SECTION A CASE QUESTIONS (Total 50 marks)

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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 Company background Real Time Finance Limited ( Real Time ) is a Hong Kong company and its financial year end is 31 December. It is a leading loan finance company specialised in mortgage and short-term loans. Real Time provides short-term loans to small and medium enterprises ( SME ) for working capital and instalment loans to individuals mainly to take out their accumulated high interest charge credit card outstandings. For SME loans and mortgages, they are either secured by collateral or corporate guarantee. Real Time was established in It now has more than 10 branches located in different districts in Hong Kong. The management team of Real Time has more than 20 years of banking experience in consumer credit and business financing. They provide customers with an alternative financing channel that is simpler, quicker and more convenient compared to traditional bank loans. In an initiative to streamline and add user-friendliness to loan applications, Real Time has successfully expanded its loan portfolios. Loan applications Real Time has designed a set of loan approval and collateral appraisal processes that is efficient and transparent for addressing the immediate and short-term financing needs of customers. All loan applications are first subject to a preliminary credit approval by Real Time s Risk Management department using a credit evaluation system with inputs of the borrower s business background or employment, income level, cash flow conditions, collateral quality, repayment track records and outstanding balances recorded in the commercial and consumer credit databases. The preliminary approved applications are then submitted to the lending approval committee and the general manager for further assessment and approval. In Real Time, all loan granting is centrally reviewed and approved by the lending approval committee and the general manager. The lending approval committee consists of six members including the general manager, two members from the Finance department, two members from the Risk Management department and the legal counsel of Real Time. All loan granting is subject to the final review and approval by the general manager who is the Chairman of the committee. The Risk Management department performs all the fact finding related to a borrower such as the background of the borrower, loan purposes and financial ability of the borrower. The Treasury department monitors loan draw down and repayment processing once the loans are approved by the lending approval committee and the general manager. Module C (June 2015 Session) Page 1 of 9

2 Loans recording and provisioning Effective from July 2014, Real Time implemented an in-house developed loan management system, CalQuick. All loans of Real Time are recorded in CalQuick. At a business day end, the Treasury department uploads to CalQuick the details of loans for which drawn down or funding has been completed for the day after sign off by the Head of the Treasury department. Similarly, the Treasury department uploads to CalQuick the details of loans for which full repayments have been made after sign off. The interest income and accrued interest are all computed automatically by CalQuick based on interest rate, initial loan amount, duration of loan and drawn down date inputted in accordance with the details of the signed loan agreements. Before the implementation of CalQuick, interest income was calculated using a spreadsheet. The Accounts department manually posted the interest income, accrued interest and outstanding loan balances to the general ledger in the APPEX Account system at month end through manual journal entries. APPEX Account is a packaged system purchased from a third party accounting system solution service provider, without any customisation. CalQuick has an interface with APPEX Account. It automates the interest income calculation and recording into the general ledger in the APPEX Account. The Head of the Accounts department signs off the month end reconciliation of the total loan balances in CalQuick to APPEX. Real Time s management meets monthly in a board meeting to review the provision against loan receivables based on statistics reported by CalQuick and the preset provisioning policy. External auditors The following events occurred during the audit process. ABC & Co has been Real Time s auditor for several years. You are the new engagement manager for Real Time and will have the planning meeting with the engagement partner next week. You are now reviewing the last year s audit files to understand the client s business. You are also given a set of the latest financial information of Real Time up to 31 October 2014 for reference. When you read through the last year s audit file, you learnt that approximately 10% of the transactions of Real Time were cash transactions. 50% of the customers of Real Time were individuals and 50% were SME clients. 80% of the loans were secured by collaterals such as property, machine and inventory. 15% of the loans were secured by corporate guarantee and 5% of the loans were unsecured. Module C (June 2015 Session) Page 2 of 9

3 Financial Performance Extract of financial information (in HK$ million): 31 October 2014 (unaudited) 31 December 2013 (audited) Operating results: Interest income Profit attributable to shareholders Total assets 2,400 2,080 Cash and bank balances 1, Loan receivables Net assets 1,820 1,330 Loan to provision ratio 3.5% 3.5% You have requested information regarding the loan portfolio as of 31 October 2014 from the management. When you reviewed the loan portfolio, you noted that the customer mix had changed from 31 December The proportion of individual customers increased to 80% compared to 31 December The proportion of the collateral secured loans decreased to 60%, corporate guarantee loans remained as 15% and the unsecured loans increased to 25%. Real Time s management has stated to you that the loan portfolio mix shifted from mortgages or SME loans to personal financing due to the government s cool down procedures aimed at the residential property market and the general economy. The loan business to replace credit card debt is also growing rapidly. Module C (June 2015 Session) Page 3 of 9

4 Question 1 (21 marks approximately 38 minutes) Based on the information provided in the case of the lending activities of Real Time and its organisation set up, assess the risk of material misstatements relating to the following: accuracy and occurrence assertions of interest income; and existence and valuation assertions of loan receivables. State your reasoning and observations to support your assessment. (9 marks) Suggest audit procedures to address the risks of material misstatements identified in Question 1 for the following: accuracy and occurrence assertions of interest income; and existence and valuation assertions of loan receivables. (12 marks) Note: Question 3(c) covers the consideration of system change. You are not required to discuss the impact on the audit relating to system change in this question. Question 2 (13 marks approximately 23 minutes) During the audit planning meeting with the management team, the Chief Financial Officer ( CFO ) explained to you that the cash transactions of Real Time increased from 10% for the year ended 31 December 2013 to approximately 30% for the ten-month period ended 31 October 2014 as a result of the increase in individual customers. These individual customers prefer cash transactions. Would this information change your risk assessment in terms of fraud because the misappropriation of cash can be conducted by staff other than management? Explain your risk re-assessment with reasoning. (3 marks) What are control activities and monitoring of controls? (2 marks) (c) In response to the significant increase in cash transactions, from the case, suggest possible control activities that can help Real Time management to mitigate the potential risk of material misstatement in the financial statements relating to cash and bank balances. Module C (June 2015 Session) Page 4 of 9

5 Question 3 (16 marks approximately 29 minutes) (c) As an auditor of Real Time, identify two information systems in Real Time that you are concerned with the audit process. (2 marks) Propose the Information Technology General Controls ( ITGC ) test plan and explain the testing objectives for the two information systems identified in Question 3. (6 marks) In response to the interest income calculation and recording process, propose the audit procedures for interest income that you will perform for the completeness and accuracy assertions: (i) (ii) before the automation, effective from July 2014; and after the automation. Note: Your proposed audit procedures should cover both test of control and test of details. * * * * * * * * Module C (June 2015 Session) Page 5 of 9

6 End of Section A

7 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 4 (12 marks approximately 22 minutes) You are the auditor of Space Limited. As at 31 December 2014, Space Limited recorded a goodwill of HK$400 million. The goodwill has arisen from a business combination when Space Limited acquired Star Limited during the year ended 31 December For the purpose of the impairment assessment of the goodwill as at 31 December 2014, the management of Space Limited has engaged an external valuer to advise as to the business valuation of Star Limited. The external valuer applied the discounted cash flow model and the following information to prepare the business valuation of Star Limited Actual Forecast Revenue 800 1,000 1,250 1,562 1,935 2,441 Net profit Profit margin 8% 10% 10% 10% 10% 10% Growth rate 10% 25% 25% 25% 25% 25% Net cash inflow Discount rate: 12% Business value: HK$560 million During your audit planning, you decided to use the work of your firm s internal expert to assist the audit team for the goodwill assessment. In accordance with HKSA 620 (Clarified) Using the work of an auditor s expert, what would you consider when you use the work of an auditor s expert? (4 marks) Based on the information provided, suggest and discuss the audit procedures you would perform to assess the impairment of goodwill. Module C (June 2015 Session) Page 7 of 9

8 Question 5 (10 marks approximately 18 minutes) List four types of threats which may affect the objectivity of an auditor. For each of these threats, suggest a policy or procedure that an audit firm can apply to prevent the occurrence of these threats. (4 marks) Rose Limited is a company listed on the Hong Kong Stock Exchange. Recently, Rose Limited has requested your firm to submit an audit engagement proposal for its statutory audit of the consolidated financial statements for the year ending 31 December You are in charge of Rose Limited s audit proposal. You know that Rose Limited is a multinational corporation specialising in printing. Your firm has recently entered into a service contract for professional printing service provided by Rose Limited for the period from 1 January 2015 to 31 December You have started to assess if such a business relationship may have an impact on your submission of the audit proposal. Evaluate the threat arising from the business relationship with Rose Limited and suggest the possible safeguards that you can consider. (6 marks) Question 6 (8 marks approximately 14 minutes) Excellent Limited is a company listed on the Hong Kong Stock Exchange. Excellent Limited is engaged in construction projects contracted by certain reputable real estate developers. Recently, the directors of Excellent Limited were aware that one of its key construction projects may face a significant delay in completion. In accordance with the terms as set out in the respective construction contract, the customer has the right to claim against Excellent Limited for any loss arising from such delay. Based on the project team s estimation, the claim may amount to HK$100 million. From the corporate governance perspective, suggest actions that the directors of Excellent Limited should take. Question 7 (8 marks approximately 14 minutes) Aloha Limited is a company dually-listed in the stock exchanges of China and Hong Kong. Aloha Limited is required to change its auditor every five years. Your firm has been approached to act as the auditor of Aloha Limited for the year ending 31 December What are the procedures that you should perform before accepting Aloha Limited as an audit client? Module C (June 2015 Session) Page 8 of 9

9 Question 8 (12 marks approximately 22 minutes) You have recently been appointed as the auditor of Messy Limited for the statutory audit of its financial statements for the year ended 31 December During the audit, you noted that the prior period comparatives for the year ended 31 December 2013 were not audited. No stock take was performed by the management as at 31 December Below is a summary extract from the financial statements of Messy Limited: Statement of financial position 31 December December 2013 HK$ HK$ (unaudited) Fixed assets 5,000 - Inventories 150, ,000 Cash at bank 25,000 1, , ,000 Trade payables (300,000) (100,000) (120,000) 1,000 Share capital 1,000 1,000 Retained earnings (121,000) - (120,000) 1,000 Statement of profit or loss Year ended Year ended 31 December December 2013 HK$ HK$ (unaudited) Revenue 500,000 - Cost of goods sold (508,000) - Gross loss (8,000) - Selling expenses (55,000) - Administrative expenses (47,000) - Loss before tax (110,000) - Tax (11,000) - Loss after tax (121,000) - Suggest the audit procedures for Messy Limited s opening balances as at 1 January (12 marks) * * * END OF EXAMINATION PAPER * * * Module C (June 2015 Session) Page 9 of 9