2001 Decmenber (Question)

(Hong Kong) PART 3

TUESDAY 4 DECEMBER 2001

QUESTION PAPER Time allowed 3 hours This paper is divided into two sections Section A ALL THREE questions are compulsory and must be answered Section B TWO questions ONLY to be answered

Paper 3.1(HKG)

Audit and Assurance Services

Section A – ALL THREE questions are compulsory and MUST be attempted 1

Your audit client, Alakazam, sells and distributes telecommunications equipment and accessories to retail outlets. The company has expanded rapidly since the appointment of a new chief executive, Leon Izzardo, in September 2000. In October 2000, the company purchased exclusive national distribution rights to an imported WAP phone for a twoyear period. During 2001, the company has doubled its customer base and is close to achieving national coverage with its distribution network. Employee numbers have increased rapidly from 36 to 103. Head office administrators, including accounts staff, have risen from 10 to 25. In October 2001, the central distribution and servicing department was moved away from the head office into larger premises. This was necessary to handle not only the increased inventory levels and pre-delivery checks necessary, but also the rising level of after sales warranty work caused by manufacturing defects in the WAP phones. Sales of the WAP phone, which now account for 80% of Alakazam’s turnover, have recently started to fall. You have been assigned the task of planning the audit of the financial statements of Alakazam for the year ended 31 March 2002. Required: (a) Describe the principal audit risks arising and how the audit strategy will be directed to take account of them in the overall audit plan. (14 marks) (b) Mr Izzardo has now targeted Neodex, a private limited company, for acquisition by Alakazam in early 2002. Your firm has just completed a review of Neodex’s published financial statements for the year to 31 December 2000 and held brief discussions with its two directors. The main findings were as follows: (1) Shares in Neodex are owned equally by the technical director, Stefan Koyla, and marketing director, Georgio Neratu, who set up the company three years after graduating from university. (2) Neodex has successfully developed a small range of specialised data interface network servers (DINS) which significantly reduce the costs of communication systems. Each unit sells for $3,500 – $5,000. Monthly sales are increasing slowly but steadily since Georgio presented the products at an IT exhibition earlier this year. (3) Between them, Stefan and Georgio assemble and package DINS in a small rented office. The manufacture and assembly of the principal component (a circuit board) is outsourced. Stefan would like to recruit an assistant so that he has time to prototype his new design for the Virtual Private Network (VPN) market. (4) Neodex has only one employee who acts as telephonist, receptionist, secretary and bookkeeper. Required: (i)

Outline the principal matters to be considered by Alakazam in deciding whether or not to acquire Neodex. (5 marks)

(ii) Explain the implications of the acquisition for the conduct of your audit of Alakazam for the year to 31 March 2002. (6 marks) (25 marks)

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(a) ‘Quality control policies and procedures should be implemented at both the level of the audit firm and on individual audits.’ SAS 240 ‘Quality Control for Audit Work’ Describe the nature and explain the purpose of quality control procedures appropriate to the individual audit. (7 marks) (b) You are the manager responsible for the quality of the audits of new clients of Signet, a firm of Certified Public Accountants. You are visiting the audit team at the head office of Agnesal, a limited liability company. The audit team comprises Artur Bois (audit supervisor), Carla Davini (audit senior) and Errol Flyte and Gavin Holst (trainees). The company provides food hygiene services which include the evaluation of risks of contamination, carrying out bacteriological tests and providing advice on health regulations and waste disposal. Agnesal’s principal customers include food processing companies, wholesale fresh food markets (meat, fish and dairy products) and bottling plants. The draft accounts for the year ended 30 September 2001 show turnover $19·8 million (2000 $13·8 million) and total assets $6·1 million (2000 $4·2 million). You have summarised the findings of your visit and review of the audit working papers relating to the audit of the financial statements for the year to 30 September 2001 as follows: (1) Against the analytical procedures section of the audit planning checklist, Carla has written ‘not applicable – new client’. The audit planning checklist has not been signed off as having been reviewed by Artur. (2) Artur is currently assigned to three other jobs and is working from Signet’s office. He last visited Agnesal’s office when the final audit commenced two weeks ago. In the meantime, Carla has completed the audit of tangible non-current assets (including property and service equipment) which amount to $1·1 million as at 30 September 2001 (2000 $1·1 million). (3) Errol has just finished sending out requests for confirmation of accounts receivable balances as at 30 September 2001 when trade accounts receivable amounted to $3·5 million (2000 $1·6 million). (4) Agnesal’s purchase clerk, Jules Java, keeps $2,500 cash to meet sundry expenses. The audit program shows that counting it is ‘outstanding’. Carla has explained that when Gavin was sent to count it he reported back, two hours later, that he had not done it because it had not been convenient for Jules. Gavin had, instead, been explaining to Errol how to extract samples using value-weighted selection. Although Jules had later announced that he was ready to have his cash counted, Carla decided to postpone it until later in the audit. This is not documented in the audit working papers. (5) Errol has been assigned to the audit of inventory (comprising consumable supplies) which amounts to $150,000 (2000 $90,000). Signet was not appointed as auditor until after the year-end physical count. Errol has therefore carried out tests of controls over purchases and issues to confirm the ‘roll-back’ of a sample of current quantities to quantities as at the year-end count. (6) Agnesal has drafted its first ‘Report to Society’ which contains health, safety and environmental performance data for the year to 30 September 2001. Carla has filed it with the comment that it is ‘to be dealt with when all other information for inclusion in the company’s annual report is available’. Required: Identify and comment on the implications of these findings for Signet’s quality control policies and procedures. (18 marks) (25 marks)

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[P.T.O.

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You are the manager responsible for the audit of Aspersion, a limited liability company, which mainly provides national cargo services with a small fleet of aircraft. The draft accounts for the year ended 30 September 2001 show profit before taxation of $2·7 million (2000 – $2·2 million) and total assets of $10·4 million (2000 – $9·8 million). The following issues are outstanding and have been left for your attention: (1) The sale of a cargo carrier to Abra, a private limited company, during the year resulted in a loss on disposal of $400,000. The aircraft cost $1·2 million when it was purchased in October 1992 and was being depreciated on a straight-line basis over 20 years. The minutes of the board meeting at which the sale was approved record that Aspersion’s finance director, Iain Jolteon, has a 30% equity interest in Abra. (7 marks) (2) As well as cargo carriers, Aspersion owns two light aircraft which were purchased in 1998 to provide business passenger flights to a small island under a three year service contract. It is now known that the contract will not be renewed when it expires at the end of March 2002. The aircraft, which cost $450,000 each, are being depreciated over fifteen years. (7 marks) (3) Deferred tax amounting to $570,000 as at 30 September 2001 has been calculated relating to tangible non-current assets at a tax rate of 30% using the liability method (HKSSAP 2.112 Accounting for deferred tax). On 1 December 2001, the government announced an increase in the corporate income tax rate to 34%. The directors are proposing to adjust the draft accounts for the further liability arising. (6 marks) Required: For each of the above points: (i)

comment on the matters that you should consider; and

(ii) state the audit evidence that you should expect to find, in undertaking your review of the audit working papers and financial statements of Aspersion. (20 marks) NOTE: The mark allocation is shown against each of the three issues.

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Section B – TWO questions ONLY to be attempted 4

(a) Explain, with reasons, how a member of The Association of Chartered Certified Accountants or a member of The Hong Kong Society of Accountants should respond to a request to provide a ‘second opinion’. (5 marks) (b) Avid, a limited liability company, is a wholly-owned subsidiary of Drago. As a result of Drago divesting its non-core activities, Avid ceased to trade in the year to 30 September 2000 when its trade and assets were sold to a competitor. At 30 September 2000, Avid’s remaining assets (including amounts due to group companies, current investments, cash and cash equivalents) were sufficient to meet Avid’s provisions which totalled $9·7 million in respect of: –

year 2000 product liability

–

staff redundancies

–

claims for unfair dismissal

–

property leases

–

breach of contracts with distributors and suppliers.

The audit opinion on the financial statements for the year ended 30 September 2000 was unqualified. All known claims and liabilities have since been settled. The draft financial statements for the year ending 30 September 2001 show the balance on the provisions account to be $3·9 million. Avid’s finance director, Marek, has approached you, as a personal friend, to discuss the following extract from the draft auditor’s report which he received yesterday: ‘As more fully explained in note 7 an amount of $3·9m has been included in ‘Provisions’ in respect of general risks facing the Company. The directors consider that such a provision is prudent in the light of the impending liquidation of the Company. In our opinion future liabilities should be recognised in accordance with HKSSAP 2.128 ‘Provisions, Contingent Liabilities and Contingent Assets’. If liabilities had been so recognised, the effect would have been to increase the profits brought forward in the financial statements to 30 September 2000 by $3·9m. ‘In our opinion, because of the effects of the matters discussed above, the financial statements do not give a true and fair view of the financial position of the Company as of 30 September 2001, and of the results of its operation and its cash flows for the year then ended . . .’ Required: Comment on the suitability or otherwise of the proposed auditor’s report. Your answer should discuss the appropriateness of alternative audit opinions. (10 marks) (15 marks)

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[P.T.O.

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Aventura International, a listed company, manufactures and wholesales a wide variety of products including fashion clothes and audio-video equipment. The company is audited by Voest, a firm of Certified Public Accountants, and the audit manager is Darius Harken. The following matters have arisen during the audit of the group’s financial statements for the year to 30 June 2001 which is nearing completion: (1) During the annual physical count of fashion clothes at the company’s principal warehouse, the audit staff attending the count were invited to purchase any items of clothing or equipment at 30% of their recommended retail prices. (2) The chief executive of Aventura International, Armando Thyolo, owns a private jet. Armando invoices the company, on a monthly basis, for that proportion of the operating costs which reflects business use. One of these invoices shows that Darius Harken was flown to Florida in September 2000 and flown back two weeks later. Neither Aventura nor Voest have any offices or associates in Florida. (3) Last week Armando announced his engagement to be married to his personal assistant, Kirsten Fennimore. Before joining Aventura in March 2001, Kirsten had been Voest’s accountant in charge of the audit of Aventura. Required: Discuss the ethical issues raised and the actions which might be taken by the auditor in relation to these matters. (15 marks)

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‘There is a growing demand in both the public and private sectors for professional accountants to provide assurance on a variety of subject matter by expressing a conclusion regarding its quality or context.’ Required: Discuss this statement in the context of Standards on Assurance Engagements SAE 100 Framework for assurance engagements intended to provide either a high or moderate level of assurance, SAE 200 High level assurance engagments. (15 marks)

End of Question Paper

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