Hong Kong Printing Company Limited is a company incorporated under the Hong Kong Companies Ordinance and listed on the Hong Kong Stock Exchange.

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1 SECTION A CASE QUESTIONS (Total 50 marks) Answer ALL of the following compulsory questions. Marks will be awarded for logical argumentation and appropriate presentation of the answers. CASE Hong Kong Printing Company Limited is a company incorporated under the Hong Kong Companies Ordinance and listed on the Hong Kong Stock Exchange. Hong Kong Printing Company Limited and its subsidiaries ( HKP ) are principally engaged in the manufacture and printing of multi-colour packing products, boxes, books, brochures and other paper products. All HKP s production facilities are located in Mainland China was a very difficult year for HKP. HKP reported a loss, for the first time since its incorporation 30 years ago, of HK$23 million. The loss was caused by a drop in sales due to intense market competition, coinciding with increases in variable costs in raw materials and wages. HKP s operating results in the last five years are as follows: HK$ 000 HK$ 000 HK$ 000 HK$ 000 HK$ 000 Revenue 423, , , , ,345 Operating profit/(loss) (5,371) 14,312 32,265 28,759 24,487 Finance costs (8,889) (7,975) (10,521) (10,879) (12,038) Profit/(loss) after tax (23,151) 3,973 16,999 11,118 8,355 Because of the unexpectedly poor operating results, HKP experienced extremely severe operating cash flow problems during the year. HKP delayed paying interest to its major banks in accordance with the loan agreements. As a result of these breaches of covenants, the bank loans became repayable immediately. HKP s management obtained informal understandings from the relevant account managers of the banks that in view of the long term relationship with HKP the banks would not require HKP to repay the loans immediately. However, no formal confirmation of these waivers had been obtained from the banks. The management of HKP was not aware of the financial reporting requirement to reclassify such loans as current when they prepared the draft financial statements for the year ended 31 December Module C (February 2008 Session) Page 1 of 6

2 The draft consolidated balance sheet of HKP as at 31 December 2007 is as follows: HK$ 000 HK$ 000 Pre-paid land lease premium 30,695 31,202 Property, plant and equipment 409, ,359 Non-current Assets 440, ,561 Inventories 78, ,259 Trade and other receivables 85, ,443 Bank balances and cash 33,918 48,060 Current Assets 198, ,762 Total Assets 638, ,323 Share capital 22,255 22,255 Reserves 221, ,730 Equity 243, ,985 Long-term bank loans 234, ,734 Deferred tax liabilities 19,170 20,653 Other non-current liabilities 901 1,210 Non-current Liabilities 254, ,597 Taxation payable 1,219 1,827 Current portions of long term bank loans 25,278 23,956 Bills payable 49,516 37,772 Trade and other payables 64,257 56,186 Current Liabilities 140, ,741 Total Equity and Liabilities 638, ,323 You are a manager at XYZ & Co., HKP s auditor since its incorporation. You have been the manager-in-charge of audits of HKP s financial statements for the last 5 years. Module C (February 2008 Session) Page 2 of 6

3 Question 1 (13 marks - approximately 23 minutes) You are performing certain preliminary engagement activities for the audit of HKP s financial statements for the year ended 31 December 2007 ( 2007 audit ), including the development of an overall audit strategy, and an assessment of the risk of material misstatement at the financial statement level. Determine: the ethical issues your team should consider in deciding whether your firm should continue the client relationship with HKP and accept the 2007 audit engagement; and (6 marks) the overall response and any relevant audit procedures in response to your preliminary assessment that the risk of material misstatement at the financial statement level due to fraud and error is low. Question 2 (15 marks - approximately 27 minutes) You consider that the whole amount of long-term bank loans in HKP s draft consolidated balance sheet should be reclassified as a current liability. After you raised this issue to the management of HKP, they obtained formal confirmation of the waivers from the banks for the breaches of covenants in 2007 and have disclosed the details of the breaches and waivers in Note 1(c) of the revised draft of financial statements. On this basis, the management of HKP disagreed with your request to reclassify the loans as current. Also, the engagement partner is unsure of the correctness of your proposed re-classification because he remembered a similar case a few years ago which did not necessitate re-classification under the accounting standards applicable at that time. Regarding the proper classification of bank loans as current and non-current: assess the risk of material misstatement at the assertion level; (3 marks) (c) explain whether your audit approach in this particular case may be different from a typical situation, and determine the further audit procedures you would perform in response to the assessed risk; and (8 marks) determine how your team would resolve the differences in opinion amongst team members and with HKP in accordance with the quality control standards. (4 marks) Module C (February 2008 Session) Page 3 of 6

4 Question 3 (10 marks - approximately 18 minutes) In auditing HKP s financial statements for the last year, you have assessed the risk of material misstatement of all the assertions of HKP s trade and other payables as low, with the expectation that HKP s controls over trade and other payables are operating effectively and have performed tests of controls to confirm your expectation. Regarding the completeness of trade and other payables of HKP s financial statements for the current year: assess the risk of material misstatement at the assertion level; and (3 marks) determine the most efficient audit approach and briefly describe the further audit procedures your team would perform in response to the assessed risk. [For the purpose of this part, you should determine the audit approach, discuss the timing of the further audit procedures and give not more than three examples of further audit procedures you would perform.] Question 4 (12 marks - approximately 22 minutes) Assume that HKP finally reclassified the bank loans as current liabilities. Determine whether the use of the going concern assumption in this case is appropriate. Explain the procedures you would perform before coming up with your conclusion; and Advise the engagement partner of any modification your firm should make in the auditor s report and draft the modification. (5 marks) * * * END OF SECTION A * * * Module C (February 2008 Session) Page 4 of 6

5 SECTION B ESSAY / SHORT QUESTIONS (Total 50 marks) Answer ALL of the following compulsory questions. Marks will be awarded for logical argumentation and appropriate presentation of the answers. Question 5 (12 marks - approximately 22 minutes) Electronic commerce (e-commerce), particularly through the use of the World Wide Web, has increased rapidly. The growth of e-commerce has significant effects on an entity s traditional business environment and significant impact on the audit of financial statements. The auditors knowledge of e-commerce is fundamental to the assessment of its significance for the entity s business activities and any effect on audit risk. What business risks does a stockbroking company face by introducing e-securities trading services to its customers such that customers can process their buying and selling transactions through the Internet? What internal controls can be implemented to mitigate these risks? (12 marks) Question 6 (13 marks - approximately 23 minutes) Many trading, wholesaling, and manufacturing companies have material trade receivable balances. Trade receivable is usually classified as loans and receivables under HKAS 39 Financial Instrument: Recognition and Measurement with initial measurement at fair value plus transactions costs and subsequent measurement at amortised cost. Comment on the matters to be considered by the independent auditors in evaluating the adequacy of the impairment loss on bad and doubtful accounts of trade receivable. (13 marks) Module C (February 2008 Session) Page 5 of 6

6 Question 7 (25 marks - approximately 45 minutes) Benny is a Certified Public Accountant (Practising) in Hong Kong. Having completed the audit of XYZ Limited s financial statements for the year ended 31 December 2006, Benny is currently doing the audit for Rose, who is a HKICPA QP student and a newly-recruited accounting officer at XYZ Limited, has told Benny that she has seen a series of journals totalling HK$2 million without any supporting documentation or explanation in the accounting ledgers for Rose is under the supervision of XYZ Limited s Accounting Manager who has been in the same position for the last five years. Initially, Benny considered the questionable journals as material in the context of the audit of XYZ Limited s financial statements for the year ended 31 December (c) (d) As Rose appears to question (or even suspect) the validity of the entries, briefly explain the steps that she would generally take in reporting the questionable journals. (5 marks) Explain Benny s responsibilities in identifying the questionable journals. (5 marks) Describe the specific audit procedures Benny would generally perform in discharging his responsibilities in connection with Rose s tip-off. (8 marks) Explain whether or not writing a letter to XYZ Limited s board of directors explaining the findings would release Benny from considering the impact of those questionable journals on the audit report. * * * END OF EXAMINATION PAPER * * * Module C (February 2008 Session) Page 6 of 6