The independence and quality control issues to be considered in the audit planning stage and the proposed relevant responsive actions are as follows:

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1 SECTION A CASE QUESTIONS (Total: 75 marks) Answer 1(a) The independence and quality control issues to be considered in the audit planning stage and the proposed relevant responsive actions are as follows: Fees for public interest entities Where a firm has an audit client which is a public interest entity and, for two consecutive years, the total fees received from the client and its related entities represent more than 15% of the total fees, the firm shall: discuss the fact with the audit committee; and call out engagement quality control reviews by an independent accountant. The engagement audit partner, Walter Miller, has served the client for six years and this is the seventh year that he is involved in the audit of HGL and there may be a risk of familiarity threat. Walter Miller should plan for a rotation in the current year or in the next year. The quality review partner assigned to this engagement will retire one month before the expected report date of the engagement. However, according to HKSA 220 (Clarified) Quality Control for an Audit of Financial Statements, for the audit of a listed entity, an engagement quality control review is required. Thus, a new quality review partner should be assigned to this engagement. Answer 1(b) According to HKSA 240 (Clarified) The Auditor s Responsibilities Relating to Fraud In An Audit Of Financial Statements, the auditor has to obtain written representations from the management and those charged with governance that they: acknowledge their responsibility for the design, implementation and maintenance of internal controls to prevent and detect fraud; have disclosed to the auditor the management s assessment of the risk of fraud in the financial statements; have disclosed to the auditor their knowledge of fraud or suspected fraud, involving management; employees with significant roles in internal control; or others where fraud could have a material effect on the financial statements; and have disclosed to the auditor their knowledge of any allegations of fraud or suspected fraud communicated by employees, former employees, analysts, regulators or others. Audit issue: If the management did not perform the assessment on the risk that the financial statements may be materially misstated due to fraud, they will not be able to provide such a representation to the auditor. Final Examination (December 2014 Session) Paper I 1 of 13

2 Thus, the engagement team should: request the management to perform such an assessment and disclose the results to them before the completion of the audit. arrange a discussion among the team members that particular emphasis should be placed on how and where the financial statements may be susceptible to fraud. discuss with those charged with governance the possible presence of fraud risk factors of the Group including incentive or pressure to commit fraud, perceived opportunity to commit fraud, and ability to rationalize the fraudulent action. inquire the internal audit team for knowledge of any actual, suspected or alleged fraud, and its view on the risks of fraud. Answer 1(c)(i) According to HKSA 540 (Clarified) Auditing Accounting Estimates, Including Fair Value Accounting Estimates, And Related Disclosures, the specific audit procedures for the assessment of the risks of material misstatement for accounting estimates in relation to the provision for receivable may include the following: Understand the requirements of the applicable financial reporting framework relevant to estimates (including disclosures), i.e. Hong Kong Financial Reporting Standards. Discuss with Paul to understand how management makes the accounting estimates for the provision for receivables: (i) (ii) (iii) (iv) (v) method used specific review of customer s repayment history and assessment of recoverability; relevant controls reviewed and approval by the Chairman and the CFO; what are the underlying assumptions adopted; whether there is any change in the method used from the prior period; and how management has assessed the effect of estimation uncertainty. Review the outcome of accounting estimates included in prior period financial statements or, where applicable, their subsequent re-estimation for the purposes of the current period. Ask Paul about changes in circumstances in the current year that give rise to the reversal of the significant provision of receivable made in the last year. Final Examination (December 2014 Session) Paper I 2 of 13

3 Answer 1(c)(ii) The general substantive audit procedures in relation to the assessment of provision for receivables include: Perform analysis on aging of receivables as well as turnover days. Review the subsequent settlement report to assess whether there is any recoverability issues. Review the adequacy of the provision for receivables through discussion with the HGL management based on the repayment history, subsequent settlement as well as the financial strength of the customers. For old debts on the aged trial balances or the aging report, obtain further information regarding their recoverability by holding discussions with the management and review of customers' correspondence. If the customer has agreed any repayment plan with the company, assess the reliability and feasibility of the plan. Answer 1(d) The impact on the HGL audit plan as a result of the software upgrade includes: Ensure program changes were authorised, correctly defined, tested and properly implemented to ensure the proper, consistent operation of automated application controls. Since the software module was upgraded during the year, both the application controls before and after the upgrade have to be tested to obtain audit comfort throughout the year. Typical audit procedures: (i) (ii) review the authorisation record to ensure there is proper segregation of duties that the one who initiates the program changes is different from that authorises the changes; and review the log of changes (either generated by the system or manual log) to ensure the program changes are properly tracked and tested. Final Examination (December 2014 Session) Paper I 3 of 13

4 Answer 2(a) The natural hedging measures include: (1) Currency of invoice The Group can invoice its foreign customers in domestic currency (HKD). The Group can do business with its foreign suppliers in domestic currency (HKD). The Group can enter into contracts with its customers or suppliers in foreign currency but specifying a fixed exchange rate. (2) Matching receipts and payments The Group can offset its foreign currency payments against its foreign currency receipts. (3) Matching assets and liabilities The Group can hedge its foreign currency income/receipts by borrowing in the same foreign currency. The Group can hedge its long-term foreign investment/asset by borrowing a long-term loan in the same foreign currency. (4) Leading and lagging The Group can make payments ahead of or beyond the due date to take advantage of exchange rate movements. Answer 2(b)(i) The effective 90-day forward rate under the money market hedge arrangement is: (1 ia) F0 S0x (1 ib) where F 0 = forward rate S 0 = current spot rate i a = interest rate in the term currency country (i.e. Thailand) i b = interest rate in the base currency country (i.e. Hong Kong) F x Final Examination (December 2014 Session) Paper I 4 of 13

5 Answer 2(b)(ii) The foreign currency exposure is: 1 1 Financial impact in HK$ = THB50,000,000x ( ) = THB50,000,000x( ) = HK$180,000 Exposure = probability x financial impact = 0.8 x HK$180,000 = HK$144,000 Answer 2(c)(i) The steps and calculations for money market hedge are as follows: (1) borrow HKD for 1 year now; (2) convert the borrowed HKD amount into EUR; (3) place the EUR amount on a 1 year deposit; (4) repay the HKD borrowing at maturity in 1 year's time; and (5) fulfil the investment commitment by using the EUR deposit at maturity in 1 year's time. EUR200,000,000 Amount of Euro to be deposited = EUR197,044, Amount of HKD to be borrowed = HK$197,044,335 x and converted to Euro = HK$2,113,773,399 Amount of HKD to be repaid = HK$2,113,773,399 x (1+0.05) at maturity = HK$2,219,462,069 Answer 2(c)(ii) The effective forward rate (HKD/EUR) = 2,219,462, ,000,000 = Final Examination (December 2014 Session) Paper I 5 of 13

6 Answer 2(d) The fundamental principles under the Code of Ethics for Professional Accountants are: integrity, objectivity, professional competence and due care, confidentiality and professional behaviour. The possible breaches of the fundamental principles are: (1) integrity the CFO may not be straightforward and honest in his business relationship with the Bank if he did not inform his employer of this offer. (2) objectivity the offer may invoke a conflict of interest with the CFO s employer or may incur an undue influence of the Bank which may affect the CFO s professional or business judgment. (3) professional behaviour despite the fact that the offer may not represent material financial or monetary interest, a professional accountant accepting some kind of benefit not as a result of normal arm's length professional or business relationships may affect the good reputation of the profession in a negative way. Answer 2(e) The CFO may do one or more of the following: (1) Seek advice from higher levels of management or those charged with governance of his employer. (2) Seek advice from KBC (the organisation which makes the offer). (3) Seek advice from a legal advisor. (4) Seek advice from the HKICPA. Answer 3(a)(i) An entity s functional currency is the currency of the primary economic environment in which it operates. Each entity in a group has its own functional currency as determined in accordance with HKFRSs. There is no concept of a group functional currency under HKFRS. Final Examination (December 2014 Session) Paper I 6 of 13

7 In determining the functional currency of an entity, the entity emphasises the currency that determines the pricing of the transactions that it undertakes, rather than focusing on the currency in which those transactions are denominated. Primary factors to be considered in determining an appropriate functional currency include: (i) (ii) (iii) (iv) (v) the currency that mainly influences sales prices for goods and services often this will be the currency in which sales prices for its goods and services are denominated and settled; the currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services; the currency that mainly influences labour, material and other costs of providing goods and services often this will be the currency in which these costs are denominated and settled; the currency in which funds from financing activities are generated (i.e. issuing debt and equity instruments); and the currency in which receipts from operating activities are usually retained. When determining the functional currency of a foreign operation, it is necessary to consider the relationship between the foreign operation and the reporting entity and consequently whether this should be the same as the functional currency of its parent: (a) (b) (c) (d) whether the activities of the foreign operation are conducted as an extension of the reporting entity rather than with a significant degree of autonomy; whether a high or low proportion of the foreign operation s activities comprise transactions with the reporting entity; whether cash flows from the foreign operation s activities directly affect the cash flows of the reporting entity and are readily available for remittance to it; and whether the foreign operation generates sufficient cash flows from its own activities to service existing and normally expected debt obligations without additional funds from the reporting entity. Final Examination (December 2014 Session) Paper I 7 of 13

8 In respect of this case, based on the case background information as provided: Activities (1) Trade payables - HG products purchased from subsidiaries in Japan & Korea Currencies USD (2) Sales of HG products in China RMB (3) Share capital injected by HIL USD (4) Loans or advances made by HIL USD (5) Bank loans USD (6) Staff costs, operating & administrative expenses HKD (7) Cash reserves & deposits RMB / USD Both the USD dollar and RMB are key to the operations of HBC. An entity can have only one functional currency. Company management should exercise its judgement to determine whether USD or RMB is HBC s functional currency. Greater weighting should be given to indicators under items (i) to (iii) above before considering indicators under (iv) & (v). Further consideration would need to be given to the specific facts and circumstances and the environment in which HBC operates, for example: (i) (ii) (iii) (iv) all directors of HBC are also directors of HGG and it is likely that all strategic and operational directions or policies of HBC (e.g. sales prices or customer target groups) are set at the ultimate parent level of HGL without a significant degree of autonomy. HG products are purchased from HGG s subsidiaries or suppliers in Japan or Korea and hence it is likely that a high proportion of HBC s activities comprise transactions with HGG and its subsidiaries. HBC is newly set up and probably needs additional funding from HGG & its subsidiaries (e.g. advances from HIL or trade payables with HGG subsidiaries in Japan & Korea under extended credit terms). The trade finance facilities of HBC are guaranteed by HGG. In the absence of further evidence contrary to the case information as provided, the above indicates that HBC operates as an extension of its parent entity and hence it is likely that USD would be considered to be the functional currency of HBC. Once the functional currency is determined, it is not changed unless there is a change in those underlying transactions, events and conditions. Final Examination (December 2014 Session) Paper I 8 of 13

9 Answer 3(a)(ii) Nature and substance of the terms of the loan would determine the accounting treatment of the inter-company loans. (a) Long-term loan with no fixed repayment terms Where settlement is neither planned nor likely to occur in the foreseeable future and the parent does not intend to require repayment of the intragroup balance, the loan is in substance, a part of HIL s net investment in HBC. In HIL s standalone financial statements, the exchange differences would be recognised in profit or loss. In HIL s consolidated financial statements, the exchange differences would be recognised initially in other comprehensive income and reclassified from equity to profit or loss on disposal of net investment. (b) Long-term loans with fixed repayment terms or history of repayments Long-term loans with fixed repayment terms or history of repayments indicate that the parent intends to require repayment of the intragroup loan and hence it does not qualify to be recognised as part of HIL s net investment in HBC under HKAS21. Exchange differences would be recognised in profit or loss. (c) Short-term loans Exchange differences would be recognised in profit or loss. Answer 3(a)(iii) Hedge of highly probable forecast sale transactions is an example of cash flow hedge. Currency forward contract is a derivative, generally has a fair value of zero at inception. Currency forward contract is subsequently measured at fair value, with the effective portion of changes in its fair value recognised in other comprehensive income and presented within equity, normally in a hedging reserve. The ineffective portion of the gain or loss on the hedging instrument is recognised immediately in profit or loss. The change in fair value of the hedging instrument that is recognised in other comprehensive income is reclassified to profit or loss when the hedged forecast cash flows affect profit or loss (i.e. when sales are recognised). Final Examination (December 2014 Session) Paper I 9 of 13

10 The net effect of reclassifying the cumulative effective portion of the hedging instrument included in other comprehensive income from equity to profit or loss when the sale occurred shall result in the sale being reflected in profit or loss at the contracted rate inherent in the currency forward contract. Answer 3(b)(i) S.381 of the new Hong Kong Companies Ordinance ( the new HKCO ) includes more explicit requirements on when a company may exclude a subsidiary on the grounds of immateriality: an individual subsidiary may only be excluded from consolidation if the inclusion of the subsidiary is not material for the purposes of giving a true and fair view of the financial position and the financial performance of the group; and more than one subsidiary may only be excluded from consolidation if the inclusion of the subsidiaries taken together is not material for the purposes of giving a true and fair view of the financial position and the financial performance of the group. Answer 3(b)(ii) Under s.379(3)(b) of the new HKCO, a parent with material subsidiaries which is not whollyowned is only exempt from preparing consolidated financial statements if all of the following criteria are met: the parent must be a partially-owned subsidiary of another body corporate; at least 6 months before the end of the financial year, the directors must write to the members to notify them that they do not intend to prepare consolidated financial statements for this financial year; and 3 months before the financial year end, no member has written to the company requesting the company to prepare consolidated financial statements. * * * END OF SECTION A * * * Final Examination (December 2014 Session) Paper I 10 of 13

11 SECTION B ESSAY QUESTIONS (Total: 25 marks) Answer 4(a) Date : 3 June 2014 To : Amy Lam, Sales Director of HGG From : XXXX, Tax Director of HGL Discussion Paper on Tax Issues Tax exposure of HBC in Hong Kong: HBC will be considered as carrying on a business in Hong Kong as: (i) (ii) (i) (iv) its central control and management will be in Hong Kong (Board meeting to be held in Hong Kong); it will operate a bank account in Hong Kong; Amy and HBC s staff will work in Hong Kong (e.g. meeting in Hong Kong); and back office support of HBC (e.g. shipping functions) will be in Hong Kong. The nature of HBC's business will be trading: In determining whether the trading profits are sourced in Hong Kong, according to DIPN 21 (Revised), one needs to consider where the sales and purchase transactions are effected, where effected does not merely mean legally executed (as this would depend on formal legal rules of offer and acceptance), but contemplate all the relevant operations carried out to earn the profits, including the solicitation of orders, negotiation, conclusion, trade financing, shipment and performance of the contracts. Purchase Amy s team will travel to Japan and Korea to negotiate and conclude the purchase contracts. Orders will be placed there. Sales the salespersons will travel to China to solicit the distributors and accept orders in China. Both the sales and purchases contracts were negotiated and concluded outside Hong Kong. Although the letter of credit was arranged in Hong Kong, it is generally regarded as ancillary compared to where the purchase and sale contracts are negotiated and concluded. Under the operations test, one looks at the place at which the operations take place from which the profits in substance arise. Accordingly, there is a strong argument that the trading profits are sourced outside Hong Kong. Final Examination (December 2014 Session) Paper I 11 of 13

12 the burden of proof rests with the taxpayer or HBC and HBC should provide adequate supporting evidence as mere assertion that the transaction is conducted offshore will not be accepted by the IRD; supporting documentations (such as travel itineraries, , or written correspondence of Amy s team and the salespersons with the suppliers and customers respectively) are required; the shipping and whether the products go through the ports in Hong Kong is not a key factor; and letter of credit / bank account the IRD will look into these factors, especially the arrangement of letter of credit in Hong Kong, and try to assess the profits arising from such transactions (Eurotech HK case). Yet on the authority of ING Barings, these factors should not render the profits taxable. Answer 4(b) HBC s China Enterprises Income Tax exposures: Permanent Establishment ( PE ) as defined under the Arrangement between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income ( PRC- HKDTA ) refers to a fixed place of business through which the business of an enterprise is wholly or partly carried on. It covers an agency PE where a dependent agent acting on behalf of an enterprise has and habitually exercises an authority to conclude contracts in the name of the enterprise. As the salespersons employed by HBC spent most of their time in the Mainland and they have and habitually exercise the authority to conclude contracts on behalf of HBC in the Mainland, the activities of these salespersons will likely constitute a PE of HBC in Mainland China. If it is the case, HBC would be considered as having a PE in China and hence subject to China Enterprises Income Tax for the profit attributable to the PE. Answer 4(c)(i) HBC salespersons Hong Kong salaries tax issues: The salaries of the salespersons will be wholly taxable if they are derived from Hong Kong employments even if some services, e.g. reporting / meeting, are rendered in Hong Kong, and some are rendered in China or outside Hong Kong. Final Examination (December 2014 Session) Paper I 12 of 13

13 Their income will be fully taxable regardless of the number of days spent in Hong Kong during a year of assessment unless all of their services were performed outside Hong Kong. A 60-day visit rule applies to employees / expatriates who are visitors to Hong Kong and where their visits are limited to not more than 60 days in a year of assessment. For these persons, they are deemed to have rendered all their services outside Hong Kong. The IRD considers the definition of visits as being not applicable to anyone whose work base is in Hong Kong. Those who do not have a work base outside Hong Kong will not generally be considered as visiting Hong Kong. For the purpose of claiming the 60-day rule, any part of a day spent in Hong Kong will be treated as one full day. Days include both the day of arrival and the day of departure, whether they fall on weekends, holidays and workdays. Answer 4(c)(ii) Partial income exemption issue: This partial exemption is applicable for employees having a source of employment in Hong Kong. If an employee is subject to tax that is of substantially the same nature as salaries tax in an overseas jurisdiction (e.g. Individual Income Tax in China) in respect of the services rendered in that jurisdiction, provided that overseas tax has been paid, that part of the income which has been subject to overseas tax can be excluded from Hong Kong salaries tax. Best regards, Signed XXXX Tax Director of HGL * * * END OF EXAMINATION PAPER * * * Final Examination (December 2014 Session) Paper I 13 of 13