payables, e.g. send account payable confirmation, perform purchase cut-off test. Answer 7(a) The three key characteristics of fraud are: (1) incentive or pressure to commit fraud management is under pressure to achieve unfeasible earnings or aggressive budget; (2) opportunity to commit fraud management has the ability to override an internal control without detection; and (3) rationalisation of committing a fraudulent act individual may possess an attitude or character that allows them knowingly and intentionally to commit a dishonest act. Answer 7(b) The risk of both management fraud and employee fraud is low. This is because: Low incentive or pressure for management to commit fraud as the key management are also the owners of the company. Management is less focused on share price appreciation and publicity but more on the profitability of the company. The board usually sets achievable budget; the incentive and pressure for employees to commit fraud greatly depends on the linkage of meeting the budget and employees remunerations. Since meeting the financial budget is not the only criterion in assessing employees performance because other key performance indicators ( KPIs ) count, there is less risk for employees to manipulate the financial results. Module C (December 2014 Session) 9 of 12
Low opportunity for employees to commit fraud as the CEO and the executive director are heavily involved in the daily operation. They exercise strong controls in the day-to-day operations, including monitoring controls e.g. business performance review on a weekly basis, and transaction level controls e.g. reviewing and approving all sales and purchase transactions. Management set strong tone at the top and emphasizes ethical behaviour which helps cultivate employee a positive attitude to honest act and give less rationalization for employees to commit any fraudulent act. Answer 8(a) An auditor s expert is an individual or entity possessing expertise in a field other than accounting or auditing, whose work in that field is used by the auditor to assist the auditor in obtaining sufficient appropriate audit evidence. A management s expert is an individual or entity possessing expertise in a field other than accounting or auditing, whose work in that field is used by the entity to assist the entity in preparing the financial statements. Answer 8(b) Given the fact that the period end valuation of the shopping arcade is prepared by management s internal property consultation, the engagement team should consider the following in order to determine the usefulness of the work of management s expert: Competence, capabilities and objectivity of the internal property consultant. Nature, scope and objectives of the valuation prepared by the internal property consultant. The extent that management can exert influence or control over the work of the internal property consultant. The technical regulations or standards with which internal property consultant has to comply with. Appropriateness of the valuation methodology used and reasonableness of the assumptions used. The engagement team should also consider if they have sufficient knowledge and experience in reviewing management s valuation results. Module C (December 2014 Session) 10 of 12
If the engagement team considers that there is the potential bias of the valuation prepared by the internal property consultant, or the valuation not being performed in accordance with an appropriate valuation methodology, or the data reliability used for the valuation is in doubt, the engagement team can consider to engage an independent auditor s expert to perform an independent valuation for audit reference, or the engagement team can develop a point of reference for the valuation results if the engagement team is satisfied that they have sufficient knowledge and expertise in the property valuation in Beijing. HKSA 620 (Clarified) Using the Work of an Auditor s Expert provides guidance on the use of the work of an auditor s expert, including the consideration of nature, extent and timing of the procedures of an auditor s expert. In engaging an auditor s expert for the property valuation, the engagement team should evaluate the objectivity, competence and capabilities of the independent external valuer; agree the scope of work, methods and assumptions used; review and evaluate the expert s work; re-perform the calculation of revaluation, etc; and confirm that the valuation bases are in line with HKAS 40 Investment Property and HKFRS 13 Fair Value Measurement, etc. Last but not least, the engagement team should inspect the draft financial statements to check that the client has recognised appropriately the changes in fair value of the shopping arcade in the statement of comprehensive income in accordance with HKAS 40. Answer 9 HKSA 550 (Clarified) Related Parties provides guidance on the auditor s responsibilities with regard to related party relationship and transactions in an audit of financial statements. In assessing the risk of material misstatements relating to the related party transactions, the engagement team should consider the following procedures: Understand from management the nature of related party relationships and transactions. Inquire the management for the identity of the related parties, the relationship between Big Bulb and the related parties, and the types and purposes of the related parties transactions. Understand the terms and conditions of the related party transactions that are outside the normal course of business. Module C (December 2014 Session) 11 of 12
Understand management s control over related party relationships and transactions. for example, controls established to identify, account for, and disclose related party relationships and transactions in accordance with the applicable financial reporting framework; to authorise and approve significant transactions and the arrangement with related parties; to authorise and approve significant transactions and arrangements outside the normal course of business. Understand management s controls over the completeness of related party relationships and transactions. Understand and evaluate the effectiveness of Big Bulb s information system in identifying and summarizing transactions and the outstanding balance between Big Bulb and its related parties. Inquire those charged with governance, the internal auditors or in-house legal counsel, if any, or review the meeting minutes of shareholders and those charged with governance for indications of significant related party transactions that are not identified by the management. * * * END OF EXAMINATION PAPER * * * Module C (December 2014 Session) 12 of 12