2003 December (Answer)

7/29/2019 2003 December (Answer)

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Answers


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Part 3 Examination Paper 3.1 (HKG)

Audit and Assurance Services (Hong Kong) December 2003 Answers

1 HYDRASPORTS

(a) (i) Business risks (ii) Financial statement risks

Tutorial note: As part (ii) is clearly related in the requirement to part (i), it is appropriate that a tabular approach be

adopted.

The standard design of facilities increases operationalrisk as any difficulties encountered in one facility will becompounded by the number of other facilities (potentiallyall) which are similarly affected. This is illustrated by theclosure of the saunas.

Tutorial note: Standard design may also reduce risk asit results in a higher quality product.

The carrying amount of the associated non-currentassets (i.e. equipment, fixtures and fittings) is likely to beoverstated as they are likely to be impaired if they are notin use.

Centralised control through company policy is resultingin inefficient and ineffective operations as managers

cannot respond on a timely basis to local needs.

Management circumvention or override of controlprocedures laid down by head office may result in

system weaknesses. If errors arising are not detectedand corrected the risk of misstatement in the financialstatements is increased.

Business reporting risk is likely to be increased by centremanagers preparing monthly accounting returns.Operational risk may be increased if centre managerscannot fulfil their day-to-day responsibilities (e.g. relatingto customer satisfaction, human resources, health andsafety).

Information processing risk is increased as accountinginformation flowing into the financial statements may notbe properly captured, input, processed or output by thecentre managers.

Inherent risk, of errors arising, in monthly branchreturns is high.

Advanced payments contribute to business reporting and

financial (cash flow) risk. Cash received must beavailable to meet the costs of providing future services.

Revenue may be overstated if an accurate cutoff is not

achieved. In particular, there is an estimate risk indetermining the amount of deferred income at thebalance sheet date.

An error of principle may also arise if Hydrasportsrevenue recognition policy does not comply withHKSSAP 18 Revenue.

Hydrasports cannot operate a centre if a licence issuspended, withdrawn or not renewed (e.g. throughfailing a local authority inspection or failing to apply forrenewal).

An error of principle arises if licences are not capitalisedas intangible assets (but instead written off as expenseswhen incurred).

Intangible assets (licences) should be reviewed for

impairment at each balance sheet date (e.g. for centreswhich are closed).

Closure may result in customers finding alternativefacilities with permanent loss of fee revenue.

Early bird customers dissatisfaction similarly increasesoperational risk.

Failure risk (i.e. that Hydrasports will not continue tooperate as a going concern) is increased.

This creates disclosure risk if the disclosures relating togoing concern as the basis of accounting do not meet therequirements of HKSSAP 1 Presentation of FinancialStatements.


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Serious accidents may prompt investigation by localauthority resulting in penalties, fines and/or withdrawalof licence to operate.

If licences are withdrawn, the intangible asset (amountsprepaid) should be written off to the extent that moniesare not refundable.

The likelihood of contingent (if not actual) liabilitiesincreases disclosure risk.

Although fees are non-refundable, suspension of afacility (e.g. sauna) may result in customers asking forpartial refund. In particular Hydrasports may have anobligation to refund fees paid in advance when centresare closed (e.g. the Verne centre from JulySeptember2003).

Provisions may be understated at 31 December 2003 ifHydrasports has a legal obligation to refund fees whereit has failed to provide services.

Permanent loss of customers requiring childcare facilitiesincreases operating risk. Compliance risk is increased ifthe new guidelines are not met.

Similarly, inability to retain lifeguards increasesoperational risk that pools cannot open (due to healthand safety regulations). Compliance risk is increased by

the possibility that pools may be operated without alifeguard being on duty.

Disclosure risk is (again) increased if fines/penaltiesarising are material and not disclosed.

High staff turnover indicates increased operational risk(poor human resource management, inefficiency inworking practices, reduced capacity, etc).

Staff costs may be overstated as the risk that paymentsmay be made to leavers is increased.

Limitations on centre managers levels of authority maynot be commensurate with their responsibilities.Empowerment risk arises if managers are not properlyled (and if they, in turn, do not properly lead their centrestaff).

Any lack of integrity may increase the risk ofmanagement and/or employee fraud, illegal acts andunauthorised use of company assets. In particular theassertion of existence of assets may be at risk (resultingin overstatement).

More centres may become loss-making if the reasons forfalling membership are not addressed.

Loss-making centres should be tested for impairment ascash-generating units.

The hydrotherapy pool cannot operate until constructionis completed and completion may be threatened by cashflow difficulties.

The value of the asset in construction should be writtendown if it is impaired (even though it has not yet beenbrought into use).

Cash flow difficulties increase liquidity/financial risk. See above reference to going concern and disclosurerisk.

Obsolete gym equipment increases operational risk ascustomer satisfaction decreases and health and safetyrisks are increased.

Depreciation may be overstated if Hydrasports continuesto calculate depreciation on fully-depreciated assets.

Disclosures for capital commitments (e.g. to replaceequipment) in the financial statements may beinappropriate if Hydrasports does not have funds tofinance such commitments.

The reduction in insurance cover reduces the recoverableamount of assets in the event of loss through fire (forexample). Inability to replace lost/damaged assetsincreases operational risk (see obsolete gym equipmentabove).

See above reference to going concern and disclosurerisk.

Operational risk is increased if the substantial increase inliability insurance premiums is a reflection of an increasein the level of claims being made.

Disclosure risk is increased in relation to contingentassets (for reimbursement under insurance policies).


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(b) Principal audit work

Deferred income

Agreeing Hydrasports analysis of joining fee and peak/off-peak membership fees on a sample basis.

Tutorial note: Initial joining fees should not be deferred but recognised when received.

Reconciling membership income to fees paid. If customers can renew their membership without payment there shouldbe no deferral of income (unless the debt for unpaid fees is also recognised).

Assessing the collectibility of unpaid fees (if any) by reviewing after date receipts and correspondence with members.

Recomputing the deferred income element of fees received in the three months before the balance sheet date.

Comparison of year-end balance with prior year and investigation of variance.

Hydrotherapy pool

Verifying the initial cost of this constructed asset will include an examination of:

the contract with the builder contractors billings; and stage payments.

Hydrasports is likely to be advised by its own expert (a quantity surveyor) on how the contract is progressing. Audit work

will include a review of the experts assessment of stage of completion as at the balance sheet date, estimated costs tocompletion, etc.

Physical inspection of the construction at the year end to confirm work to date and assess the reasonableness of stage ofcompletion.

Borrowing costs associated with this substantial (heavy) investment should be agreed to finance terms and payments.The calculation of any amount capitalised should be recomputed to confirm accuracy.

The basis of capitalisation, if any, should be agreed to comply with HKSSAP 19 Borrowing Costs (e.g. interest accruingduring any suspension of building work should not be capitalised).

As the construction has already cost twice as much as budgeted, its value in use (when brought into use) may be lessthan cost. Managements assessment of possible impairment (of the hydrotherapy pool and the centre) should be criticallyappraised.

Tutorial note: The asset should not yet be subject to depreciation as it has still to be brought into use.

(c) Performance indicators social/environmental responsibility

Member satisfaction

Number of people on membership waiting lists (if any).

Number of referrals/recommendations to club membership by existing members.

Proportion of renewed memberships.

Actual members: 100% capacity membership (sub-analysed between peak and off-peak).

Membership dissatisfaction

Proportion of members requesting refunds per month/quarter.

Proportion of memberships lapsing (i.e. not renewed).

Staff

Average number of staff employed per month.

Number of starters/leavers per month.

Staff turnover/average duration of employment.

Number of training courses for lifeguards per annum.

Predictability

Number of late openings (say more than 5, 15 and 30 minutes after advertised opening times).

Number of days closure per month/year of each facility (i.e. pool, crche, sauna, gym) and centre.

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Safety

Incidents reports documenting the date, time and nature of each incident, the extent of damage and/or personal injury,and action taken.

Number of accident free days.

Other society

Local community involvement (e.g. facilities offered to schools and clubs at discount rates during off-peak times).

Range of facilities offered specifically to pensioners, mothers and babies, disabled patrons, etc.

Participation in the wider community (e.g. providing facilities to support sponsored charity events).

Environment

Number of instances of non-compliance with legislation/regulations (e.g. on chemical spills).

Energy efficiency (e.g. in maintaining pool at a given temperature throughout the year).

Incentives for environmental friendliness such as discouraging use of cars/promoting use of bicycles (e.g. by providingsecure lock-ups for cycles and restricted car parking facilities).

Evidence

Tutorial note: As there is a wide range of measures of operational performance which candidates could suggest, there isalways a wide range of possible sources of audit evidence. As the same evidence may contribute to providing assurance onmore than one measure they are not tabulated here, to avoid duplication. However, candidates may justifiably adopt atabular layout.

Membership registers clearly distinguishing between new and renewed members, also showing lapsed memberships.

Pool/gym timetables showing sessions set aside for over 60s, ladies only, schools, clubs, special events, etc.

Staff training courses and costs.

Staff timesheets showing arrival/departure times and adherence to staff rotas.

Documents supporting additions to/deletions from payroll standing data (e.g. new joiner/leaver notifications).

Engineers inspection reports confirming gym equipment, etc is in satisfactory working order. Also, engineer and safety

check manuals and the maintenance program.

Levels of expenditure on repairs and maintenance.

Energy saving equipment/measures (e.g. insulated pool covering).

Safety drill reports (e.g. alarm tests, pool evacuations).

Accident report register showing date, nature of incident, personal injury sustained (if any), action taken (e.g. emergencyservices called in).

Any penalties/fines imposed by the local authorities and the reasons for them.

Copies of reports of local authority investigations.

The frequency and nature of insurance claims (e.g. to settle claims of injury to members and/or staff).


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2 PACIFIC GROUP

(a) Applicable vs non-applicable risks (b) Internal controls (only FOUR applicable risks

are required to be addressed)

Tutorial note: Remember that not all controls arepreventative! Some should detect (so as to correct!) thingsthat have gone wrong.

(i) Lack of investment Applicable risk

PG has a strategy of following developments ratherthan setting the pace for the industry (by keepingthe product up to date with competitor products).

PGs business success therefore depends on atimely awareness of competitors activities.

Failure to respond to innovations in the marketplace (e.g. in graphic design) will threatenadvertising revenues.

(ii) Uncreditworthy customers non-applicable

It is in the nature of providing goods/services oncredit terms that a proportion of revenue will not becollectible (i.e. the risk of bad debts is one whichcan be reasonably borne).

Given the large number of advertising customers itis unlikely that additional controls would be costeffective.

(iii) Incomplete data transfer Applicable risk

Invoices will be incomplete/inaccurate if datatransfer is incomplete. There is a lack of controls toprevent what should be judged to be potentiallysignificant (as advertising revenues are verymaterial).

(iv) Non-charges Applicable risk

Individual advertisements are not significant (being


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(v) Inaccurate production non-applicable

Individual advertisements are less than $5,000(even if a multiple placement is wrong in the firstinstance it should be corrected for any repeats).

(vi) Misappropriated cash Applicable risk

Cash receipts are significant and prone to theft resulting in the loss of assets. Also, accountsreceivable may be overstated if cash receipts fromcredit customers are unrecorded resulting in lossof customer goodwill if they are chased for non-payment when they have settled amounts due.

Any lack of quality (integrity) in PGs people maydamage PGs reputation.

(vii) Unauthorised access non-applicable

The potential for deliberate or intentional errorarising from unauthorised access to the editorialand invoicing systems is relatively unlikely as basicCIS controls should be expected to be in place.

(viii) Systems not available Applicable risk

Unavailability of the editorial system is judged the

more significant as, if advertisements do not getpublished on a timely basis, customers may not payand/or take their future business elsewhere.

(ix) Transfer accounting information non-applicable

Although potentially significant to reported results itis unlikely to affect PGs financial strength (for

example). Also the process is computerised andthere are no other potential risks which suggest alack of programmed controls.

(x) Risk of litigation Applicable risk

Although PG might be expected to have insuranceadequate to cover the financial costs of being suedfor printing advertisements which do not meet theCode of Advertising, it is unlikely that this would besufficient to cover reputational risk.

Tutorial note: Some of the potential risks are more clearly applicable than others. Candidates will be given credit for allwell reasoned arguments.

1 Typographical errors

Tutorial note:Advertisements cannot be guaranteed to beerror-free as typos1 cannot be wholly avoided. This istherefore another example of a risk that can be accepted ata level commensurate with the level of day to day business.

Two people should man the front desk at all times.A duty log should be kept (date, time, staff member).

The desk must not be left unattended while cash is heldthere.

All cash received from customers should be counted andrecorded and a signed, pre-numbered receipt given tothe customer.

Cash and a copy of the signed receipt should betransferred, securely, to cashiers.

The existence of CCTV at the front desk should be madeevident, to act as a deterrent.

Back up/recovery/contingency plans must be in place to

ensure that PG can receive and process advertisementseven when its computer systems are unavailable.

Salvage plans for continuing operations should be tested.For example, in the event of an office fire, PG may havean arrangement with a third party to outsource theeditorial production of the advertisements (andmagazine) to them.

PGs policy on adhering to the Code of Advertisingshould be communicated to all editorial staff.

Any doubts about the propriety of an advertisementshould be raised with a responsible official before it isauthorised for publication.

Tutorial note: If, alternatively, this is judged to be anapplicable risk suitable controls might include:

physical and logical access controls; and

computer logs of attempted and unauthorised access(e.g. outside normal working hours).

Tutorial note: If judged to be applicable suitable controlsmight (again) include such monitoring controls as salescontrol account reconciliations and a review of gross

margins.


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3 VEMA

(a) Change in depreciation method

(i) Matters

The depreciation charge for the year has been reduced by $13m ($42m $29m) as a result of the change,therefore reported profit before tax has been increased by 105% ($13m $124m 0105) and is therefore

material.Tutorial note: Alternative calculation, $13m $(124m 13m) 117%

The write back to reserves (prior period adjustment) is 43% ($47m $110m 0043) of total assets andtherefore material.

Tutorial note: It is not appropriate to gauge the materiality of this item against PBT as it represents a balance sheetadjustment and has no bearing on the income statement.

The net book value of tangible non-current assets has been uplif ted by $60m ($13m + $47m) which is 55% oftotal assets and, again, material.

Management is responsible for reviewing the useful life of tangible non-current assets periodically and, if significantlydifferent, adjusting the depreciation charge for the current and future periods (HKSSAP 17 Property, Plant andEquipment).

Tutorial example: Two-year old vehicles at the beginning of the period, which management now estimate to havea remaining useful life of a further two years from the end of the current period (i.e. five years in total):

opening balance = 1/3 of cost (2/3 having already been depreciated)

current period charge = 1/3 opening balance (writing off balance over next three years).

Management is also responsible for reviewing the depreciation method periodically and changing it, if necessary, toreflect the change in expected pattern in economic benefits. This is accounted for as a change in accounting estimate(i.e. adjusted through current and future periods depreciation charge).

Managements restatement of opening reserves is the treatment for a change in accounting policy or the correctionof a [fundamental] error (HKSSAP 2 Net Profit or Loss for the Period, Fundamental Errors and Changes in AccountingPolicies). This is incorrect. The change in depreciation method is a change in accounting estimate, which, by nature,is an approximation.

Tutorial note: The measurement basis depreciated cost has not changed.

The audit opinion should be qualified except for non-compliance with HKSSAPs 2 and 17 unless the write back toopening reserves is removed and the current year charge is recalculated on the remaining useful lives (and not ascurrently calculated, retrospectively, as though the new method had always been applied).

(ii) Audit evidence

Agreement of opening balances of cost, accumulated depreciation and net book value to prior year working papersand financial statements.

Clients schedules showing remaining useful lives with current year depreciation calculated at 25% of broughtforward reduced balance (25% cost on additions in the period).

Tutorial note: If Vemas management was not prepared to provide these calculations, the auditor would need to

estimate what the correct depreciation charge for the current year should be, to quantify the extent of theirdisagreement.

A proof in total calculation of what the depreciation charge for the year under the new basis should be (i.e. 25% (opening NBV + Additions NBV of disposals)).

Test checking a sample of remaining useful lives per clients schedules to the fixed asset register.

Review of Vemas fleet vehicle replacement policy (e.g. as documented in an operational manual for fleet managers).

Review of age of fleet assets disposed of during the year to check for consistency with assertion that this is nowevery 4 to 7 years.

Scrutiny of profits/losses on disposals of vehicles should expect to have consistently reported profits if they arecurrently depreciated too quickly.

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(b) Termination payment

(i) Matters

$786,000 represents 63% of profit before tax and is therefore material. (However, it is not material to the balancesheet, being only 07% of total assets.)

Tutorial note: It is more meaningful to assess the impact of the gross amount on the financial statements ratherthan the net payment to the former director.

Mr Z was made redundant in the previous accounting period (to 30 September 2002) and the after-date payment,in December 2002, was therefore a subsequent event.

If the audit for the year ended 30 September 2002 was not finished when the termination payment was made, itshould have already been accounted for, i.e. the liability recognised (SSAP 9 Events After the Balance Sheet Date).

If the liability should have been known about, but was omitted from the prior year financial statement, the errorshould be corrected by a restatement of opening reserves.

It is not unusual that such a sensitive transaction be accounted for using a journal entry, rather than processedthrough a payroll, especially as Mr Z should have been removed from the payroll last year.

Tutorial note: This avoids drawing staffs attention to the payment.

The golden handshake has been lost in administrative expenses. Although it may not be considered sufficiently

material to warrant separate presentation on the face of the income statement it appears sufficiently material to bepresented separately in the notes (HKSSAP 1 Presentation of Financial Statements).

As a regional director Mr Z would have been a related party (key management personnel), making the payment tohim a related party transaction. The amount should therefore be disclosed in the notes to the financial statements(HKSSAP 20 Related Party Disclosures).

Whether the $194,000 included within Other liabilities represents the accurate deduction of tax/social securitycontributions or a balance due to Mr Z.

(ii) Audit evidence

Documentation in last years working papers concerning provisions made for redundancies arising from the regionalre-organisation.

The bank payment $592,000 in December 2002. Settlement during the year to 30 September 2003 of $194,000. For example, inclusion of this amount in payments

of tax deducted at source/pay as you earn and a notification of receipt from the relevant taxation authority.

Mr Zs employment contract and directors service contract, in which the terms of the termination payment were setout.

Any correspondence with Mr Z. For example, a letter accompanying the payment of $592,000 stating that it is infull and final settlement of the termination of his employment.

Written management representation that there are no payments to current or former directors relating to the currentor prior period which have not been included in the financial statements.

Tutorial note:A management representation supporting the assertion of completeness of transactions and events.

(c) Legal liability

(i) Matter

Although Weddell contributes a mere 32% of Vemas profit before taxation, it comprises 31% of total assets. Thesubsidiary is therefore material to the consolidated financial statements.

The amount of the contingent liability disclosed is immaterial to Vema being 16% of Vemas profit before taxationand less than 02% of total assets.

Tutorial note: Although it is 50% of Weddells profit before taxation it may not be considered material even inWeddells financial statements as it represents only 06% of the companys total assets. Materiality in relation toPBT is distorted because the company is reporting a near break-even position.

The amount of the legal liability for costs and damages not provided for is material to Vema, being 89% of Vemasprofit before taxation (and 1% of total assets). (It is 32% of Weddells total assets and would turn its reported profit

into a loss.)

The courts verdict in November was an adjusting post balance sheet event providing additional evidence regardingthe amount and likelihood of settlement of a liability. It should therefore be adjusted for i.e. the liability recognised.

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The lodgement of an appeal is also a post balance sheet event however it is non-adjusting arising from a conditionthat did not exist at the balance sheet date (the court hearing).

As Weddell is a subsidiary it is, by definition, controlled by Vema and the management of Weddell can be told toadjust the subsidiarys financial statements.

Tutorial note: It is unlikely that Weddells statutory accounts will have been finalised/filed before Vemas.

If no adjustment is made in Weddells financial statements the auditors report thereon should be qualified except

for on grounds of disagreement about the amount and nature of a liability (being actual rather than contingent).Tutorial note: Although this is not the responsibility of the primary auditor the other auditors opinion is onesource of evidence available to the primary auditor.

If the amount is not adjusted in Weddells financial statements, an adjustment should be made by Vemasmanagement on consolidation (otherwise the audit opinion on the consolidated financial statements would need tobe qualified except for non-compliance with HKSSAP 28 Provisions, Contingent Liabilities and Contingent Assets).

(ii) Audit evidence

The official notification of the courts ruling.

A copy of the appeal lodged with the court.

Legal advice regarding the possible success of the appeal.

Copy correspondence with legal advisers including a copy of the external confirmation letter obtained by Weddellsauditor.

Consolidation/reporting pack from Weddell and their local auditors report thereon (if applicable).

The local firms auditors report on the financial statements of Weddell, when available.

Tutorial note: This should be before the auditors report on Vemas consolidated financial statements is signed.

4 FRAZIL

(a) Auditors responsibilities for reporting on compliance with IFRSs

It has long been established that:

the auditors principal responsibility for reporting (generally) is to express an opinion on whether the financial statementsare prepared, in all material respects, in accordance with an identified financial reporting framework (SAS 100 Objectiveand General Principles Governing an Audit of Financial Statements);

the auditors report must clearly indicate the financial reporting framework used to prepare the financial statements (SAS600 Auditors Reports on Financial Statements).

Specifically, auditors responsibilities for reporting on compliance with IFRSs are set out in the International Auditing PracticeStatement Reporting on Compliance with International Financial Reporting Standards (IAPS 1014) issued by IFACsInternational Auditing and Assurance Standards Board (IAASB).

(i) Only IFRSs

The auditor should be alert to indicators of non-compliance. In the event of any material departure the auditor is

responsible for giving a qualified except for or adverse opinion, on the grounds of disagreement unless managementchanges the accounting policy and/or disclosure, as necessary, in order to comply with IFRSs.

(ii) Both IFRSs and national standards or practices

For an unqualified opinion to be justified, the financial statements will need to comply with both frameworks,simultaneously, without need for reconciliation. (This will be rare. For example, where IFRS has been adopted as thenational reporting framework.)

The auditor is responsible for determining which is the predominant framework and encouraging management to reportonly in that framework. If the problem is not removed in this way the auditor reports on each framework (qualifying theaudit opinion on at least one).

(iii) National standards or practices with disclosure of extent of compliance

As with any assertion the auditor must consider whether assertions made in the notes with respect to the extent of suchcompliance are factually correct and not misleading. If disclosures are misleading, the auditors report expresses aqualified or adverse opinion, unless the comment on compliance is removed.

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(b) Implications for the auditors report

(i) Non-compliance with IAS 38

According to IAS 1 Presentation of Financial Statements, fair presentation requires that financial statements should notbe described as complying with IFRSs unless they comply with all the requirements of each applicable:

standard; AND

IFRIC interpretation.

IAS 38 Intangible Assets requires that development costs which meet all the specific criteria (e.g. technical feasibility)for asset recognition MUST be recognised as an asset and not expensed.

Tutorial note: The question does not call for the regurgitation of those criteria.

Total development costs expensed during the year represent 45% of reported profit before tax and are therefore material.The $14 million which should have been capitalised represents:

13% of total assets;

38% of development costs incurred during the year; and

17% of PBT.

Although clearly material to PBT it is not particularly material to the balance sheet. However, this is only the amount

which should be capitalised for the current year. If not adjusted for this year, it would be an unadjusted error, thecumulative effect of which should be considered in the subsequent year.

Therefore, as there is clearly non-compliance, which is material, the financial statements do notcomply with IFRS.

Management should be asked to:

increase intangible non-current assets by $14 million;

reduce development expenses by $14 million (thereby increasing profit to $96 million);

change the accounting policy note for development costs to state that an asset is recognised when certain criteria aremet.

In the absence of which the audit opinion should be qualified except for disagreement unless the assertion ofcompliance with IFRS is deleted.

Tutorial notes:

(1) As there is no reason to suppose that the prior year policy was other than to expense as incurred, there is nobrought forward balance and IAS 38 transitional provisions are not retrospective.

(2) If, having capitalised the intangible asset, it is apparent that it is impaired, an appropriate impairment loss shouldbe recognised (even 100%).

(ii) Reporting on the Internet

The auditors duty of care is not extended solely by virtue of the report being published in an electronic form as wellas hard copy (i.e. manually signed financial statements).

Tutorial note: Although some commentators may argue contrary to this, this is what is asserted by recently issuedguidance (e.g. by IFAC, in UK, Australian AGS, etc).

The directors are primarily responsible for web-published financial statements (e.g. signing them). Managementshould have an internet reporting policy to ensure the same integrity of financial information as that published intraditional (i.e. paper) form.

Frazils management should be in discussion with the auditors to agree the extent to which audited information willbe included on the website (rather than informing that the annual report is to be so published).

Audit procedures to check the information being presented electronically should include:

reviewing the process by which the financial statements to be put on the web are derived from the financialinformation contained in the manually signed financial statements (e.g. by conversion to PDF or HTML format);

proofing the content of the electronic version against the hard copy;

confirming that the auditors signature copied into an electronic medium is protected from modification;

checking that the conversion has not distorted the overall presentation of the financial information.

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It will be particularly important that it should be clear to all users of the financial information available from thewebsite which information has been audited and which has not. (Identification of what has been reported on withpage numbers is possible with pdf format, but there are no page numbers for html presentation of annual reports.)All hyperlinks in and out of the audited financial statements should be flagged (e.g. through a secure siteentering/leaving notification).

If the auditors report on the hardcopy financial statements refers to page numbers which are not supported by theweb-based version it will require amendment.

Managements responsibility for implementing an appropriate security infrastructure should be acknowledged in themanagement representation letter. This should encompass control procedures to reduce, as far as possible, the riskthat changes are not properly authorised, and ensure that all changes can be detected and monitored.

Tutorial note: Managements responsibilities are not diminished when the enterprise uses a third party to maintain itswebsite even though the maintenance of the website has been put in the hands of a third party, management cannotoutsource its responsibilities.

5 SEPIA

(a) Professional enquiry

Professional issues raised

Krill has a professional duty of confidentiality to its client, Squid. If Krills lack of response is due to Squid not having given

them permission to respond, Sepia should not accept the appointment. However, in this case, Anton Fargues should have:

notified Squids management of the communication received from Sepia; and

written to Sepia to decline to give information and state his reasons.

Krill should not have simply failed to respond.

Krill may have suspicions of some unlawful act (e.g. defrauding the taxation authority), but no proof, which they do not wishto convey to Sepia in a written communication. However, Krill has had the opportunity of oral discussion with Sepia to conveya matter which may provide grounds for the nomination being declined by Sepia.

Steps by Sepia

Obtain written representation from Squids management, that Krill & Co has been given Squids written permission torespond to Sepias communication.

Send a further letter to Krill by a recorded delivery service (i.e. requiring a signature) which states that if a reply is notreceived in the next seven days (say) Sepia will assume that there are no matters of which they should be aware andso proceed to accept the appointment. (Advise also that unless a response is received, a written complaint will be madeto the relevant professional body.)

Make a written complaint to the disciplinary committee of the professional body of which Anton Fargues is a member so that his unprofessional conduct can be investigated.

(b) Take-over bid


Sepia has a professional duty of confidentiality to its existing audit client, Vitronella.

Vitronella may ask Sepia to give corporate finance advice on Hatchets take-over bid which would be incidental to the

audit relationship. Providing Sepia can maintain and demonstrate integrity and objectivity throughout, there would beno objection to Sepia providing such an additional service, to advance their existing clients case.

It is often in a companys best interests to have financial advice provided by their auditors, and there is nothing ethicallyimproper in this. So it seems unusual that Hatchet should have approached Sepia, rather than their current auditors.

HKSAs Professional Ethics1 consider that it would not be improper for an audit firm to audit two parties, even if thetake-over is contested, and that to cease to act could damage the clients interests. However, the situation is differenthere in that Sepia is not Hatchets auditor.

Sepia should take all reasonable steps to avoid conflicts of interest arising from new engagements and the possessionof confidential information. Sepia cannot therefore resign from Vitronella in order to undertake the advisory role forHatchet. (A relationship which has ended only in the last two years is still likely to constitute a conflict.)

Steps by Sepia

As it is clear that a material conflict of interest exists, Sepia should decline to act as adviser to Hatchet.

Advise Vitronellas management that Hatchets approach has been declined.

1 Similarly ACCAs Rules of Professional Conduct

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(c) Lowballing


Lowballing is a practice in which auditors compete for clients by reducing their fees for statutory audits. Lower audit feesare compensated by the auditor carrying out more lucrative non-audit work (e.g. consultancy and tax advice).

The fact that Keratin has quoted a lower fee than the other tendering firms (if that is the case) is not improper providing thatthe prospective client, Benthos, is not misled about:

the precise range of services that the quoted fee is intended to cover; and

the likely level of fees for any other work undertaken.

Although an admission to lowballing Setting the early price in an arrangement at a low amount to secure business with theintent later to raise the price may sound improper, it does not breach current ethical guidance providing Benthos understandsthe situation. So, for example, Keratin could offer Benthos a free first-year audit, providing Benthos appreciates what thecost of future audits would be.

The risk is, that if the non-audit work does not materialise, Keratin may be under pressure to cut corners or resort to irregularpractices (e.g. the falsification of audit working papers) in order to keep within budget. If a situation of negligence (say) werethen to arise, Keratin could be found guilty of incompetence.

As the provision of other services is under scrutiny and becoming increasingly restricted this risk is likely to be high. Forexample, non-audit services which are prohibited in the US include bookkeeping, financial information systems design and

implementation, valuation services, actuarial services, internal audit (outsourced), human resource services for executivepositions, investment and legal services.

Keratin may not be just lowballing on the first year audit fee, but in the longer term. Perhaps indicating that future increasesmight only be in line with inflation. In this case if, rather than comprise the quality of the audit, Keratin were to substantiallyincrease Benthos audit fees, a fee dispute could arise. In this event Benthos could refuse to pay the higher fee. It might bedifficult then for Keratin to take the matter to arbitration if Benthos was misled.

Steps by Sepia

There are no steps which Sepia can take to prevent Benthos from awarding the tender to whichever firm it chooses.

If Keratin is successful in being awarded the tender, Sepia should consider its own policy on pricing in future competitivetendering situations.

6 PROFESSIONAL RESPONSIBILITIES AND LIABILITY

Tutorial note: The answer which follows is indicative of the range of points which might be made. Other relevant material willbe given suitable credit.

(a) External audit opinion

Responsibilities

Management is primarily responsible for the proper preparation and presentation of financial statements and this is clearlystated in the auditors report. The statutory auditors duty is to report, expressly, an opinion on a true and fair view (orpresents fairly in all material respects). In some jurisdictions this duty may extend to reporting expressly (as in the Republicof Ireland) or by exception (as in Great Britain) on matters such as whether or not all information and explanations necessaryfor audit purposes have been received.

The auditors report is addressed (usually) to the shareholders and it has long been established that the auditor is liable toshareholders in cases of negligence.

Tutorial note: Cases which could be cited here include London and General Bank Ltd (1895); Re Kingston Cotton Mill(1896); Re Thomas Gerrard & Son Ltd (1967).

Cases on liability to third parties have focused on the question of whether a duty of care is owed and the issue of foreseeability(e.g. Donoghue v Stevenson (1932); Candlerv Crane Christmas (1951); Hedley Byrne v Heller & Partners (1963);JEBFasteners v Marks Bloom (1981); Twomax Ltd v Dickson, McFarlane & Robinson (1983),Al Saudi Banque v Clarke Pixley(1989)).

However, the case ofCaparo Industries plc v Dickman and Others (1990) narrowed the scope of liability by introducing acondition of proximity of relationship into duty of care.

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Recent developments

In the US, the Sarbanes-Oxley Act, introduced in the wake of the Enron and Worldcom scandals, requires the principalexecutives and finance officers (CEOs and CFOs) to certify that accounts of SEC-registered companies:

do not contain any untrue statements or omit anything that would be necessary for the report not to be misleading; and fairly present the companys financial position and results.

Such a demonstration of managements responsibility may assist auditors in claiming that they are not liable in cases where

management is fraudulent. As a deterrent, wilful breach of this provision2

can result in a $5 million fine or 20 yearsimprisonment (or both).

In the Bannerman case3, a Scottish court held that auditors could be held to have a duty of care to a third party (in this casea lending bank) if they knew, or ought to know, that the bank would rely on audited accounts and they did not disclaimliability. The knew or ought to have known principle is the same as in pre-Caparo cases (above). What is different aboutthe Bannerman case is that the auditors failure to disclaim liability was what supported the existence of the duty of care.

Impact on professional liability

The auditors responsibility to conduct an audit in accordance with auditing standards is unchanged. However, liability tothird parties is clearly increased if the auditor does not disclaim such liability. This is not to be confused with:

a disclaimer of liability to shareholders; or

the disclaimer of an audit opinion in accordance with SAS 600 Auditors Reports on Financial Statements.

Auditors wishing to manage the risk of liability to third parties are advised to include a separate disclaimer of suchresponsibility, at the same time stating that the auditors report is to the shareholders (as a body) and that audit work isundertaken solely for that purpose.

(b) Internal financial controls

Responsibilities

Risk management is the primary responsibility of management whose fiduciary duties include the safeguarding of assetsand ensuring the completeness and accuracy of financial records. Internal audit provides objective assurance and advice toboards, especially the non-executive directors, on the effectiveness of the risk management processes and the ways in whichrisks are managed and controlled.

In accordance with existing auditing standards, the external auditor is required to make a preliminary assessment of internal

controls and to test them if seeking to place reliance on them as audit evidence.Developments

There has been much debate concerning reporting, in the public interest, statements by directors of listed companies. UKListing Rules (for example) require that auditors review the effectiveness of managements systems of internal control.However auditors are notrequired to provide assurance on internal control (as suggested by The Combined Code).

Tutorial note: As illustrated above, marks will be awarded for relevant reference to developments in corporate governance(e.g. Cadbury, 1992; Hampel, 1998; Combined Code, 1998; Turnbull, 1999), in the context of the question set.

The spectacular collapses of Barings Bank/Enron clearly demonstrate the need for management to have risk managementpractices and effective internal financial controls. It is unlikely that auditors can report on such matters in short form. Thejudgements involved and the lack of generally accepted suitable criteria will require a lengthy narrative report to avoidmisunderstandings in communicating conclusions.

Post-Enron legislation in the US, the Sarbanes-Oxley Act, now requires4

that CEOs and CFOs certify that: they are responsible for internal controls and have reported on their effectiveness; and

all significant control weaknesses and management frauds have been reported to the auditors and the audit committee.

Auditors are required to report on managements report on internal control effectiveness.


Reporting on the effectiveness of financial internal controls is perceived to increase auditors liability if the auditor fails toidentify significant risks or potential weaknesses in the design and operation of a system of internal financial controls. Inparticular, allegations of negligence may be directed to the auditor because of a lack of understanding that absolute assuranceis not possible due to inherent limitations of internal control (e.g. human error, collusion, and management override).

2 Effective on 20 July 2002 (when the Act was passed)3 Royal Bank of Scotland v Bannerman Johnstone Maclay and others4 Effective 29 August 2002

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(c) Management representation letters

Responsibilities

Management representation letters provide written evidence that management acknowledges its collective responsibility forthe preparation of the financial statements and that they have approved them. Auditors have a professional responsibility togather sufficient audit evidence to support their audit opinion, including obtaining written representations when appropriate.

SAS 440 Representations by Management requires that:

written representation be obtained when sufficient appropriate evidence cannot reasonably be expected to exist;

the reliability of representations be reconsidered if contradicted;

if management refuses to provide representation the implications for the auditors report be considered.

Also, auditors are required to consider whether the individuals making the representation can be expected to be well informedon the particular matters.

Recent developments

The High Court decision in the Barings case5 raised some key issues in relation to the protection which managementrepresentations afford to auditors. A director, having little knowledge or understanding of Nick Leesons activities (althoughhe was nominally his boss), made representations that there had been no irregularities and that the financial statements werefree of material errors and omissions.

The judge said that the external auditors (D&T) defence against the claim for damages which they faced, that the directorwas recklessly fraudulent, would have succeeded if fraudulent misrepresentation could have been established. In somejurisdictions it is a criminal offence for an officer of a company to knowingly or recklessly make misleading or false statementsto the companys auditors.

It is already clear in SAS 440 that management representations cannot be a substitute for evidence that auditors expect tobe available and that uncorroborated representations do not normally constitute sufficient audit evidence. The Baringsjudgement does not contradict the basic principles and essential procedures contained in SAS 440. However, it hashighlighted the need for emphasis of the guidance in this area.

To add substance to auditors considering whether individuals are well-informed on the matters about which they are makingrepresentations, it is recommended6 that management include a specific representation that they can properly make theirrepresentations.


If more cases of criminal charges are brought against officers, as a deterrent to making deceptive statements, the reliability ofmanagement representations as audit evidence should be increased. Professional liability is thereby reduced if there are fewercases brought or proved against the auditor.

5 Barings Futures (Singapore) Pte Ltd (BFS) v Deloitte & Touche Singapore [2002]6 In a Technical Release

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Part 3 Examination Paper 3.1 (HKG)

Audit and Assurance Services (Hong Kong) December 2003 Marking Scheme

Marks must only be awarded for points relevant to answering the question set. Unless otherwise indicated, marks should not be awardedfor restating the facts of the question.

For most questions you should award 1/2 a mark for a point of knowledge, increased to 1 mark for the application of knowledge and11/2 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) pointsshould 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 candidates answer is above or belowthe 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 itdoes 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 isnot a proper reflection of the standard of the candidates answer, you should review the candidates answer and adjust marks, whereappropriate, so that the total mark awarded is fair.

Marks

1 (a) (i) Business risks

Generally 1/2 mark for identification + 1 mark each point of explanation max 8

Ideas

Operations risks standard design licences alternative facilities/competition customer satisfaction/poor service levels (e.g. staff lateness) human resourcesEmpowerment risks centralised controlInformation for decision-making risks business reporting risksFinancial risks advance payments loss of revenue cash flow

Compliance risks rights to operate safety management (lifeguards, crche facilities)


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Marks

(a) (ii) Financial statement risk

Generally 1 mark each point max 8

IdeasAssets impairment/overstatement (licences, tangibles and GCUs) useful lives

existence assuranceLiabilities understatement/non-disclosure (contingent and actual)Income statement revenue (overstatement/non-compliance SSAP 18) staff costs overstatementControls control risk fraud/illegal actsInherent risks branch accountingDisclosure risk going concern (SSAP 1) contingent liabilities/assets capital commitments

(b) Principal audit work

Generally 1 mark each area ofprincipal audit workmaximum 3 marks each (i) and (ii) 6

IdeasDeferred income accounting estimate cutoff/accrual basis/matching test in totalHydrotherapy pool

initial measurement/cost reliance on an expert (SAS 520) borrowing costs (SSAP 19) Impairment (SSAP 31) vs depreciation (SSAP 17)

(c) Performance indicators

Generally 1/2 mark for each measure suggested1/2 1 mark each source of evidence max 8

IdeasPerformance measures types of performance measure (e.g. efficiency, capacity) numbers/proportions/%s

facilities (available vs closed) members (lapsed, renewed, introduced) accidents (personal, chemical)

Audit evidence oral vs written internal vs external auditor generated procedures (AEIOU)7

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7 SAS 400 identifies five procedures for obtaining audit evidence: Analytical, Enquiry, Inspection, Observation and compUtation.


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Marks

2 (a) Applicable risks

Generally 1/2 mark for appropriate identification as applicable max 38

Up to 11/2 marks each point of explanation max 15max 14

Ideas (types of risk)

Environment competition regulatoryProcess operations financial empowerment information processing integrityInformation for decision-making process/operations business reporting environment/strategic

(b) Internal controls

Generally 1 mark each point, max 2 4 applicable risks max 6

Ideas control procedures/specific controls control environment/pervasive controls monitoring activities (including reconciliations)

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8 Judgemental marks award none if no discernment (e.g. all risks identified as non-applicable or applicable).8] Award 1/2 for each non-applicable risk consistent with reasoned assessments.


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Marks

3 (i) Matters

Generally 1 mark each commentmaximum 5 marks each issue 3 max 12

Ideas materiality (assessed) relevant SSAPs (e.g. 1, 2, 9, 17, 20, 28) and The Framework

risks (e.g. FS assertions existence, completeness) responsibilities (e.g. for consolidated financial statements)

(ii) Audit evidence

Generally 1 mark each item of audit evidence (source)maximum 5 marks each issue 3 max 12

Ideas (SAS 400) oral vs written internal vs external auditor generated procedures (AEIOU)

max 20

(a) max 8(b) max 6(c) max 6

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Marks

4 (a) Auditors responsibilities for reporting on compliance with IFRSs

Generally 1 mark each comment max 5

Ideas generally/background SAS 100, 600 new authority IAPS 1014

IFRSs only disagreement except or adverse both IFRS and national simultaneous compliance, predominant framework national with disclosure of IFRS compliance assertion factually correct or misleading

(b) Implications for auditors report

Generally 1 mark a comment max 10

Ideas(i)i IAS 38 non-compliance SSAP 1 fair presentation

IAS 38 mandatory requirement Materiality current year vs cumulative effect9

Conclusion on compliance Amendments required unqualified opinion If not amended except for disagreement(ii) Reporting on the Internet Responsibilities (auditor/management) Extent of audited information Audit procedures Identification of audited information vs unaudited information

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9 Maximum 2 marks

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Marks

5 Professional issues

Generally 1 mark each commentmaximum 5 marks each of three matters

IdeasProfessional issues raised

Integrity (management and/or audit firm) Objectivity/independence Confidentiality Relevant ethical guidance i.e. (a) Changes in professional appointment (b) Corporate finance advice including take-overs (c) Fees Meaning of lowballingSteps (i.e. ACTIONS) Obtain . . . what? . . . why? Ask/advise . . . who? . . . when?

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6 Responsibilities and liabilities

Generally 1 mark a point

Ideas (illustrative) Traditional responsibilities/liabilities of

management internal audit external audit

Recent change (legal/professional) What change has been in response to Impact on professional liability of external auditors

(a) max 6(b) max 5(c) max 4

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2003 December (Answer)

Documents

Transcript of 2003 December (Answer)