2003 June (Question)

(Hong Kong) PART 3 TUESDAY 3 JUNE 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

ABC, a limited liability company, undertakes construction contracts, which include offices, factories, warehouses, schools and bridges. ABC’s customers include businesses and local government departments. Recent cut-backs in local government expenditure have resulted in fewer contracts being started this year than budgeted. The statement of accounting policy for construction contracts in ABC’s financial statements is as follows: ‘Revenue is recognised using the percentage of completion method, calculated on the basis of costs incurred as a percentage of expected total costs. ‘Anticipated losses are provided for in full as soon as the possibility of loss is forecast.’ Direct costs attributed to specific contracts include: (1) (2) (3) (4) (5) (6) (7) (8)

architects’ design costs, legal fees and engineering assistance materials issued to the site site supervision (apportioned foremen’s salaries) site labour costs (allocated from the payroll and subcontractors’ invoices) costs of hiring portable buildings and leasing plant and equipment depreciation of plant, equipment and vehicles transportation costs of resources (e.g. materials and plant) between sites insurance and telephone.

Indirect expenses incurred by ABC’s head office which relate to construction activities are attributed to projects at 70% of direct costs. You are the auditor of ABC. Last year your firm qualified the auditor’s report due to a lack of evidence to support the client’s schedules of estimated costs to completion. During the year, a quantity surveyor joined the client’s management team to: (1) supervise monthly physical counts at the major construction sites; (2) monitor costs to date against monthly rolling budgets; and (3) prepare year-end schedules, by contract, of total costs to completion (i.e. direct costs incurred to the balance sheet date, attributable overheads and estimated costs to completion). You are satisfied that the quantity surveyor is appropriately qualified and experienced. Required: (a) Identify and explain the principal audit risks to be considered when planning the approach to the final audit of ABC for the year ending 30 September 2003. (12 marks) (b) Explain the nature and extent of the reliance which you should seek to place on the work of the quantity surveyor. (5 marks) (c) Describe the audit work to be performed in respect of total costs to completion.

(8 marks) (25 marks)

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You are a manager in Costello, a firm of Certified Public Accountants, which has recently adopted a business risk methodology. You have been involved in briefing clients about this ‘top down approach’ and promoting the risk management assurance services which Costello offers. The following information concerns one of your clients, Ferry, a limited liability company: In July 1999, Ferry purchased exclusive rights to operate a car and passenger ferry route until December 2008. This offers an alternative to driving an additional 150 kilometres via the nearest bridge crossing. There have been several ambitious plans to build another crossing but they have failed through lack of public support and government funds. Ferry refurbished two 20-year-old roll on, roll off (‘Ro-Ro’) boats to service the route. The boats do not yet meet the emission standards of Environmental Protection Regulations which come into force in 2004. Each boat makes three return crossings every day of the year, subject to weather conditions, and has the capacity to carry approximately 250 passengers and 40 vehicles. The ferry service carried just 70,000 vehicles in the year to 31 December 2002 (2001: 58,000; 2000: 47,000). Hot and cold refreshments and travel booking facilities are offered on the one hour crossing. These services are provided by independent businesses on a franchise basis. Ferry currently receives a subsidy from the local transport authority as an incentive to increase market awareness of the ferry service and its efficient and timely operation. The subsidy increases as the number of vehicles carried increases and is based on quarterly returns submitted to the authority. Ferry employs 20 full-time crew members who are trained in daily operations and customer-service, as well as passenger safety in the event of personal accident, collision or breakdown. The management of Ferry is planning to apply for a recognised Safety Management Certificate (SMC) in 2004. This will require a ship audit including the review of safety documents and evidence that activities are performed in accordance with documented procedures. A SMC valid for five years will be issued if no major non-conformities have been found. Your firm has been asked to provide Ferry with a business risk assessment (BRA) as a management assurance service. Required: (a) Describe what is meant by the term ‘top down approach’ in the context of business risk audit methodology. (5 marks) (b) Identify and explain the business risks facing Ferry which should be assessed.

(10 marks)

(c) Describe the processes by which the risks identified in (b) could be managed and maintained at an acceptable level by Ferry. (10 marks) (25 marks)

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[P.T.O.

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You are the manager responsible for the audit of Dexy, a long-established limited liability company. Dexy sells furniture and home furnishings through retail stores and home catalogues (i.e. mail order). The draft financial statements for the year ended 31 March 2003 show profit before taxation of $3·2 million (2002 – $2·9 million) and total assets of $36·4 million (2002 – $33·0 million). The following issues are outstanding from the audit fieldwork and have been left for your attention: (a) During the year Dexy took a seven year non-cancellable lease on a suite of offices on the 13th floor of a new development. The lease payments are $130,000 paid annually in advance. The present value of lease payments, calculated as $770,000, has been recognised as a leased asset and lease liability. The leased asset is being amortised on a straight line basis over seven years. (8 marks) (b) Advertising costs have increased significantly over recent years and the annual budget is now $350,000. The majority of these costs are incurred in June and December when promotional activities include the publication and distribution of a product catalogue and the design of co-ordinated magazine and billboard advertisements for products to be sold over the next six months. Dexy’s management has recently reviewed the company’s policy to expense all such costs as incurred and decided that they will now be time-apportioned over the six-month period when the related products will be sold. $125,000 has been included in the balance sheet as at 31 March 2003 within prepaid expenses. This amount includes product catalogue inventory, prepaid advertising costs and other deferred expenditure. (6 marks) (c) Dexy owns a painting by a little known artist, Lennox, which cost $7,000 when it was purchased in 1953. Following a news report that another painting by Lennox had sold at auction for more than a million dollars, the directors had Dexy’s painting revalued by an independent appraisal company. The painting is now carried in the balance sheet at its fair value of $1·35 million and the excess over cost has been credited to equity. The painting, which had previously been displayed in Dexy’s reception office, has been moved to the chief executive officer’s residence for safekeeping. (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 Dexy. 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) Comment on the limitations that shareholders may perceive exist in the standard unmodified auditor’s report as described in SAS 600 ‘Auditors’ reports on financial statements’. (5 marks) (b) You are an audit manager in Fine & Young, a firm of Certified Public Accountants. One of your audit clients, Icehouse, is a textbook publisher. Icehouse is planning to expand through the acquisition of a number of small publishers of other media such as video tapes and CDs. The finance director of Icehouse has been reviewing the financial statements of potential targets. He has come across an auditor’s report dated 19 January 2003, on financial statements for the year ended 30 September 2001, which does not have the standard wording of an unmodified report. The finance director has now approached you for an explanation of its meaning. The scope and opinion paragraphs are as follows: ‘Scope ‘We conducted our audit in accordance with Statements of Auditing Standards issued by the Hong Kong Society of Accountants. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the financial statements, and of whether the accounting policies are appropriate to the company’s circumstances, consistently applied and adequately disclosed. We planned our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance as to whether the financial statements are free from material misstatement. ‘However, the evidence available to us identified certain transactions which had not been included in the previous year’s records and as a result had been omitted from the financial statements for the year ended 30 September 2000. ‘Adjustments have been made and are disclosed in Note 22. In forming our opinion, we also evaluated the overall adequacy of the presentation of information in the financial statements. We believe that our audit provides a reasonable basis for our opinion. ‘Opinion ‘In our opinion the financial statements give a true and fair view of the state of affairs of the Company as at 30 September 2001 and of its loss and cash flows for the year then ended. ‘The company’s liabilities exceed its assets at 30 September 2001 creating an adverse situation which management believes is reversible over the coming twelve months. Management further believes that the company is capable of continuing to trade for twelve months from the date of this report. ‘19 January 2003’ Required: Identify and explain the shortcomings of this report.

(10 marks) (15 marks)

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[P.T.O.

5

You are a manager in Depeche, a firm of Certified Public Accountants. You have specific responsibility for undertaking annual reviews of existing clients and advising whether an engagement can be properly continued. The following matters arose in connection with the audit of Duran, a company listed on a stock exchange, for the year to 31 December 2002: (1) The audit team included a manager, two supervisors, two qualified seniors and six trainees. The final audit, which lasted approximately five weeks, was very time-pressured and the team worked late into the night towards the end of the audit. Duran’s staff were very supportive throughout and paid for evening meals that were brought in so that the audit team could work with minimum disruption. (2) Duran’s chief finance officer, Frankie Sharkey, was so impressed with the commitment of the audit staff that he asked that Depeche pay them all a bonus through an increase in the audit fee. In April 2003, Depeche paid all the members of the team below manager status a bonus amounting to a week’s salary. The bonus was processed through Depeche’s payroll, in the same way as overtime payments, and recharged to Duran as part of audit expenses. (3) One of the points initially drafted for possible inclusion in the report to the company’s audit committee concerned the illegal dumping of drums, containing used machine oil, on nearby wasteland. Notes of discussions between the audit manager and Frankie show that it is the company’s unwritten policy to disregard the local environmental regulations and risk incurring the fines, which are only small, as it would be costly to use the nearest licensed disposal unit. The matter is not referred to in the final report. Required: (a) Comment on the ethical and other professional issues raised by each of the above matters.

(10 marks)

(b) Discuss the appropriateness of available safeguards and advise whether or not Depeche should continue as the auditor to Duran. (5 marks) (15 marks)

6

There is no doubt that the auditing profession is damaged when auditors give a stamp of approval to the financial statements of a well known company which subsequently collapses. Required: Discuss the ways in which the auditing profession could respond to the issues raised by possible audit failures. (15 marks)

End of Question Paper

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