SECTION A CASE QUESTIONS (Total: 50 marks)

Transcription

1 SECTION A CASE QUESTIONS (Total: 50 marks) Answer 1(a) The risk of material misstatements relating to the accuracy assertion of interest income is high. The interest income increased significantly for the 10 months ended 31 October 2014 compared to the year ended 31 December The annualised interest income has increased by over 36%. However, the loan receivables balance as at 31 October 2014 only increased by 4% when compared to 31 December There may be potential accuracy errors in interest income recognition. In addition, the customer mix changed significantly as at 31 October 2014 compared to 31 December Individual customers increased significantly from 50% to 80%. The significant change of customer mix may be due to a change of business strategy. It also indicates increasing risk to the accuracy of the customers profile from the audit perspective, which may imply the potential risk of material misstatements on the existence of the loan receivable and occurrence of the loan interest income are high. Moreover, the proportion of the collateral secured loans decreased from 80% as at 31 December 2013 to 60% as at 31 October The unsecured loans significantly increased from 5% as at 31 December 2013 to 25% as at 31 October The loan to provision ratio remained unchanged over the period though there was a significant change of security profile. This may imply a high risk of the irrecoverability of the loan receivable balances, which may affect the valuation assertion of the loan receivable balances. Answer 1(b) In view of the significant amount and number of interest income transactions, a combination of the control and substantive test approach is considered to be a more efficient and effective approval compared to a substantive test approach in testing the occurrence and accuracy of the interest income and the existence and valuation of the loan receivable balance. In response to the risk of material misstatements relating to the occurrence and accuracy assertions of interest income, the proposed audit procedures include: Understand the management s process and controls over interest income recognition. Evaluate the effectiveness of the process and controls over the interest income recognition. Validate the key controls over the interest income recognition process. Module C (June 2015 Session) Page 1 of 12

2 Review signed loan agreements and the archived recording of loan acceptance and identify key contract terms, such as interest rate and duration of loan. Recalculate the interest income in accordance with key terms specified in the loan agreements. Test check the instalment (loan and interest) repayment and agree the cash receipts with the accounting record. In response to the risk of material misstatements relating to the existence of the loan receivable balance, the proposed audit procedures include: Perform a receivables circularisation on a sample of year-end loan receivables. Follow up all balance disagreements and non-replies to the loan receivables confirmation. Perform alternative procedures for any exceptions and non-replies to the loan receivables confirmation. Examine the underlying documents e.g. loan agreements, bank statements and bank receipt notes. In response to the risk of material misstatement relating to the recoverability of the loan receivables (i.e. valuation assertion), the proposed audit procedures include: Understand the management s control over credit risk assessment for each of the loan customers and the provision assessment on loan receivable. Evaluate the effectiveness of the management s control over credit risk assessment and the provision assessment for loan receivable. Validate the management s key control over credit risk assessment and the provision assessment for loan receivable. Understand the management s loan receivable provision policy. Assess the reasonableness of the management s loan receivable provision policy. Obtain from the management their loan-to-provision assessment. Compare the management s loan-to-provision assessment to actual loan receivables written off. Module C (June 2015 Session) Page 2 of 12

3 Review the adequacy of the allowance for uncollectable loan receivables through discussion with the management. Examine the large loan customers as at year-end and assess the risk of collectability of each loan balance. Review the minutes of the loan approval committee and board minutes for credit policy-making and provisioning. Discuss with the management and assess the adequacy of the provision on overdue loan instalments and interest receivables. Answer 2(a) In view of the significant increase in cash transactions from 10% for the year ended 31 December 2013 to 30% for the 10 months ended 31 October 2014 and the change of customer mix with individual borrowers increasing to 80% as at 31 October 2014, the significant increase in cash transactions and significant increase in individual customers both imply a higher risk of fraud in the occurrence of interest income during the year and existence of loan receivable as at year end. In addition, the increase in cash transactions also increases the risk of fraud in terms of the misappropriation of cash. Answer 2(b) Control activities are the policies and procedures that help ensure that management directives are carried out. The monitoring of controls is a process to assess the effectiveness of internal control performance over time. It includes assessing the design and operation controls on a timely basis and taking necessary corrective actions modified for changes in conditions. Answer 2(c) Control activities that can help management to mitigate the potential risk of material misstatement to the financial statements relating to cash and bank balances can be summarised into the following five different aspects: (a) Authorisation Each cash transaction should be approved by at least two appropriate persons. For example, the granting of a new loan and payment of a new loan in cash should be reviewed and approved by the lending approval committee and general manager. Receipts of cash interest/ principal repayment should be reviewed and approved by the treasurer and accounting manager. Module C (June 2015 Session) Page 3 of 12

4 (b) Physical controls There should be controls and procedures established to ensure the cash on hand is properly safeguarded every day. For example, there should be control procedures on daily cash counting and performing reconciliation of cash record to transaction record. Cash over a certain amount (i.e. over HK$100,000) should be deposited in a bank on a daily basis. Cash should be stored in a safe and only trustworthy personnel should be given the key of the safe. (c) Segregation of duties Key functions involved in cash transactions should be carried out by different personnel. For example, approval of a cash loan should be carried out by the loan lending committee and the general manager. Payment of a cash loan should be handled by the Treasury department with the approval from the loan lending committee and the general manager. The related cash transaction should be recorded by the Accounts department. The daily cash counting and reconciliation of cash record to the transaction record should be carried out by a designated person from the Accounts department. (d) Information processing Management should ensure each cash transaction is recorded on a timely basis and based on appropriate supporting documents with review and approval. (e) Performance review Cash and bank reconciliation should be performed at each month end. Any difference between the cash/ bank record and the transactions record should be properly followed up. Answer 3(a) APPEX account and CalQuick are the two financially significant information systems used by Real Time. Answer 3(b) Below is the outline of the ITGC test plan for the APPEX account and CalQuick. APPEX Account and CalQuick are considered to be financially significant accounting systems used by Real Time and therefore ITGC should be tested to ensure there are controls and procedures that are adequate to provide secure, effective and efficient day-to-day operation of the computer facilities. The following areas should be considered to be included in the ITGC test plan: Development of computer applications. Prevention and detection of unauthorised changes to programmes. Testing and documentation of programme changes. Module C (June 2015 Session) Page 4 of 12

5 Controls to prevent the wrong programmes or files being used. Controls to prevent unauthorised amendments to data files. Controls to ensure continuity of operation. Controls over network security. The engagement team should understand the processes and controls of the above areas with Real Time s IT personnel, evaluate the effectiveness of the process and controls with reference to the size of operation of Real Time and perform validation tests on the key controls identified in the IT general controls. Answer 3(c) Since CalQuick was implemented during the year and automates the interest income calculation and recording process, the engagement team should perform a walk-through test with management to understand the automated controls built in CalQuick for calculating the interest income and the process and controls for safeguarding the completeness and accuracy of the financial data inputs used in the interest income calculation. If there is evidence that the processes and controls in relation to the interest income calculation and recording are appropriate to Real Time in terms of its operation scale after evaluation, the engagement team should consider testing the effectiveness of the automated interest income calculation process. It is equally important to test the control effectiveness of the completeness and accuracy of the data inputs used in CalQuick for calculating the interest income as garbage in means garbage out. Furthermore, the engagement team should also test the effectiveness of the interfaces between CalQuick and APPEX and the reconciliation of CalQuick to APPEX to ensure the interest income is properly recorded in the general ledger. Since the automated controls have not been implemented before July 2014, the engagement team should test the effectiveness of the manual controls adopted by the management on the interest income calculation and recorded during the first six months of In addition, since interest income was calculated using spreadsheets before the automation of the interest income calculation process, the engagement team should also understand the data protection controls concerning the spreadsheets and test the effectiveness of these controls. Both before and after the automation of interest income calculation, a substantive test on interest income should be performed to cover the whole period since interest income is a material balance and a substantive test is required. * * * END OF SECTION A * * * Module C (June 2015 Session) Page 5 of 12

6 SECTION B ESSAY / SHORT QUESTIONS (Total: 50 marks) Answer 4(a) The competency of the auditor s expert should be considered. Competency is related to the expert s professional certification, experience in the field, or licensing. The capability of the auditor s expert should be considered. Capability is related to the auditor s expert capability to exercise his competence in the engagement. The objectivity of the auditor expert should be considered. The auditor should specifically inquire as to the interests and relationship that may create a threat to that expert s objectivity. The risk of material misstatement in the matter should be considered. This is based on the nature and complexity of the matter that involves the expert s work. The significance and impact of that expert s work in the audit should be considered. Answer 4(b) In accordance with HKSA 540 (Clarified) Auditing Accounting Estimates, including Fair Value Accounting Estimates and Related Disclosures, the auditor should obtain sufficient appropriate audit evidence to conclude whether the accounting estimates for impairment assessment made by the management is reasonable in the circumstances. The auditor should: enquire with the management about their process to prepare the forecast of Star Limited, the source of the financial information and the personnel involved for the preparation of the forecast, and whether it is retrieved from the management s regularly prepared budget; and consider if the management use appropriate CGUs (Cash-generating units) when preparing the forecast. The auditor should compare the management s previous years business plan of Star Limited to the respective historical results in order to ascertain (i) how accurate the management previous business plan was and (ii) whether there are any significant changes to the current business plan. The auditor should re-perform the calculation of the cash flow projection to check its accuracy. Module C (June 2015 Session) Page 6 of 12

7 The auditor should discuss with management the reasonableness of assumptions and data used and the appropriateness of the assessment model. The auditor should compare the historical key financial results to the forecast and challenge the management on the following: Why was a steady growth rate (25%) and profit margin (10%) maintained throughout the forecast period? Given the fact, the historical growth rate was 10% and the profit margin was 8%, how can the growth rate achieve 25% per year and the profit margin improve by 2% in the forecast period? Why is the forecast period five years? Why does the net cash inflow amount equal the net profit for each of the respective forecast years? Did the management consider any cash flow items such as capital expenditure and bank borrowing repayment? The auditor may also compare the forecast to the data derived from wider industry information, secondary research and so on to test the reasonableness of the management s forecast. The auditor may perform a sensitivity analysis by testing different assumptions and analysing the likelihood of a potential impairment. The auditor should discuss with the external valuer to ascertain why the discounted cash flow model is applied for the methodology of the business valuation of Star Limited. The auditor should challenge the discount rate applied by the external valuer and compare the discount rate to the industry index and evaluate if it is reasonable. The auditor should review all the directors meeting minutes up to the report date to ensure that all the relevant matters have been considered in the goodwill assessment. The auditor should obtain sufficient appropriate audit evidence about whether the disclosures in the financial statements related to accounting estimates are in accordance with the requirements of the applicable financial reporting framework. Module C (June 2015 Session) Page 7 of 12

8 Answer 5(a) Marks are given when the student is able to apply practical policy to respond to the respective threat. Self-interest threats The firm can publish a list of its audit clients, which are public interest entities ( PIEs ) so that its professional staff are aware that these PIEs are prohibited investments. The firm can perform a regular review of professional staff s personal investment to ensure that they are in compliance with this policy. Self-review threats Peer review or technical review is required for the audit engagements in order to ensure a quality audit is performed. Advocacy threats A firm should have a policy of not permitting any contingent fee arrangement. Familiarity threats Key audit partners are required to be rotated out every 7 years. Intimidation threats Professional staff are not allowed to receive gifts from audit clients with a value specified by the audit firm or clients offers should not be accepted. Answer 5(b) S.290 of the code of ethics for professional accountants Business relationships provides specific guidance. It states that purchasing goods and services from an entity on an arm s length basis does not usually constitute a threat to independence. However, if there are a substantial number of transactions constituting a material interest, there may be a threat to independence and safeguards may be necessary. The auditor should be aware that during the audit period (Year ending 31 December 2015), the firm will purchase a service from Rose Limited as the service contract covers the 3-years ended 31 December Although the contract was entered into between Rose Limited and the firm prior to the commencement of the audit engagement, the auditor should still be required to observe the independence requirement. The auditor should consider whether the purchasing of the professional printing service from Rose Limited is on an arm s length basis where judgement is involved. Factors to demonstrate that it is on an arm s length basis may include: the auditor went through a fair and objective evaluation when selecting Rose Limited as its service provider; a comparison of terms and conditions offered by Rose Limited to the firm to the terms and conditions offered by Rose Limited to other customers. Module C (June 2015 Session) Page 8 of 12

9 The auditor should consider whether the provision of the professional printing service by Rose Limited will constitute a material interest. If financial interest is immaterial and the business relationship is insignificant to the firm, the threat created is not significant, so that the firm can submit the audit proposal to Rose Limited. However, if the financial interest is material and the business relationship is significant to the firm, the firm should consider any other safeguards, which can reduce the threat to an acceptable level, for example, the firm may consider terminating the existing contract with Rose Limited so that the audit firm can submit the audit proposal to Rose Limited. Answer 6 In Hong Kong, the Code on Corporate Governance Practices ( HK Code ) sets out the principles of good corporate governance. It refers to the companies subject to the Code as issuers. The HK Code promotes transparency and openness. Transparency means open and clear disclosure of relevant information to shareholders and other stakeholders, and not concealing information, which may affect decision-making. It means open discussion, with a default position of information provision rather than concealment. Directors should also hold responsibilities to their stakeholders. Directors should act in the best interests of the company and take the necessary steps to ensure the company stays on the right path. Directors are accountable to stakeholders for complying with statutory and regulatory requirements, safeguarding funds and taking proper stewardship of assets and resources. Any major issues should be brought to the attention of the board on a timely basis. Financial and non-financial performance measures should be established and reported. In this regard, the directors should understand thoroughly the status of the construction with the operational personnel, evaluate if a significant delay in the completion will likely to arise. Consider seeking expert advice from internal or external sources. Concurrently, the directors should establish measures to respond to the possible losses. For example, try every effort to negotiate with their customer aiming to minimise the loss and damage to the company. The directors should also assess the significance of the impact arising from the delay of the construction project and consider if a disclosure of the event is required. The impact can be a financial loss, which may cause a significant loss arising in profit or loss, and a non-financial loss, which is a reputation risk. Module C (June 2015 Session) Page 9 of 12

10 Answer 7 The incoming auditor can perform the following procedures before accepting Aloha Limited as its audit client: The incoming auditor can review Aloha Limited s previously published financial statements or any other relevant information to determine if the management has any integrity problems in the past. The incoming auditor can consult the last appointed auditors to ensure that there are no reasons behind the vacancy, which the new auditors ought to know. This is also a courtesy to the last appointed auditors to respond to the incoming auditor in a written form. For example, obtaining a professional clearance from the last appointed auditors after receiving permission from the prospective client. The incoming auditor can check any other relevant information relating to Aloha Limited or obtain references from the directors of Aloha Limited. The incoming auditor should evaluate whether they are competent to perform the engagement and whether they have the capabilities, time and resources to do the engagement. Since Aloha Limited is a dual-listed company in China and Hong Kong, a different financial reporting framework may be required. The incoming auditor should assess if he has such expertise to carry out the audit of Aloha Limited if an overseas regulatory requirement is required to be observed. In addition, he should ensure that the audit can be carried out without any legal barriers, e.g. any requirement of a professional qualification in China? The incoming auditor should comply with the relevant ethical requirements. The incoming auditor should ensure that there are no ethical issues, which are a barrier to accepting this audit client. For example, whether the auditor has a significant business relationship with Aloha Limited, which may create a self-interest threat. In addition, as Aloha Limited is a listed company, s.441 of the Code of Ethics Change of Auditors of a Listed Issuer of the Stock Exchange of Hong Kong should be observed. The proposed incoming auditor should request a copy of the letter of resignation/ termination and any correspondence issued by the last appointed auditors of Aloha Limited. If Aloha Limited refuses to send the proposed incoming auditor the letter of resignation/ termination, the proposed incoming auditor can only decline to accept nomination. Module C (June 2015 Session) Page 10 of 12

11 Answer 8 HKSA 510 (Clarified) Initial Audit Engagements Opening Balances states that when the auditor conducts an initial audit engagement, the objective with respect to opening balances is to obtain sufficient appropriate audit evidence about whether: (a) (b) (c) opening balances contain misstatements that materially affect the current period s financial statements; appropriate accounting policies reflected in the opening balances have been consistently applied in the current period s financial statements; and if changes are made, whether these changes are appropriately accounted for and adequately presented and disclosed in accordance with the applicable financial reporting framework. The suggested audit procedures for Messy Limited s opening balances are: Fixed assets Trace the purchases of fixed assets to ensure that fixed assets were recorded in the proper accounting period (i.e. fixed assets were purchased in the current year but not in prior year). If evidence indicates that purchase of fixed assets should have been recorded in the prior year, consider whether the depreciation charge might have been understated and created a consequential impact on the opening balances. Inventories Observe a current physical inventory count and reconcile it back to the opening inventory quantities. Perform audit procedures on the valuation of the opening inventory items. Perform audit procedures on gross profit and cut-off. Trade payables Trace the payment of opening accounts payable during the current period. Review the suppliers invoices and/or circularise confirmation to the key suppliers to confirm the balances as at 1 January Module C (June 2015 Session) Page 11 of 12

12 Cash at bank Obtain a bank statement and/or circularise confirmation to the banks to confirm the balances as at 1 January 2014 to agree the balance with the cash ledger. Revenue and expenses Perform the sales and purchases cut-off tests as of 1 January Review the collection of receivables and payment of expenses in January 2014 to ensure a proper cut off had been done as of 1 January Statutory review Review of the statutory records of Messy Limited. Review the incorporation certificate of Messy Limited. Review the minutes of Messy Limited for the prior year. Review any material contracts to see if there was any non-disclosure of contingencies and commitment at the prior year end date. Evaluate whether audit procedures performed in the current period provide evidence that no prior periods transactions were wrongly recorded in the current period (i.e. a proper cut-off of the opening balances). The auditor should communicate the misstatement with the appropriate level of management and those charged with governance. If the auditor is unable to obtain sufficient appropriate audit evidence regarding the opening balances, the auditor shall express a qualified opinion or issue a disclaim report on the financial statements, as appropriate. * * * END OF EXAMINATION PAPER * * * Module C (June 2015 Session) Page 12 of 12