2001 December (Answer)

Answers

Part 3 Examination – Paper 3.1(HKG) Audit and Assurance Services (Hong Kong)

Answers

Tutorial note: These model answers are longer and more detailed than would be expected from any candidate in the examination. They should be used as a guide to the form, style and standard of answer which candidates should aim to achieve. Although comprehensive, these answers may not include all valid points mentioned by a candidate – credit will be given to candidates mentioning such points. 1

Alakazam (a) Potential risk areas Tutorial note: A tabular format has NOT been used because, although it is sometimes appropriate and can create the impression of a logical answer, it is not always suitable. A columnar approach is inappropriate unless there is a close (e.g. oneto-one) relationship between what is being put into the columns. This suggested answer demonstrates the higher skill of considering the risk areas collectively in planning the audit approach. Chief executive As chief executive, Leon Izzardo holds a dominant position and the recent success (expansion) of Alakazam may be largely attributable to him. The appropriateness of the going concern basis may be questioned if Leon were to leave (say before the WAP phone rights are renewed or a replacement product found). Also, the need for funds to finance the ongoing expansion may create management bias to overstate the company’s profitability (e.g. by understating amortisation of distribution rights, warranty provisions, etc). Growth Sales growth, resulting from the purchase of distribution rights, has resulted in business expansion (increasing the workforce and requiring new premises). All of which requires financing. There is a possibility that Alakazam is overtrading (i.e. entering into commitments which exceed its available short-term resources). Accounting and internal control systems The increase in administrative and accounts staff will facilitate greater segregation of duties and this should reduce control risk. It is expected that head office will have implemented new/improved control procedures, for example: – centralised purchasing (implied by central distribution); – centralised payroll; and – credit control (new customer accounts). However, the incidence of errors arising may be increased, as compared with last year, if the rapid expansion has put the accounts departments under pressure such that existing internal controls have lapsed. Also, errors arising may not be detected if, for example, new accounting staff have insufficient training or experience. Product Alakazam is heavily dependent on just one product to which the company has distribution rights for less than a year (say nine months) from now. Inventory could be overvalued due to: – a reduction in price (if product has to be sold more cheaply to maintain sales volume/market share); – falling demand if the market is saturated; – manufacturing defects; – technological obsolescence/new models being introduced by a competitor. Trade receivables Trade receivables could be overvalued as the risk of bad and doubtful debts may be increased due to: – laxity in creditworthiness checks (in the drive to expand the customer base); – disputes arising from the manufacturing defects. Liabilities/Contingencies Liabilities associated with expenditure on sales warranty work may be understated, for example, if their extent as at the year end is not ascertained. The financial statements could be materially misstated in respect of contingencies or post balance sheet events if they are not properly accounted for. In particular: – adequate provision should be made for sales warranty work; – contingent assets (e.g. if there is recourse to the supplier of the WAP phone over defects) should be disclosed; – disputes with customers and the WAP phone supplier (over defects) resulting in litigation may require provision and/or disclosure of contingent liabilities. Going concern The going concern basis may not be appropriate because: – the future of the company may be dependent on Leon Izzardo; – working capital may be inadequate to deal with overtrading; – the scale of operations is dependent on one product (the WAP phone) and supplier; – sales are falling; – manufacturing defects may result in loss of sales/customer goodwill.

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Intangible assets Intangible assets and profit for the year may be overstated in respect of any carry forward of distribution rights capitalised last year. Amounts involved are likely to be material and management will probably be biased in favour of carry forward (e.g. amounting to 6/24 × cost). This will be imprudent if, for example, future sales of the WAP phone are in doubt and the value of distribution rights is impaired. Conclusions Inherent risk is high as the financial statements may be materially misstated due to the likelihood of errors arising and the high degree of subjectivity involved regarding accounting matters (going concern, warranty provisions, inventory valuations, intangible assets, etc). Control risk is likely to be low in some areas (e.g. purchases) but potentially higher in others (e.g. inventory). To render detection risk low will require a substantive approach to the higher risk and judgemental areas (e.g. inventory valuation, warranty provision) though reliance will be placed on controls if appropriate (e.g. purchases and payroll). (a)

Audit strategy Obtaining information The permanent audit file should be updated in respect of: – new premises purchased/rented; – loan creditors/financing arrangements; – significant new customers; – new appointments of key personnel (e.g. in administration, servicing and distribution); – changes in the accounting and internal control systems. Recording the system Changes in the accounting system and internal controls may have been made piecemeal during the expansion and possibly informally and without adequate documentation. It may be appropriate to make a new record of the systems rather than amend prior year narrative notes. Flowcharts could be prepared in respect of those parts of the system which are established and likely to remain so. The ongoing expansion and possible need to accommodate changes should be borne in mind. Materiality assessment Monetary materiality is likely to be much higher for the year to 31 March 2002 than for the prior year given: – WAP phone sales for a whole year (prior year only six months); – doubling of customer base; – trebling of workforce; – new premises. Tests of control Effective controls will be relied on where tests of control and reduced substantive procedures are, in combination, more efficient than a wholly substantive approach. Areas in which this is most likely to be appropriate include: – purchases; – payments to suppliers; – payroll costs; – receipts from retailers (trade customers). Accounting policies The appropriateness of capitalising distribution rights (assumed) must be substantiated by: – agreeing client’s schedule of costs to supporting invoices; – discussing, with management, sales forecasts; – monitoring after date sales of the WAP phone. Attendance at year-end physical inventory count To confirm the accuracy of recorded quantities, the physical count will be attended at the central distribution department. Particular attention will be given to: – the quantity and condition of phones held in the servicing department; – any deliveries accepted during the count; and – the client’s procedures for despatches to retail outlets during the count (if any). Analytical procedures Although the expansion of operations will significantly distort account balances with the prior year there will be scope for analytical procedures. In particular, the material correctness of recorded sales other than the WAP phones may be substantiated by a month-on-month comparison of turnover and review of gross profit margins. The reasonableness of payroll costs may be ascertained by inflating prior year employee costs, by department (sales, distribution, servicing, administration), for the increase in the number of employees. Trade receivables A year-end circularisation of retailers will probably reveal disputed amounts in respect of defective products. The adequacy of Alakazam’s provision for after date credit notes must be carefully monitored. The recoverability or otherwise of accounts in dispute should be confirmed by vouching receipts of after date cash.

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Warranty provision In addition to providing for credit notes issued to customers (in respect of faulty goods returned), provision should be made for costs incurred by the servicing department after the year end for phones sold prior to the year end. It is likely that the client will not have much experience in exercising judgement in this area and may therefore be looking for guidance. Reliance on management representation, as to the adequacy of the provision, may therefore be inappropriate. Legal advice Communication with the company’s legal adviser and possibly, also, an independent lawyer should be established as specialist evidence may be required in respect of: – the legal interpretation of the agreement with the manufacturer especially regarding the defects; – the legal interpretation of the conditions of sales warranty; – legal opinion on the outcome of any litigation with the manufacturer or customers. Bank/loan creditors Confirmations will be required, so details of the company’s bankers and other providers of finance must be ascertained in good time before the year end. Specifically, care should be taken to ensure that information is obtained on the following: – title deeds held (e.g. to head office premises); – dates planned for review/renegotiation of facilities; – bills of exchange, letters of credit or other means of settling amounts due to the overseas supplier. Discussion with management Matters to be discussed with management include: – developments in financing negotiations; – basis of preparation and assumptions used in forecasts; – whether Alakazam is involved in any litigation. Assuming that there is no conflicting evidence that contradicts management’s representations, it may be appropriate to obtain written management representations. (b)

Proposed acquisition of Neodex (i) Matters to be considered Tutorial note: As the requirement did not specify the nature of the principal matters to be considered (e.g. financial, operational, strategic) there is a lot of scope for just 5 marks. What is important, is that they should be matters considered by the acquiring company. ●

Whether the planned ‘acquisition’ is: – for a controlling interest or 100% ownership; – of Neodex’s shares, its business or its assets (see below). (Consolidated group accounts will have to be prepared if Neodex is acquired as a subsidiary.)

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The eagerness of the two parties to proceed with the negotiations. Alakazam is the company making the moves to acquire Neodex and the directors of Neodex may therefore have the ‘upper hand’ in negotiating an acceptable offer price.

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Stefan and Georgio are relatively young and perhaps lacking in business acumen. Stefan, in particular, may be keen to see the DINS exploited by Alakazam for a faster and greater return than they could achieve on their own.

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What is it that Leon Izzardo is trying to acquire for Alakazam? One motive for the acquisition is likely to be the DINS (and possibly Stefan’s new design). To secure new designs, the expertise of Stefan must be retained (e.g. by offer of share options) and motivated (e.g. by profit-related pay).

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Agreement must be reached with both shareholder-directors to acquire (at least a controlling interest in) the company. To buy all Neodex’s shares, the same offer may need to be made to both directors.

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Stefan may perceive his shareholding to be the more valuable (because of his intrinsic value to the company as the technical/design director). The offer to Stefan could be differentiated from that to Georgio Neratu by leaving Stefan with a shareholding.

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Benefits of synergy are unlikely to accrue (e.g. economies of scale) as Neodex is so small in all respects (e.g. assets, employees) in relation to Alakazam. However, there may be an opportunity to insource the manufacture and assembly of circuit boards.

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The form in which Stefan/Georgio will require consideration (e.g. cash and/or shares).

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The amount of investment needed in advertising DINS (and how soon) in order to increase sales.

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If substantial, cash (for consideration and a major advertising campaign) may have to be diverted from existing projects or raised from external borrowings.

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The acquisition may facilitate diversification and further growth if Stefan’s prototype is successful.

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Whether any interest in acquiring Neodex, rights to DINS or Stefan has been expressed by any other party.

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Given the recent fall in Alakazam’s WAP phone market, Alakazam is actively seeking opportunities to expand (and thereby reduce the risk of business failure).

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(ii)

Implications of acquisition for conduct of audit As Neodex is so small in relation to Alakazam it is unlikely that there will be a significant impact on the resources (staff, time, etc) required to complete the audit. However, if Neodex is acquired as a subsidiary, Alakazam will need to prepare consolidated accounts. Assuming that the audit of Neodex is also transferred as a result of the acquisition, there will also be a need to liaise with the previous auditors (‘professional etiquette’). Tutorial note: Preparation of consolidated accounts may be for the first time as there is no reference in the Q to the existence of other group companies. The fair value of the tangible assets acquired (probably not much more than assembled units DINS and unassembled components) is likely to be significantly less than the purchase consideration. If fair value can be determined for development expenditure (e.g. in respect of the design of DINS and the new prototype) that meets the criteria for recognition as an intangible asset, it should be capitalised and amortised (rather than subsumed within goodwill on acquisition). Assuming the acquisition takes place in early 2002, post-acquisition results will be immaterial to the consolidated income statement (to 31 March 2002). It is likely that Neodex will require audited financial statements for the 15 month period to 31 March 2002. If Neodex’s current auditors are retained (unlikely), the extent to which reliance can be placed on their work must be assessed. Most of the background information required to plan the audit of items relating to Neodex will have already been obtained during the pre-acquisition review work. A substantive approach to relevant account balances (e.g. inventory of DINS) will be adopted as Neodex did not have systems suited to tests of control. As Alakazam needs to invest heavily in promoting DINS, advertising expenditure around the year end may be material (some of which may be prepaid). The acquisition of Neodex (i.e. DINS) may be a mitigating factor when assessing the doubts surrounding the going concern status of Alakazam.

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Agnesal (a) QC procedures Quality controls are the policies and procedures adopted by a firm to provide reasonable assurance that all audits done by a firm are being carried out in accordance with the objective and general principles governing an audit (SAS 240). Individual audit level ● Work delegated to assistants should be directed, supervised and reviewed to ensure the audit is conducted in compliance with SASs. ●

Assistants should be professionally competent to perform the work delegated to them with due care.

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Direction (i.e. informing assistants about their responsibilities and the nature, timing and extent of audit procedures they are to perform) may be communicated through: – briefing meetings and on-the-job oral instruction; – the overall audit plan and audit programs; – audit manuals and checklists; and – time budgets.

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Supervisory responsibilities include monitoring the progress of the audit to ensure that assistants are competent, understand their tasks and are carrying them out as directed. Supervisors must also address accounting and auditing issues arising during the audit (e.g. by modifying the overall audit plan and audit program).

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The work of assistants must be reviewed to assess whether: – it is in accordance with the audit program; – it is adequately documented; – significant matters have been resolved; – objectives have been achieved; – conclusions are appropriate (i.e. consistent with results).

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Documentation which needs to be reviewed on a timely basis includes: – the overall audit plan (including risk assessments); – the audit program (and modifications thereto); – results from tests of control/substantive procedures and conclusions drawn; – financial statements, proposed audit adjustments and the proposed audit opinion.

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An independent review (i.e. by personnel not otherwise involved in the audit), to assess the quality of the audit (before the issue of an audit report) should be undertaken for listed and other public interest or high risk audit clients.

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(b)

Implications of findings for QC policies and procedures Tutorial note: ‘Planning an answer’ means, as a minimum, deciding how marks are likely to be allocated and structuring the answer accordingly. In general, the more a question is broken down into parts, the less time needs to be spent on ‘formal’ writing out of an answer plan. In this Q there are 18 marks for addressing 6 matters i.e. just 3 marks of answer for each. However, there are also ‘pervasive’ issues which can be brought out as overall conclusions on QC policies and procedures at the level of the audit firm. It is a higher skill to recognise causes and effects or other links between the findings. (1) Analytical procedures Applying analytical procedures at the planning stage, to assist in understanding the business and in identifying areas of potential risk, is an auditing standard and therefore mandatory. Analytical procedures should have been performed (e.g. comparing the draft accounts to 30 September 2001 with prior year financial statements). Audit staff may have insufficient knowledge of the highly specialised service industry in which this new client operates to assess risks. In particular, Agnesal may be exposed to risks resulting in unrecorded liabilities (both actual and contingent) if claims are made against the company in respect of outbreaks of contamination (e.g. CJD, BSE, foot and mouth, listeria, etc). The audit has been inadequately planned and audit work has commenced before the audit plan has been reviewed by the audit supervisor. The audit may not be carried out effectively and efficiently. (2) Supervisor’s assignments The senior has performed work on tangible non-current assets which is a less material (18% of total assets) audit area than trade receivables (57% of total assets) which has been assigned to an audit trainee. Tangible non-current assets also appear to be a lower risk audit area than trade receivables because the carrying amount of tangible non-current assets is comparable with the prior year ($1·1m at both year ends), whereas trade receivables have more than doubled (from $1·6m to $3·5m). This corroborates the implications of (1). The audit is being inadequately supervised as work has been delegated inappropriately. It appears that the firm does not have sufficient audit staff with relevant competencies to meet its supervisory needs. (3) Direct confirmation It is usual for direct confirmation of accounts receivable to be obtained where accounts receivable are material and it is reasonable to expect customers to respond. However, it is already more than two months after the balance sheet date and, although trade receivables are clearly material (57% of total assets), an alternative approach may be more efficient (and cost effective). For example, monitoring of after-date cash will provide evidence about the collectibility of accounts receivable (as well as corroborate their existence). This may be a further consequence of the audit having been inadequately planned. Alternatively, monitoring of the audit may be inadequate. For example, if the audit trainee did not understand the alternative approach but mechanically followed circularisation procedures. Depending on the reporting deadline, there may still be time to perform a circularisation. However, consideration should be given to circularising the most recent month end balances (i.e. November) rather than the year end balances (which customers may be unable or reluctant to confirm retrospectively). (4) Cash count Although $2,500 is very immaterial, the client’s management may well expect the auditor to count it, albeit routinely, to confirm that it has not been misappropriated. Monitoring of the trainee may have been inadequate. For example, Gavin may not have understood the need to count the cash immediately the request was made of the client. However, the behaviour of Gavin also needs to be investigated in that he failed to report back to the audit senior on a timely basis and allowed himself to be unsupervised. The trainees do not appear to have been given appropriate direction. Gavin may not be sufficiently competent to be explaining sample selection methods to another trainee. Although it is not practical to document every matter, details should have been recorded to support Carla’s decision to change the timing of a planned procedure. (Carla’s decision appears justified as it is inappropriate to perform a cash count when the client is ‘ready’ for it). Also, if some irregularity is discovered by the client at a later date (e.g. if Jules is found to be ‘borrowing’ the cash), documentation must support why this was not detected sooner by the auditor. (5) Inventory Inventory is almost as immaterial as the cash in (4) from an auditing perspective, being less than 2·5% of total assets (2000 2·1%). Although it therefore seems appropriate that a trainee should be auditing it, the audit approach appears highly inefficient. Such in-depth testing (of controls and details) on an immaterial area provides further evidence that the audit has been inadequately planned. Again, it may be due to a lack of monitoring of a mechanical approach being adopted by a trainee. This also demonstrates a lack of knowledge and understanding about Agnesal’s business – the company has no stock-intrade, only consumables used in the supply of services.

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(6) ‘Report to Society’ The audit senior appears to have assumed that this is ‘other information’ to be included in a document containing audited financial statements (the annual report). ‘To be dealt with’ presumably means ‘to be read’ with a view to identifying significant misstatements or inconsistencies. However, Agnesal may be intending to publish it as an entirely separate report and require an assurance service (other than audit) such as an independent verification statement on performance standards. As the preceding analysis casts doubts on Signet’s ability to deliver a quality audit to Agnesal, it seems highly unlikely that Signet has the resources and expertise necessary to provide such assurance services. QC policies procedures at audit firm level/Conclusions That the audit is not being conducted in accordance with SASs (e.g. 210 ‘Knowledge of the Business’ and 410 ‘Analytical Procedures’) means that Signet’s quality control policies and procedures are not established and/or not being communicated to personnel. That audit work is being assigned to personnel with insufficient technical training and proficiency indicates weaknesses in procedures for hiring and/or training of personnel. That there is insufficient direction, supervision and review of work at all levels to provide reasonable assurance that audit work is of an acceptable standard suggests a lack of resources. Procedures for acceptance of clients appear to be inadequate as the audit is being conducted so inefficiently (e.g. procedures are inappropriate and/or not cost-effective). In deciding whether or not to accept the audit of Agnesal, Signet should have considered whether it had the ability to serve the client properly. The partner responsible for accepting the engagement does not appear to have evaluated the firm’s (lack of) knowledge of the industry. 3

Aspersion Tutorial notes (1) ‘Matters’ will often encompass considerations of ‘risk’, ‘materiality’ and ‘accounting treatment’ (i.e. the omission of recognition and/or disclosure as well as benchmark and alternative treatments). (2) Many points can only be made as either ‘matters’ or ‘audit evidence’ (and there is no ‘one-for-one’ relationship between the two that would warrant a columnar approach). However, some points could be made as either (or both) although the emphasis would need to be different. For example, a matter to consider is the audit program for the identification of related parties and RPTs, whilst the evidence will include copies of extracts from minutes and company registers and written management representation. (1) Related party transaction – sale of cargo carrier (i) Matters The cargo carrier was in use for 8/9 years and would have had a carrying value of $720,000 at 30 September 2000 (assuming nil residual value and a full year’s depreciation charge in the year of acquisition and none in the year of disposal). Disposal proceeds were only therefore $300,000 (say). The $400,000 loss represents 15% of profit before tax and is therefore material. Abra appears to have a related party relationship with Aspersion as Iain: – is one of the key management personnel of Aspersion (being the finance director); and – has an equity interest in Abra which is presumed to constitute significant influence (being greater than 20%). This relationship will be further strengthened/closer/more apparent if: – Iain is also a shareholder of Aspersion and/or a director of Abra; – any close members of Iain’s family are also shareholders of Abra (being a private company). The reason for the sale e.g. whether this aircraft was: – surplus to operating requirements (i.e. not being replaced); or – being replaced with a newer model (perhaps more likely as total assets have increased by $600,000 during the year). The reason for the loss on sale e.g. whether the: – sale was at an under-value (if the sale to the related party was not at arm’s length); – aircraft had a bad maintenance history (or was otherwise impaired); – useful life of a cargo carrier is less than 20 years. If the latter, it is likely that tangible non-current assets are materially overstated in respect of cargo carriers still in use. How selling price was determined. For example, whether the asset was independently valued or whether this was Abra’s best offer. Also whether there were any other unrelated potential purchasers or offers made. The principal terms of the sale e.g. for settlement of the purchase price. The board was aware of the related party relationship (as it was minuted) when the sale was approved. Whether RPTs have been identified and disclosed in prior period financial statements.

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The related party relationship and the sale of the cargo carrier to Abra should be disclosed in a note to the financial statements for the year to 30 September 2001. The elements of such a material transaction which are likely to be necessary (for an understanding of the financial statements) are: – the amount(s) involved (i.e. sale proceeds and loss); – any outstanding balance of amounts due from Abra; – how price was determined (e.g. by an independent valuation). If suitable disclosure is not made, the audit opinion would be qualified ‘except for’ disagreement (non-compliance with HKSSAP 2.120 ‘Related Party Disclosures’). (ii)

Audit evidence Notes on the client’s procedures for the identification of RPs and RPTs. ● Any list of known RPs on the permanent audit file should be evidenced as having been updated. ● Extracts from statutory records e.g. principal shareholders (from the share register) and directors’ interests (from the register of directors’ interests). ● A copy (or extracts) of any valuation report on the carrier. ● A copy of any advertisement placed for the sale of the carrier. ● Extracts from correspondence with Abra (and any other potential purchaser). ● A copy of the sales invoice (or other document transferring title to Abra). ● Evidence of receipt of proceeds (e.g. vouched to cash at bank) and direct confirmation from Abra of any amount outstanding at 30 September 2001. ● Carrying amount (cost less accumulated depreciation) agreed to the fixed asset register and recalculation of the loss on disposal. ● A review of maintenance expenses and records (e.g. to confirm reason for loss on sale). ● Proposed wording for the note disclosure in the financial statements. ● Written management representation that there were no RPs or RPTs required to be disclosed in the financial statements other than those which have been disclosed (completeness assertion). ●

(2) Impairment – light aircraft (i) Matters The annual depreciation charge for each of these two aircraft is $30,000 (1/15 × 450,000). The aircraft have been depreciated for only 2½ years to 30 September 2001 (assuming time apportionment in 1999 when the aircraft were brought into use) and have a total carrying amount of $750,000 (2 × [450,000 – (2½ × 30,000)]). This represents 7·2% of total assets (and some greater % of tangible non-current assets) and is therefore material. Tutorial note: Alternatively it could be assumed (though less appropriate) that a full year’s depreciation was charged in the year to 30.9.99 (i.e. three years’ accumulated depreciation to 30.9.01). The aircraft were purchased for a specific use which will cease six months after the balance sheet date. The value of the aircraft may be impaired and Aspersion should have made a formal estimate of their recoverable amount (HKSSAP 2.131). Whether management has estimated net selling price and/or value in use. Whether Aspersion prepares management accounts and budgets and has experience in projecting cash flows (for determining value in use). Management’s intentions, for example: – to sell the aircraft; – to find an alternative use (e.g. providing other business or pleasure flights). The amount of any impairment loss identified and whether or not it is: – material (say $100,000); – to be recognised in the financial statements. (ii)

Audit evidence A copy of the service contract confirming expiry in March 2002. ● Physical inspection of aircraft (evidence of existence and condition at 30 September 2001). ● Notes of discussions with Aspersion’s management concerning negotiations for: – the sale of the aircraft; or – obtaining new service contracts. ●

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Extracts from any correspondence. A copy of any (draft) agreement for: – the sale of the aircraft after the contract expires; – new business or pleasure contracts. Discounted cash flow projections for any proposed new venture/contracts (i.e. value in use). Comparison of projected cash flows with budgets and assumptions (e.g. aircraft days available and average daily utilisation per aircraft).

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(3) Deferred tax – change in tax rate (i) Matters The total provision amounts to 21% of PBT and is therefore material. (However the deferred tax expense/income for the year may not have been material.) Under HKSSAP 2.112 deferred tax is calculated on the ‘temporary’ differences between the ‘tax base’ and ‘carrying amount’ of assets. The increase in liability if calculated at 34% ($570,000 × (34/30 – 1) = $76,000) represents 2·8% of PBT. Considered in isolation, this amount is not material. The tax rate that should be used is the rate that is expected to apply to the period when the liability is settled, based on tax rates that have been (substantively) enacted by the balance sheet date (HKSSAP 2.112). The increase in tax rate announced on 1 December is a non-adjusting post balance sheet event (HKSSAP 2.109). Also, the extra 4% does not meet the definition of a liability (‘a present obligation arising from past events’) and no provision should be recognised (HKSSAP 2.128). If the directors adjust the draft accounts there will be non-compliance with HKSSAP 2.109, 2.112 and 2.128 which may be regarded as material ‘by nature’. (ii)

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Audit evidence ● A copy of the computations of: – deferred tax liability (balance sheet); – current tax expense (income statement); – deferred tax expense/income. ● A numerical reconciliation between tax expense and accounting profit multiplied by the applicable tax rate. ● Schedules of carrying amount (i.e. cost or revalued amounts net of accumulated depreciation) of non-current assets agreed to: – the asset register (individual assets and in total); – general ledger account balances (totals). ● Completed audit program for tangible non-current assets (e.g. inspecting invoices for additions, agreeing depreciation rates to prior year accounting policies, etc). ● Client’s schedules of tax base agreed, on a test basis, to: – the asset register (for completeness); – prior year working papers (completeness and accuracy of brought forward balances).

Avid (a) Responding to a request How? When asked to provide a ‘second opinion’ (i.e. concerning the application of accounting standards or principles to specific circumstances or transactions of an entity which is not an audit client) a member should seek to minimise the risk of giving inappropriate guidance, by ensuring that they have access to all relevant information. The member should therefore: – ascertain why their opinion is being sought; – contact the auditor to provide any relevant facts; – with the entity’s permission, provide the auditor with a copy of their opinion. If asked to give an opinion in a hypothetical situation the member should make it clear that their response is not based on specific facts or circumstances relating to a particular organisation. Reasons The member who is not the entity’s auditor must be alert to the possibility that their opinion – if it differs from that of the auditor – may create undue pressure on the auditor’s judgement and so threaten the objectivity of the audit. The member’s opinion is more likely to differ if it is based on information which is different (or incomplete) as compared with that available to the auditor. The member should decline to act if permission to communicate with the auditor is not given. (b)

Comment on suitability The proposed auditor’s report gives an adverse opinion on the grounds of disagreement with accounting treatment. The financial statements appear not to have complied with HKSSAP 2.128 in that $3·9 million shown as a liability does not meet the criteria for recognition as a provision. The auditor agreed with the setting up of the provision (as the prior year audit opinion was not qualified). However, in reviewing the unutilised provision at 30 September 2001, it should be adjusted to reflect the current best estimate. This appears to be zero (as all known claims, etc have since been settled). As a provision should only be used for expenditures for which the provision was originally recognised, the balance on the provision should be reversed (HKSSAP 2.128) and disclosed separately within profit from ordinary activities (as it is likely that the expenses for which the provision was originally set up were disclosed separately per HKSSAP 2.102).

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The directors’ argument of prudence does not appear to be justified. That the proposed audit qualification is one of disagreement means that the auditor has sufficient evidence to support his opinion that the provision is not required. If the directors wish to draw the users of financial statements attention to uncertainties and possible contingent liabilities (e.g. for claims not received) they should do so by way of disclosure in a note to the accounts. The provision is an accounting estimate. $9·7 million should have been the directors’ best estimate at 30 September 2000. Assuming it is now nil, the $3·9 million balance should be included in the determination of profit or loss in the year to 30 September 2001 (HKSSAP 2.102). However, the auditor is proposing a prior period adjustment (i.e. restating the opening balance of retained earnings) which is covered by HKSSAP 2.102. This suggests that the auditor considers that there was a fundamental error in the determination of the prior period provision (and not merely that the approximation was inaccurate). For example, mathematical mistakes may have occurred in estimating the Y2K product liability or facts about the contracts or leases may have been misinterpreted (to suggest that liabilities existed which did not). In proposing a prior period adjustment the auditor is implying that they would have qualified their previous year’s opinion (had they known of the error before they issued it). As 40% of the provision was not utilised and should be written back (in some way) it is clearly material (as the balance sheet contains relatively little else). In proposing an adverse opinion the auditor is concluding that the non-compliance (with HKSSAP 2.128) is ‘so material and pervasive’ that his qualification is not adequate to disclose the misleading nature of the financial statements. However, the adjustment proposed is to restate the retained profits brought forward which has no impact on the results of operation or cash flows for the current year. Alternative audit opinions It is unlikely, given the amount involved, that Avid can avoid qualification without adjusting for the provision. Therefore, an unqualified opinion (either with or without an emphasis of matter paragraph) would NOT be appropriate. A disclaimer of opinion would also be inappropriate (as there is nothing to suggest a lack of evidence through limitation on scope). It is not certain from the information available whether the audit opinion should be qualified on grounds of non-compliance with HKSSAP 2.128 and/or HKSSAP 2.102. In either case provisions (in current liabilities) should be reduced and either: – profit for the year increased by $3·9 million (if non-compliance with HKSSAP 2.128); or – retained profit brought forward increased by $3·9 million (as per the proposed report if non-compliance with HKSSAP 2.102). In either case the matter is material but not pervasive and the auditor’s disagreement should be expressed in an ‘except for’ opinion. 5

Aventura International Tutorial note: The requirement uses the term ‘the auditor’ rather than, more specifically, ‘Voest’ or ‘the audit team’ (say) so that candidates can respond from a wider range of standpoints. (1) Goods If this was the first time that such an offer had been made to audit staff it should not have been accepted during the physical count. Before accepting offers of goods, audit staff should discuss with their superiors (e.g. audit manager) the propriety of doing so. Voest may have a policy not to accept any offer of goods or services on grounds of the threat to objectivity impairment. Unless the value of any benefit is modest, accepting goods (also services and undue hospitality) may threaten objectivity. 30% of MRP (manufacturer’s recommended price) amounts to a 70% discount which may not be modest, especially as it has been offered in respect of ‘any items …’. The modesty, or otherwise, of the offer should have been compared against the staff discount scheme (if any) which Aventura offers to its employees. If Aventura does not offer staff discounts, the offer of discounted goods should have been declined. Voest could contemplate the audit staff accepting offers of goods on terms no more beneficial than those offered to employees. However, consideration should also be given to whether or not audit staff are likely to take up such an offer (e.g. if fashion designs are for a teenage market). If the offer is attractive, Voest should consider whether accepting it might raise issues for staff planning (e.g. if assigning staff to Aventura might be perceived as a reward or favouritism). The offer should certainly not be taken up at the physical count as it would contribute to movement (which should be minimised). Also, if it later transpired that there was a problem with the count or the subsequent inventory valuation (e.g. if the audit team failed to identify obsolete or slow-moving items) there would be the risks of: – claims of negligence (that the audit team were not sufficiently diligent); – objectivity impairment or even misconduct (the goods might have the appearance of a bribe). In summary, the offer might be taken up: – if no more beneficial than to employees; but – only at a time when it would not interfere with the conduct of the audit; and – with the approval of the audit partner

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(2) Services/Hospitality Tutorial note: Although there is some overlap with the nature of the matter in (1), it is a higher skill to be able to raise different points by making distinctions, rather than repeating those points already made. Armando has invoiced Aventura for Darius’s holiday flights (implied). Clearly this is not tax allowable business expenditure in the accounts of Aventura (akin to entertainment expenses/hospitality). The value of return flights is unlikely to be regarded as modest (e.g. by less senior members of the audit team and ‘the man in the street’) – especially if he took his family. The audit manager should not have accepted the use of the jet without the express permission of the audit engagement partner (and/or partner in the firm responsible for giving guidance on ethical issues). Darius may have paid for the use of the jet. As the jet is Armando’s, Darius could have paid Armando directly. Armando should not then have raised an invoice to Aventura for re-imbursement as business usage. Even if an amount paid by Darius represents a commercial rate for the chartering of a private jet, the mere fact that Armando should make it available might suggest a close (business or personal) relationship between them. If Darius used the jet without the knowledge of Voest If it has only come to light during the current year’s audit that Darius used the jet (whether or not he paid for it) he should be removed from the assignment immediately. In this event, it should also be noted that the trip was timed before the audit of the prior year financial statements was completed. All audit work on the financial statements for the year ended 30 September 2001 should be reviewed by a newly assigned manager/partner (even at the risk of not meeting any reporting deadline). Particular attention should be paid to all matters of the audit manager’s judgement. Even if there is no evidence of the manager’s work having been ‘slack’ in respect of the current year’s audit, it would be appropriate to review how he dealt with any final review points on the prior year audit. Darius should be asked whether he has used the jet on other occasions (e.g. in September 2001) and this should be confirmed with Armando. The integrity of Darius as a senior employee of the firm should also be questioned. Darius’s relationships with other clients and assignments should be investigated by Voest. Tutorial note: Another ‘angle’ which could be taken on the scenario is that Darius has undertaken a special investigation for Aventura. The issues and actions regarding the provision of other services to audit client will clearly be relevant (and earn marks). (3) Ex-audit staff employed by client As Kirsten was only the accountant in change (AIC), not the audit manager or partner, it is unlikely that a significant lack of objectivity could have impaired the audit opinion for the year ended 30 September 2000. The audit files and financial statements should have been reviewed by the manager and partner in the knowledge that Kirsten was about to leave (if she had not already left). However the objectivity of the prior year audit may have been impaired if Kirsten already had a personal relationship with Armando before she joined Aventura and while she was still employed by Voest. On being made aware of the relationship (even if it was only last week) the engagement partner/Voest should have arranged for a ‘cold’ second partner review of the audit working papers for the prior year. If there is any possible lack of evidence in respect of a material area, the audit program for the current year should be reviewed and amended (as necessary). As the former AIC, Kirsten may have close relationships with the audit team conducting the current year’s audit. However, the audit team should have been adequately briefed and be alert to the possibility that she could influence them, however unwittingly (e.g. in simply explaining how she ‘did things’ previously). The extent to which reliance (if any) has been placed on any representations by Kirsten should be reviewed in the light of the announcement. The audit engagement partner should review the audit strategy (e.g. in terms of its predictability) to ensure that Kirsten’s previous knowledge of it (presumably passed on to Armando) will not impair its effectiveness. 6

Providing assurance Tutorial note: A simple ‘discuss’ question should not be approached as ‘write everything I know about this topic’. Candidates will be expected to address the key words and phrases in the statement in a logical order. The statutory audit of historical financial statements is an example of a traditional assurance service which has been provided by auditors for many years. Factors which have contributed to a growing demand for different assurance services by accountants include: – business expansion (e.g. through acquisitions and mergers) and globalisation; – developments in information technology and communication networks; – greater accountability of corporate managers; – the accounting profession taking the opportunity to provide non-audit services. In the public sector, assurance is increasingly sought on information concerning the performance of national health service departments and education providers (e.g. ‘league tables’ published in the national press in the UK). In the private sector, there is an increasing demand for large companies to assess the quality of their management and communications systems, whilst consumers demand assurance that e-commerce ensures data integrity and confidentiality.

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Professional accountants bring independence to assurance services because they are bound to adhere to an ethical code (e.g. HKSA’s ‘Rules of Professional Ethics’ or the ACCA’s ‘Rules of Professional Conduct’). Such codes require that other fundamental principles, including integrity, professional competence, due care and confidentiality, be observed. The term ‘professional accountant’ includes ‘auditor’. The objective of an assurance engagement is to enhance the credibility of information (by evaluating the subject matter against suitable criteria and to expressing a conclusion that conveys a degree of confidence to the intended users). Thus, assurance services improve the quality or context of information for decision-makers to use. Quality concerns the relevance and reliability of information which is inter-related with sufficiency (a measure of quantity). Context concerns the format in which information is presented. Types of assurance services include: Risk assessments – evaluating whether an entity has appropriate systems to manage its business risks; ● Performance measurement – assessing the quality of performance measurement systems as a basis for determining whether the organisation’s goals and objectives are achieved; ● Information systems – providing assurance that the entity’s information systems provide relevant and reliable information for financial and operating decisions; ● E-commerce – evaluating whether an entity’s website conforms to the principles and criteria for business-to-consumer electronic commerce. ●

Subject matter, which may be as at a point in time or for a period of time, must be identifiable and in a form which allows evidence to be gathered. For example: ● Data (e.g. prospective financial information); ● Systems (e.g. internal controls); ● Behaviour (e.g. corporate governance). An engagement which seeks to provide a ‘high’ (but not absolute) level of assurance (e.g. an audit) is concluded by the expression of an opinion on whether the subject matter (e.g. financial statements) conform, in all material respects, to suitable criteria (e.g. financial statement assertions). This is called ‘positive assurance’. However, an engagement may seek to provide only a ‘moderate’ level of assurance either because the professional accountant’s procedures are less extensive than for an audit (e.g. a review engagement) or because the subject matter is less reliable (e.g. prospective financial information). The conclusion is expressed in a ‘negative’ form (i.e. that no information came to light to suggest that the subject matter did not conform with stated criteria or assertions).

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Part 3 Examination – Paper 3.1(HKG) Audit and Assurance Services (Hong Kong)

Marking Scheme

Marks must only be awarded for points relevant to answering the question set. Unless otherwise indicated, marks should not be awarded for restating the facts of the question. For most questions you should award ½ a mark for a point of knowledge, 1 mark for the application of knowledge and 1½ marks for a point demonstrating the higher skill expected in Part 3. The model answers are indicative of the breadth and depth of possible answer points, but are not exhaustive. Most questions require candidates to include a range of points in their answer, so an answer which concentrates on one (or a few) points should normally be expected to result in a lower mark than one which considers a range of points. In awarding the mark to each part of the question you should consider whether the standard of the candidate’s answer is above or below the pass grade. If it is of pass standard it should be awarded a mark of 50% or more, and it should be awarded less than 50% if it does not achieve a pass standard. When you have completed marking a question you should consider whether the total mark is fair. Finally, in awarding the mark to each question you should consider the pass/fail assessment criteria: – – – – – – – – –

Adequacy of answer plan Structured answer Inclusion of significant facts Information given not repeated Relevant content Inferences made Commercial awareness Higher skills demonstrated Professional commentary

In general, the more of these you can assess in the affirmative, the higher the mark awarded should be. If you decide the total mark is not a proper reflection of the standard of the candidate’s answer, you should review the candidate’s answer and adjust marks, where appropriate, so that the total mark awarded is fair. 1

(a)

Marks

Potentially high risk areas Generally 1 mark each risk explained (briefly) Areas of potential risk – chief executive – growth (rapid expansion/over-trading), cashflow – accounting and internal control systems – product dependence, valuation, faults – trade receivables – warranties/contingent liabilities – going concern – intangibles

max 8

Generally 1 mark each comment relating to audit strategy Audit process – obtaining information/PAF – recording the system – materiality assessment – tests of control – substantive procedures (‘AEIOU’1) – inventory – warranty provision

max 8

_____

max 14 (b)

1

(i)

Principal matters Generally 1 mark each matter relevant to acquisition decision Ideas – acquisition ® meaning? (if 100% sub ® group a/cs) – Leon ® initiator? – held equally ® same offer required? – Stefan ® worth more?/how to keep him? – purchase price ® cash?/where from?

ISA 500 identifies 5 procedures for obtaining audit evidence: Analytical, Enquiry, Inspection, Observation and Computation

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max 5

(ii)

Impact on conduct of audit Generally 1 mark each point contributing to an explanation Aspects of conduct of audit – practice management – Neodex’s auditors – consolidated group a/cs – goodwill vs intangible – planning incl materiality & y/e (non-coterminous) – audit strategy/systems/evidence – review – going concern

Marks max 6

25

2

(a)

Nature and purpose of QC procedures – individual audit Generally 1 mark each point contributing to a description Aspects of QC – meaning of QCs – competence/due care/delegation – direction/audit program – supervision/monitoring – review – documentation – independent review

(b)

Implications of findings Generally 1 mark each implication2 maximum 4 marks any one finding x 6

max 7

max 18

Specific finding ideas – relevant SASs (230, 410, 160) – materiality (SAS 220) – physical inventory count (SAS 401) – direct confirmation (SAS 401) QC at audit firm level ideas – professional behaviour – skills and competence – assignment/delegation – consultation – acceptance of clients – monitoring Others – resources – leadership 25

2

MUST be discussed in context of the firm’s QC policies and procedures

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3

(i)

(ii)

Marks

Matters Generally 1 mark each comment maximum 5 marks any one issue x 3 Ideas – materiality (assessed) – relevant HKSSAPs (e.g. 2.109, 2.112, 2.120, 2.131) – risk (e.g. completeness assertion) – implications for auditor’s report (e.g. emphasis of matter para)

max 12

Audit evidence Generally 1 mark each item of audit evidence (source) maximum 5 marks any one issue x 3 Ideas (SAS 400) – oral vs written – internal vs external – auditor generated – procedures (‘AEIOU’)

max 12

max 20 (1) (2) (3)

max 7 max 7 max 6 20

4

(a)

Explanation of a request for a ‘second opinion’ Generally 1 mark a point Ideas – meaning (e.g. application of accounting standard) – risks arising (e.g. threat to objectivity of auditor) – how to minimise/need for relevant info – communication with auditor – hypothetical situations

(b)

Proposed auditor’s report Generally 1 mark a comment Ideas – adverse opinion – non-compliance HKSSAP 2.128 – change in accounting estimate – vs fundamental error (HKSSAP 2.102) – sufficiency of evidence – materiality – vs pervasive – unqualified NOT appropriate – limitation NOT appropriate – ‘except for’

max 5

max 10

15

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5

(a)

Ethical issues and actions to be taken Generally 1 mark a point Action ideas – enquire (ask)/discuss/review/inspect/accept/decline – safeguards Reason ideas – ethical rules – risk – actual/perceived

Marks

For each matter max 4 marks for issues max 4 marks for actions max 6 marks for any one matter x 3

6

max 15

Discussion of providing assurance Generally 1 mark a point up to a maximum of Ideas Growing demands – factors Public and private sectors – illustrated (examples) Professional accountants – meaning Assurance engagement – objective Quality and context – meaning Assurance services – examples Subject matter – examples Conclusion – +ve vs –ve; high vs moderate, etc

15

For a conclusion clearly derived from the preceding discussion

max 1 max 15

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