2003 December (Question)

(Hong Kong) PART 3 TUESDAY 2 DECEMBER 2003

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

Hydrasports, a limited liability company and national leisure group, has sixteen centres around the country and a head office. Facilities at each centre are of a standard design which incorporates a heated swimming pool, sauna, air-conditioned gym and fitness studio with supervised childcare. Each centre is managed on a day-to-day basis, by a centre manager, in accordance with company policies. The centre manager is also responsible for preparing and submitting monthly accounting returns to head office. Each centre is required to have a licence from the local authority to operate. Licences are granted for periods between two and five years and are renewable subject to satisfactory reports from local authority inspectors. The average annual cost of a licence is $900. Members pay a $100 joining fee, plus either $50 per month for ‘peak’ membership or $30 per month for ‘off-peak’, payable quarterly in advance. All fees are stated to be non-refundable. The centre at Verne was closed from July to September 2003 after a chemical spill in the sauna caused a serious accident. Although the centre was re-opened, Hydrasports has recommended to all centre managers that sauna facilities be suspended until further notice. In response to complaints to the local authorities about its childcare facilities, Hydrasports has issued centre managers with revised guidelines for minimum levels of supervision. Centre managers are finding it difficult to meet the new guidelines and have suggested that childcare facilities should be withdrawn. Staff lateness is a recurring problem and a major cause of ‘early bird’ customer dissatisfaction with sessions which are scheduled to start at 07.00. New employees are generally attracted to the industry in the short-term for its non-cash benefits, including free use of the facilities – but leave when they require increased financial rewards. Training staff to be qualified life-guards is costly and time-consuming and retention rates are poor. Turnover of centre managers is also high, due to the constraints imposed on them by company policy. Three of the centres are expected to have run at a loss for the year to 31 December 2003 due to falling membership. Hydrasports has invested heavily in a hydrotherapy pool at one of these centres, with the aim of attracting retired members with more leisure time. The building contractor has already billed twice as much and taken three times as long as budgeted for the work. The pool is now expected to open in February 2004. Cash flow difficulties in the current year have put back the planned replacement of gym equipment for most of the centres. Insurance premiums for liability to employees and the public have increased by nearly 45%. Hydrasports has met the additional expense by reducing its insurance cover on its plant and equipment from a replacement cost basis to a net realisable value basis. Required: (a) (i)

Identify and explain the business risks which should be assessed by the management of Hydrasports. (8 marks)

(ii) Explain how each of the business risks identified in (i) may be linked to financial statement risk. (8 marks) (b) Describe the principal audit work to be performed in respect of the carrying amount of the following items in the balance sheet of Hydrasports as at 31 December 2003: (i)

deferred income; and

(3 marks)

(ii) hydrotherapy pool.

(3 marks)

(c) Suggest performance indicators that could be set to increase the centre managers’ awareness of Hydrasports’ social and environmental responsibilities and the evidence which should be available to provide assurance on their accuracy. (8 marks) (30 marks) 2

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Pacific Group (PG), a limited liability company, is a publisher of a monthly magazine ‘Sea Discovery’. Approximately 70% of the magazine’s revenue is derived from advertising, the remainder being subscription income. Individual advertisements, which may be quarter, half or whole page, are priced at $750, $1,250 and $2,000, respectively. Discounts of 10% to 25% are given for repeat advertisements and to major advertising customers. PG’s management has identified the following risks relating to its advertising revenues: (i)

Loss of revenue through failure to invest in developments which keep the presentation of advertisements up to date with competitor publications (such as ‘The Deep’);

(ii) Due to unsuitable credit limits being set, business is accepted from a small proportion of advertising customers who are uncreditworthy; (iii) Published advertisements may not be invoiced due to incomplete data transfer between the editorial and invoicing departments; (iv) Individual advertisements are not charged for at approved rates – either in error or due to arrangements with the advertisers. In particular, the editorial department does not notify the invoicing department of reciprocal advertisement arrangements, whereby advertising customers provide PG with other forms of advertising (such as website banners). (v) Individual advertisers refuse to pay for the inaccurate production of their advertisement; (vi) Cash received at a front desk, which is significant, may not be passed to cashiers, or be misappropriated; (vii) The risk of error arising from unauthorised access to the editorial and invoicing systems; (viii) The risk that the editorial and invoicing systems are not available; (ix) The computerised transfer of accounting information from the invoicing system to the general ledger may be incomplete or inaccurate; (x) The risk that PG may be sued for advertisements which do not meet the National Standards Authority’s ‘Code of Advertising’. Risks are to be screened out, as ‘non-applicable’, if they meet any of the following criteria: (1) the effect of the risk can be quantified and is less than $5,000; (2) the risk is mitigated by an effective risk strategy e.g. insurance; (3) the risk is likely to be low or its effect insignificant. Those risks not screened out, called ‘applicable risks’, will require further consideration and are to be actively managed. Required: (a) For each of the above risks identified by management, state, with a reason, whether it should be considered an ‘applicable risk’. (14 marks) (b) Describe suitable internal controls to manage any FOUR of the applicable risks identified in (a). (6 marks) (20 marks)

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[P.T.O.

3

You are the manager responsible for the audit of Vema, an established limited liability company. Vema offers a national network for the distribution of wholesale goods through a fleet of heavy goods vehicles (HGVs) and has one wholly-owned subsidiary, Weddell. The draft consolidated financial statements for the year ended 30 September 2003 show revenue $125 million (2002 – $114 million), profit before taxation of $12·4 million (2002 – $10·9 million) and total assets of $110 million (2002 – $93 million). The following issues arising during the final audit have been noted on a schedule of points for your attention: (a) Historically, fleet vehicles have been depreciated at 331/3% on a straight-line basis as it was Vema’s operational policy to replace them every three years. During the year, Vema decided to change the basis of calculation to 25% reducing balance to reflect the fact that HGVs are only replaced ‘as and when necessary’, usually every four to seven years. Management has calculated the current year charge on the new basis as $2·9 million (former basis; $4·2 million) and $4·7 million of accumulated depreciation has been written back in the restatement of opening reserves. (8 marks) (b) A payment of $592,000 selected in a substantive procedure has been traced to the following general ledger journal in December 2002: Debit Credit Credit

Administrative expenses Other liabilities Bank

$786,000 $194,000 $592,000

The accompanying narrative reads ‘Termination payment for Mr Z – not processed on any payroll’. The audit senior has documented that ‘Mr Z, a former director of Vema, was made redundant in July 2002 in a regional re-organisation’. (6 marks) (c) The financial statements of the subsidiary company, Weddell, for the year ended 30 September 2003, are audited by another firm. Profit before taxation of $0·4 million and total assets of $34·1 million have been included in the draft consolidated financial statements of Vema. The notes to Weddell’s financial statements as at 30 September 2003 disclose a contingent liability for a pending legal matter estimated at $0·2 million. In November 2003, the courts found Weddell to be liable for costs and damages amounting to $1·1 million. However, Weddell’s directors have refused to make a provision, for any amount, as they have lodged an appeal against the judgement. (6 marks) Required: For each of the above issues: (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 Vema for the year ended 30 September 2003. NOTE: The mark allocation is shown against each of the three issues. (20 marks)

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Section B – TWO questions ONLY to be attempted 4

(a) Explain the auditor’s responsibilities for reporting on compliance with International Financial Reporting Standards (IFRSs) when the financial statements state that they are prepared in accordance with: (i)

only IFRSs;

(ii) both IFRSs and relevant national standards or practices; and (iii) relevant national standards or practices, but which disclose in the notes to the financial statements the extent of compliance with IFRSs. (5 marks) (b) You are the engagement partner to Frazil, a private limited liability company. Frazil’s financial statements for the year ended 30 September 2003, show total assets $107 million and profit before tax $8·2 million. The following matters require your consideration: (i)

The basis of accounting note states that the financial statements have been prepared in compliance with International Financial Reporting Standards. However, the accounting policy note for development costs states that all development costs are expensed as incurred. Results of audit tests showed that of the $3·7 million development costs expensed during the year, $1·4 million should be recognised as an asset in accordance with IAS 38 ‘Intangible Assets’.

(ii) The management of Frazil has just informed you that, for the first time, the annual report is to be published on the company’s website. Required: Identify and comment on the implications of the above matters for your auditor’s report on the financial statements of Frazil for the year ended 30 September 2003. (10 marks) (15 marks)

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[P.T.O.

5

You are an audit manager in Sepia, a firm of Chartered Certified Accountants. Your specific responsibilities include advising the senior audit partner on the acceptance of new assignments. The following matters have arisen in connection with three prospective client companies: (a) Your firm has been nominated to act as auditor to Squid, a private limited company. You have been waiting for a response to your letter of ‘professional enquiry’ to Squid’s auditor, Krill & Co, for several weeks. Your recent attempts to call the current engagement partner, Anton Fargues, in Krill & Co have been met with the response from Anton’s personal assistant that ‘Mr Fargues is not available’. (5 marks) (b) Sepia has been approached by the management of Hatchet, a company listed on a recognised stock exchange, to advise on a take-over bid which they propose to make. The target company, Vitronella, is an audit client of your firm. However, Hatchet is not. (5 marks) (c) A former colleague in Sepia, Edwin Stenuit, is now employed by another audit firm, Keratin. Sepia and Keratin and three other firms have recently tendered for the audit of Benthos, a limited liability company. Benthos is expected to announce the successful firm next week. Yesterday, at a social gathering, Edwin confided to you that Keratin ‘lowballed’ on their tender for the audit as they expect to be able to provide Benthos with lucrative other services. (5 marks) Required: Comment on the professional issues raised by each of the above matters and the steps, if any, that Sepia should now take. NOTE: The mark allocation is shown against each of the three issues. (15 marks)

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Much publicity has been given to recent developments which have implications for the respective responsibilities and liabilities of management and auditors, both internal and external, relating to: (a) the external audit opinion;

(6 marks)

(b) reporting assurance on the effectiveness of internal financial controls; and

(5 marks)

(c) management representation letters.

(4 marks)

Required: Comment on responsibilities in each of the above areas and discuss the impact of recent developments on the professional liability of external auditors. NOTE: The mark allocation is shown against each of the three issues. (15 marks)

End of Question Paper

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