In addition, Angel is not involved in any regulated industry, accordingly, industry or regulatory factors are also not factors leading to the risk.

SECTION A CASE QUESTIONS (Total: 50 marks) Answer 1(a) The risks of material misstatements at the financial statement level refer to risks of material misstatements that relate pervasively to the financial statements as a whole and potentially affect many assertions. Angel is an entity whose activities are controlled by a few family members. Such a concentration of management power poses a higher risk of error. Errors may not be identified due to the lack of checking by independent parties. Management override may also cause deficiencies of internal control implemented by Angel, and consequently, increases the risks of material misstatements at the financial statement level. In addition, Angel is running separate business segments (manufacturing, wholesale and retail) with multi-locations. Therefore, the nature of its business has increased the risks of having inconsistent (and possibly confusing) systems, controls and other procedures. Angel has become a listed company recently and the management may have undue pressures on maintaining a rising sales trend and profit which may boost the share price. The related fraud risk would also increase the risks of misstatements at the financial statement level. The recent economic environment which indicated a downturn in the economy may have a financial impact on Angel s business, which would further increase the risks of misstatements of financial statements such as inadequate impairment for inventories and trade receivables. Factors relating to management s experience and knowledge would not cause a higher risk assessment because, as set out in the case, Angel is an integrated fine jewellery manufacturer and original design provider with a well-established operating history in Hong Kong and so there is no reason to mistrust the management s experience and knowledge. In addition, Angel is not involved in any regulated industry, accordingly, industry or regulatory factors are also not factors leading to the risk. Based on the foregoing, the overall risk of misstatement at the financial statement level is high. Answer 1(b) HKSA 320 (Clarified) Materiality in Planning and Performing an Audit states that the auditor, using professional judgment, shall determine materiality for the financial statements as a whole, when establishing the overall audit strategy. Module C (December 2015 Session) Page 1 of 14

We should consider the users, industry, the type of operations and other factors when determining an appropriate basis for materiality. Since Angel is a newly listed company, the users of Angel s financial statements are the public shareholders who are concerned about Angel s profitability and sales trend. Accordingly, profit before tax is a preferred basis to determine materiality since the users will consider profit as an important indicator of the performance of the entity and profit as a suitable basis to determine Angel s share price. Since this engagement has an overall high audit risk, we could apply the application of the low end of the commonly accepted percentage. Accordingly, 5% is considered appropriate. To conclude, method (ii) should be used to determine the materiality of Angel s financial statements. Answer 2(a) Angel Group recorded an inventories value of HK$100 million as at 31 December 2015. Inventories, which amounted to 33.33% of total assets, are a material component of the statement of financial position of Angel Group. The audit objectives of an inventory valuation assertion include: Costs are accurately determined in accordance with accounting standards; and Inventories are recorded at year-end at the lower of cost and net realisable value. The following facts and circumstances of Angel Group have been considered which increase the risks of material misstatements for the inventory valuation assertion: Angel Group has different forms of inventory items, raw materials, work-in-progress (i.e. semi-finished jewellery products) and finished goods, which are subject to different valuation methodologies. Inventory items which comprised gold, diamonds and gem stones, which are of high value, may require special knowledge to value. The involvement of third party sub-contractors for the provision of certain stages of work has made the valuation more complicated. The manufacturing accounting is complicated as it involves direct labour and overhead costs when the semi-finished goods are sent to Sub B for final production. The inter-company sales of the finished goods between Sub A and Sub B and the inter-company sales of finished goods between Sub A and Sub C, with different mark-ups on the inventory items, would increase the complexity of valuation as elimination of unrealised profit is required at the group level. Module C (December 2015 Session) Page 2 of 14

Inventories are kept by different entities (Sub B and C) at multi-locations (warehouses and retail stores), which would increase the risks of material misstatements of the inventories valuation as the entity control environment of Sub B and C may not be the same. Gold is a commodity. The fluctuation of the gold price would affect the net realisable value of Angel s inventories. Jewellery products are luxury items and their values are sensitive to the market economy and the wealth condition of the people in that country. This increases the risk of Angel Group suffering a loss when the selling prices drop. The determination of net realisable value of the inventories for the retail business is more complicated as selling costs for Sub C are more complex to ascertain. Answer 2(b) The proposed audit procedures are as follows: Overall Investigate Angel s inventory accounting policy, particularly that relating to overhead allocation, to consider whether the policy complies with relevant accounting standards. Obtain a full list of inventory. Recalculate the total gross amount and match the recalculated result to the amount in the statement of financial position. Apply analytical procedures including: Compare the gross profit percentage to the previous year or industry data. Compare raw materials, finished goods and total inventory turnover days to the previous year and industry averages. The auditor should perform the following: Raw materials Check the value of raw materials by vouching with suppliers invoices. Select samples of some expensive inventories from the inventory lists and check if the actual type or class of these samples agree with the accounting records. If necessary, obtain an independent expert s confirmation about the type or class of the inventories (e.g. diamonds) in the sample and their valuation. Module C (December 2015 Session) Page 3 of 14

Work-in-progress and finished goods Check if the same method is used by Sub B and Sub C to value work-in-progress and finished goods, and check the effectiveness of the system of internal controls adopted by each of Sub B and Sub C. For the raw materials acquired, agree costs with raw material requisition records, reconcile raw materials used with the respective planned production orders. For labour costs, agree costs with wage records, reconcile labour hours with time summaries. Re-perform some overhead cost allocations. deviations from the policy. Ask the entity s management about any Examine the management s calculation of the unrealised profits adjustment for the finished goods at group level. For work-in-progress held by third party sub-contractors, inspect related documentation, request confirmation, and obtain a full list of inventory items and agree with Angel s records. Lower of cost and net realisable value Examine prices at which finished goods have been sold after the year-end to ascertain whether any finished goods and/or work-in-progress need to be written down as at year end. Obsolete and slow moving inventories Make inquiries of the management to ascertain any slow-moving or obsolete inventory that should be written down as at year end. If significant levels of finished goods remain unsold for an unusual period of time, discuss with the management and consider the need to make an impairment. Answer 3(a) The key internal controls relating to the salaries and wages process include: Employee records or files should be maintained for each employee i.e. by the human resources department. Employment procedures should be specified and documented i.e. employing and dismissing an employee. Duty reporting records i.e. time-sheets or clock card records should be maintained. Module C (December 2015 Session) Page 4 of 14

Output or piecework records for the employee salaried on their piecework performed should be properly controlled and evidenced. A senior officer should be appointed to review independently the payroll records. Preparation of payroll should be performed by independent staff. Proper control and documentation are required for cheque payments, cash payments and direct debits. Deductions of any pension contributions should be properly reviewed and remitted. Independent review and comparison should be performed on a regular and on a surprise basis. Comparison between the actual and budgeted payroll should be performed regularly. Review controls on payroll costs i.e. checking authorisation. Answer 3(b) As set out in the Code on Corporate Governance Practices (the HK Code ) published by the Hong Kong Stock Exchange, detailed disclosure is required for directors remunerations such as performance-related pay and non-performance related pay. The salaries received by this director in relation to his services (as designer) are subject to such requirements when Angel is listed. A listed company should establish a remuneration committee with specific written terms of reference which deal clearly with its authority and duties. A majority of the members of the remuneration committee and the chairman should be independent non-executive directors ( INED ). There should be a formal and transparent procedure for setting a policy on executive directors' remuneration, and for fixing the remuneration packages for all directors. No director should be involved in deciding his own remuneration. Where necessary it adds that professional advice can be sought by the remuneration committee, however any professional advice made available to a remuneration committee should be independent. The remuneration committee should only perform an advisory role to the board, with the board retaining the final authority to approve executive directors and senior management s remuneration. Module C (December 2015 Session) Page 5 of 14

The remuneration committee needs to determine the listed company s general policy on the remuneration of executive directors and specific remuneration packages for each director. Packages will need to attract, retain and motivate directors of sufficient quality, while at the same time taking into account shareholders interests as well. However, assessing executive remuneration in an imperfect market for executive skills may prove problematic. The remuneration committee needs to be mindful of the implications of all aspects of the package, also the individual contributions made by each director. The annual report would need to disclose: remuneration policy; and arrangements for individual directors. Other disclosures that may be required by law or considered as good practice include the duration of contracts with directors, and notice periods and termination payments under such contracts. Details of external remuneration consultants employed by the remuneration committee to advise on determining remuneration should be provided. Answer 4 HKSRE 2410 Review of Interim Financial Information Performed by the Independent Auditor of the Entity is applicable for review of Angel s interim financial information for the six-month period ending 30 June 2016. The objective of a review engagement on the interim financial information is to enable an auditor to state whether, on the basis of procedures which do not provide all the evidence that would be required in an audit, anything has come to the auditor s attention that causes the auditor to believe that the interim financial statements are not prepared, in all material respects, in accordance with an applicable financial reporting framework (or HKAS 34 Interim Financial Reporting). Planning stage When carrying out an interim review, the auditor should adhere to the same ethical principles as when conducting the main audit of the financial statements; the auditor should agree the terms of engagement with the client; the auditor should design the necessary quality control procedures for the engagement. The auditor should plan the review engagement by performing procedures such as, read last year s audit files; consider any significant risks that were identified during the prior year s audit; consider materiality and consider impact of any corrected or uncorrected misstatements in last year s financial statements. Module C (December 2015 Session) Page 6 of 14

The auditor should ask the management about any significant changes to the internal controls of Angel and the potential effect on preparing the interim financial information. The auditor should obtain knowledge of the business by asking the client about any changes in Angel s business activities in order to reassess the auditor s judgment as to the risks of material misstatements. The auditor should read the minutes of the meetings of shareholders, those charged with governance and other appropriate committees. The auditor should ask the management how the interim financial information has been prepared and the reliability of the underlying accounting records. Inquiries are primarily made to persons responsible for financial and accounting matters, and the subjects should be related to financial reporting, such as whether there have been changes in the accounting framework; any changes in accounting policies; any unusual transactions; any known uncorrected misstatements; significant assumptions relevant to fair values, related party transactions and commitments and contingencies. Execution stage The auditor should obtain evidence that the interim financial statements agree with, or reconcile with, the underlying accounting records. The auditor should perform an in-depth analytical review of the interim financial information and document all work done to support the conclusion. These procedures will assist the auditor to identify relationships and unusual items that may indicate a material misstatement. When the auditor becomes aware that a material adjustment must be made for the interim financial statements, the auditor shall make additional inquiries and perform additional procedures. Completion stage The auditor should perform a subsequent events review by asking the management whether the events up to the date of the review report have been identified and considered when preparing the interim financial statements. The auditor should ask the management about the appropriateness of the use of going concern basis to prepare the interim financial statements. When uncorrected misstatements have come to the auditor s attention, the auditor should evaluate whether the uncorrected misstatements are material to the interim financial statements. The auditor should obtain a management s representation letter that the management acknowledges its responsibilities for the preparation of the interim financial statements and the design and implementation of internal controls. * * * END OF SECTION A * * * Module C (December 2015 Session) Page 7 of 14

SECTION B ESSAY / SHORT QUESTIONS (Total: 50 marks) Answer 5(a) The external confirmation is a direct written response to the auditor from a third party which provides a relevant and reliable audit evidence. External confirmation provides audit evidence in relation to the financial assertions of existence, completeness and rights and obligations and in addition can provide audit evidence about the absence of certain conditions. In addition, external confirmation is from a third party which represents an independent source of audit evidence. Answer 5(b)(i) HKSA 505 (Clarified) External Confirmations provides guidance on an auditor s response when the management refuses permission for the auditor to contact a third party for audit evidence. The audit engagement team should ask the finance manager for the reasons for the refusal and consider if there are valid reasons for the request and obtain evidence to support this. The audit engagement team should consider the integrity of the finance manager and the management and possible reasons for any concealment given the customer was a new customer who had just started trading with the company recently but contributed a significant balance of trade receivables of the company at year end. The audit engagement team should also evaluate the implications of the finance manager s refusal as to whether it is related to fraud and the implication for the nature, extent and timing of audit procedures. The audit engagement team should also communicate this situation with those charged with governance under HKSA 260 (Clarified) Communication with Those Charged with Governance and determine the implications for the auditor s opinion in accordance with HKSA 705 (Clarified) Modification to the Opinion in the Independent Auditor s Report. Answer 5(b)(ii) The audit engagement team should consider the reliability of the confirmation reply as the confirmation reply was not directly received by the audit engagement team. However, as the confirmation reply was sealed, it implies a lower risk of the confirmation having being amended. The audit engagement team should consider alternative procedures to verify the reliability of the confirmation reply. For example, the audit engagement team can contact the customer directly to confirm if the confirmation originated from the customer with the amount confirmed. Module C (December 2015 Session) Page 8 of 14

Answer 5(b)(iii) The audit engagement team should ask the management to reconcile the difference between the management s record and the customer s record and obtain evidence to support the reconciling items identified. This is because an immaterial difference may not necessarily imply there is no accounting error. The audit comfort gained through the understanding and validation of the management s control over the reconciling process is also an important audit evidence to support the existence and completeness assertion of the balance. Answer 6(a) The possible factors that may lead to material misstatements of financial statements of Lychee Limited include the following: There may not be appropriate and sufficient training provided to the staff of Lychee Limited on Melon Limited s system which increases the possibility of human error in recording the transactions during the operation.. There may be significant changes to the processes and controls over respective significant operating cycles of Lychee Limited that were redesigned to facilitate the use of Melon Limited s system. These new processes and controls may not be effectively implemented in Lychee Limited which increases the risks of material misstatements to the financial statements. There could be errors or missing data in converting Lychee Limited s data from the old ERP system to the new ERP system. The system conversion involves system development processes and data conversion processes. It creates opportunity for management fraud if these processes are not well planned and closely monitored. Answer 6(b) The audit engagement team can consider the following audit procedures in response to possible material misstatements of financial statements relating to the system conversion: Understand the system development processes and how the changes to the system of Lychee Limited affect the financial statements. Understand whether the management has engaged a third party consultant to assist the system switch or Lychee Limited performed the system change in-house. Module C (December 2015 Session) Page 9 of 14

Assess the competence and experience of the management team and / or the third party consultant for system conversion. Understand the management s plan for the system conversion, including the scope of changes, system design, timeframe and key milestones, training and contingency plan, if any. Ask the management about any changes to the processes and controls in respective significant business processes in response to the changes in the system. Perform a walk-through test to understand the new processes and controls implemented in response to the system changes. Evaluate and validate the control effectiveness of the newly implemented controls in the respective significant business processes to ensure the controls are operating effectively since its implementation during the year. Understand, evaluate and validate the IT general control of the new system of Lychee Limited, including controls over the data centre and network operations, system software changes and maintenance; access security; application system development and maintenance. Understand the management s controls over the data conversion processes. Consider testing the data conversion either using the control reliance approach if the audit engagement team considers the management s data conversion controls are appropriate for the size and operation of Lychee Limited or the audit engagement team can adopt the substantive approach if it considers the controls designed by the management over data conversion are ineffective. Answer 7(a) Partner A, as the audit engagement partner, shall take full responsibility for the overall quality of the Fashion Limited audit engagement. Partner A should emphasise the importance of audit quality to the audit engagement team such as: performing work that complies with professional, regulatory and legal requirements; complying with the firm s quality control policies and procedures; issuing an auditor s report that is appropriate in the circumstances; and the audit engagement team s ability to raise issues without fear of reprisals. Module C (December 2015 Session) Page 10 of 14

Partner A should discuss significant matters arising with Partner B and ensure the audit report is not issued until the quality control review has been completed and any contentious matters have been resolved. Partner B, as the engagement quality control reviewer, has the following responsibilities: discuss significant matters with Partner A; review the proposed auditor s report and the financial statements; review selected audit documentation relating to the significant judgment the audit engagement team made and the conclusion reached; and evaluate the conclusion reached for compiling the auditor s report. Since Fashion Limited is a listed company, Partner B should also consider the following: the audit engagement team s evaluation of the firm s independence in relation to the audit engagement; whether appropriate consultation has taken place on matters involving differences of opinion or other difficult or contentious matters, and the conclusions arising from those consultations; and whether documentation selected for review reflects the work performed in relation to the significant judgments, and supports the conclusions reached. Answer 7(b) As Fashion Limited is a listed company, Partner B, in carrying out his role as the quality control reviewer, should consider the following facts and circumstances: (i) Independence Partner B should assess whether the audit engagement team has formed an appropriate judgment on the firm s independence in relation to Fashion Limited s audit engagement. As Partner A has only been working on the audit engagement for 5 years, Partner A is not subject to the rotation requirement. However, Partner A and Manager C maintain a very good relationship with the management team. Partner B should remind the audit engagement team to thoroughly assess the audit engagement team s familiarity threat to the audit engagement and if there is a need to reconsider the team mix. The audit engagement team should document thoroughly their consideration and conclusion of the firm and its independence in relation to Fashion Limited. Module C (December 2015 Session) Page 11 of 14

Partner B should review the relevant assessment documented by the audit engagement team and review its correspondence with those charged with governance on such matters (e.g. relevant discussion in the Audit Committee report). (ii) Significant judgment in assessing the fixed asset impairment On any significant accounting and auditing matter, Partner B should challenge the audit engagement team if they have considered all the relevant facts and circumstances with sufficient audit evidence supported before making the conclusion. Partner B should discuss with the audit engagement team their review of the management s assessment of fixed asset impairment, understand the audit engagement team s point of view and audit evidence obtained that supported the audit engagement team s conclusion. Partner B should also review the relevant work papers that the audit engagement team prepared in supporting the work performed, evidence obtained, judgment and conclusion relating to the fixed asset impairment review. Partner B should also review the auditor s report and financial statements if relevant and sufficient disclosure relating to the fixed asset impairment has been made. Partner B should also ensure the audit engagement team has sufficient communication with those charged with governance (e.g. the Audit Committee) of the fixed asset impairment and review the audit engagement team s correspondence with those charged with governance of such matters (e.g. relevant discussion in the Audit Committee report). Answer 8(a) Alan should not tell Michael about the potential product recall. A professional accountant has a duty of confidentiality to his client. This principle is encapsulated in the HKICPA Code of Ethics for Professional Accountants which states that a professional accountant, who acquires sensitive information in the course of his work, should not use, nor appear to use, that information to his own advantage or to the advantage of any third party to which he is connected. Alan should not discuss and disclose Solar s potential product recall to any third party including Michael without Solar s consent. The product recall is a piece of sensitive market information which may have a significant impact on Solar s share price. Tipping any information relating to the product recall may be equivalent to disclosing insider information to a third party which may breach the listing rules. Alan should tell Michael that he is the audit engagement partner of Solar and has the confidentiality duty to Solar that he is not in a position to comment on Solar s performance. Module C (December 2015 Session) Page 12 of 14

Answer 8(b) HKSA 560 (Clarified) Subsequent Events provides guidance on the additional procedures the auditor should perform if he is aware of a subsequent event which materially affects the financial statements. The audit procedures to identify subsequent events should be timed to occur as near as practicable to the date of the auditor s report. The auditor has the responsibility to perform audit procedures to obtain sufficient appropriate audit evidence for any subsequent events up to the date of the auditor s report if they may require adjustment of, or disclosure in, the financial statements. Given the fact that the product recall is now known to Alan, Alan and his audit engagement team have the responsibility to assess the possible accounting and auditing impact in response to the product recall. The large scale product recall is likely to have a significant impact on the financial statements of Solar. The inventory balance of Solar at year end may be materially overstated as the affected products may not have any sales value. The warranty provision balance of Solar at year end may also be understated as additional costs may have to be incurred for fixing the recalled products or replacing the recalled products for the customers. Additional disclosures should also be considered on contingent liabilities if any litigation and claims arise as a result of the product defect or product recall. Alan should not consider that the audit has been completed until he fully assesses and understands the accounting and auditing impact which arises from the product defect and product recall. Alan should also plan and carry out appropriate audit procedures in response to the potential additional risks of material misstatements identified. Alan should only sign the auditor s report when all the audit evidence has been obtained and evaluated and the appropriate audit conclusion is made. Module C (December 2015 Session) Page 13 of 14

Answer 8(c) A qualified opinion is suggested. A qualified opinion is expressed when the auditor, having obtained sufficient appropriate audit evidence, concludes that misstatements, individually or in the aggregate, are material, but not pervasive, to the financial statements. Required audit opinion paragraphs are as below: Basis for Qualified Opinion As of the date of this report, the Company announced a product recall programme relating to one of its major products. The estimated costs to be spent on the product recall were approximately HK$10,000,000. Such product recall costs and the corresponding provision were not recognized in the financial statements for the year ended 31 December 2014. Accordingly, the costs of sales would have increased by HK$10,000,000 and income tax, net income and shareholder s equity would have been reduced by HK$1,650,000, HK$8,350,000 and HK$8,350,000 respectively. Qualified Opinion In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements give a true and fair view of the state of the Company s affairs as at 31 December 2014, and of its profit and cash flows for the year then ended in accordance with Hong Kong Financial Reporting Standards and have been properly prepared in accordance with the Hong Kong Companies Ordinance. * * * END OF EXAMINATION PAPER * * * Module C (December 2015 Session) Page 14 of 14