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 Cherry Holdings Limited and its subsidiaries (collectively referred to as Cherry Group or the Group ) are engaged in garment manufacturing. Its headquarters are located in Hong Kong. All the goods of the Group are manufactured in the factories of Cherry China Limited located in mainland China and are sold to customers in Europe, Japan and the United States, through Cherry Hong Kong Limited and Cherry Macau Limited. The organisational chart of the Group as at 31 December 2013 is as follows: Cherry Holdings Limited (incorporated in Bermuda) 100% 100% Cherry Hong Kong Limited (incorporated in Hong Kong) Cherry Macau Limited (incorporated in Macau) 100% Cherry China Limited (incorporated in China) Module C (December 2014 Session) Page 1 of 11
The financial information of the Group for the year ended 31 December 2013 (audited) and for the six months ended 30 June 2014, extracted from the unaudited management accounts, is summarised as follows: All in HK$ 000 Six months ended Year ended 30 June 2014 31 December 2013 (unaudited) (audited) Revenue 1,845,790 3,070,165 Cost of sales (1,660,423) (2,679,371) ---------------- --------------- Gross profit 185,367 390,794 Operating expenses (128,952) (240,361) ---------------- --------------- Profit before tax 56,415 150,433 Income tax expense (3,385) (10,530) ---------------- --------------- Profit for the period/year 53,030 139,903 ========= ========= As at 30 June 2014 As at 31 December 2013 Property, plant and equipment 404,889 464,156 Inventories 420,665 435,456 Trade receivables 888,002 572,159 Deposits and prepayments 200,632 212,457 Cash and bank balances 206,258 464,147 ---------------- --------------- Total assets 2,120,446 2,148,375 ========= ========= Trade payables 150,657 148,957 Accruals 63,241 56,478 Tax payable 9,283 5,898 Share capital 1,000 1,000 Retained profits 1,896,265 1,936,042 ---------------- --------------- Total liabilities and shareholders equity 2,120,446 2,148,375 ========= ========= You are the audit manager in charge of the audit of Cherry Group. From your review of the unaudited management accounts for the six months ended 30 June 2014, you noted that trade receivables are the most significant asset item in the consolidated statement of financial position of the Group. According to the credit policy of the Group, the normal credit term for sales of goods is 60 days. You plan to use computer-assisted audit techniques ( CAATs ) to audit the trade receivables. Module C (December 2014 Session) Page 2 of 11
In September 2014, the Chief Financial Officer ( CFO ) of Cherry Holdings Limited and the Group informed you that they had acquired a group of garment manufacturing companies with operations in Vietnam and Sri Lanka. Based on the financial information provided, these companies are financially significant to the audit of the Group s financial statements for the year ending 31 December 2014. You thus plan to request the component auditors in Vietnam and Sri Lanka to perform work on these components. In October 2014, the newly acquired Vietnam company, now renamed Cherry Vietnam Garment Co Limited ( Vietnam Co ), informed Cherry Group s CFO that a competitor in Vietnam, the X&M Group ( X&M ) had filed to the local court a claim against Vietnam Co for infringement of clothing design and stealing clients from X&M by means of improper conduct. The claim for compensation, damages and losses had a magnitude equivalent to ten times Cherry Group s cost of acquisition of Vietnam Co. A winding up petition against the Vietnam Co was presented in the Vietnam court by X&M. The legal representative of Cherry Group in Hong Kong also confirmed that Cherry Holdings Limited and Cherry Hong Kong Limited have been named as defendants in the court actions in Vietnam. The Vietnam lawyers of X&M have also indicated to Cherry Group that they intend to apply to the Hong Kong courts to wind up the Hong Kong company in order to meet the financial claims. Question 1 (14 marks approximately 26 minutes) (i) With the aid of the relevant financial data analysis, assess and explain the level of risk of material misstatements related to the existence and valuation assertions of the trade receivables. (ii) Based on your risk assessment in Question 1(i), what do you think the possible causes leading to such material misstatements? Note: Your answers to Question 1(ii) may not be derived all from the case information. (6 marks) Propose four substantive audit procedures that you would perform to verify the existence of the large outstanding trade receivables balance of Cherry Group. (4 marks) (c) (i) What are CAATs? (ii) Suggest how the auditor would use CAATs in the substantive testing of Cherry Group s trade receivables. (4 marks) Module C (December 2014 Session) Page 3 of 11
Question 2 (13 marks approximately 23 minutes) Both HKSA 220 (Clarified) Quality Control for an Audit of Financial Statements and HKSA 600 (Clarified) Special Considerations Audits of Group Financial Statements (Including the Work of Component Auditors) state that it is the responsibility of the group engagement team to assess the component auditors professional competence. As the auditor of Cherry Group, propose your procedures to address the following: How would you obtain an understanding of the component auditor? (7 marks) (c) How would you assess the component auditor s understanding and compliance with the ethical requirements? (3 marks) How would you assess the component auditor s professional competence? (3 marks) Module C (December 2014 Session) Page 4 of 11
Question 3 (10 marks approximately 18 minutes) Cherry Group s auditor had the following initial assessment or information after a discussion with the CFO on the claims by X&M: The claims have basic grounds to be heard but the accusation focused mainly on the period before the acquisition of Vietnam Co by Cherry Group. The acquisition of the companies in Vietnam and Sri Lanka was completed and the indirect shareholding of these companies was achieved by a combined use of off-shore tax haven investment holding companies and newly incorporated Hong Kong investment holding shelf companies. Vietnam Co s estimated % to total revenue, profit before tax and net asset value of the Group are 20%, 8% and 5% respectively, for the year ending 31 December 2014. The legal representative of Cherry Group believed that it might take a few years to have the claims resolved and it was not clear as to the extent of legal actions to be instigated in Hong Kong until further information is provided by X&M or its legal representative. Cherry Group s Management believed the general principle that a limited company is treated as a separate legal entity offers initial comfort preventing the claims against Vietnam Co from reaching Cherry Holdings Limited or Cherry Hong Kong Limited. With reference to the relevant auditing standard(s), explain and discuss the going concern assumption of Cherry Group, related to the legal claims against Vietnam Co, Cherry Holdings Limited and Cherry Hong Kong Limited. (3 marks) Explore the impact on the Auditor s Report of Cherry Group for the year ending 31 December 2014. (7 marks) (Note: assume the auditor will provide a clean audit opinion other than the above issues.) Module C (December 2014 Session) Page 5 of 11
Question 4 (13 marks approximately 23 minutes) Following the acquisition of Vietnam Co, the Management of Cherry Group plans to enhance the corporate governance of the Group by setting up an audit committee. The CFO has approached you for further guidance. Based on your understanding, advise the CFO the following: What are the roles and responsibilities of an audit committee on financial statements and statutory audit? (6 marks) What are the considerations that the audit committee should encompass when they are assessing the following: the appropriateness of accounting policies adopted by the Group; the oversight of the management s judgement and estimates for preparing the financial statements; the adequacy and usefulness of financial disclosures in the financial statements; and any other matters. (7 marks) * * * * * * * * Module C (December 2014 Session) Page 6 of 11
End of Section A
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 (10 marks approximately 18 minutes) Situation (i) The Chief Financial Officer ( CFO ) of one of your audit clients offers you two VIP tickets to the Lady Lolita Concert. Each ticket costs HK$8,000 and you will have the chance to shake hands and take photos with Lady Lolita. Situation (ii) The financial controller of another of your audit clients invites you and your team to a dinner. Situation (iii) The Chairman of a client company commits to offer your audit firm an additional 40% bonus on top of the audit fee if his company is able to get listed successfully. Situation (iv) The tax team of your firm maintains a very close relationship with one of your non-listed audit clients. They give advice to your non-listed audit client on different tax issues from tax planning to tax compliance. They also perform the review of the tax provision computation prepared by this client to support the audit team s work requirement. Discuss any ethical and professional issues as an external auditor in each of the above situations and suggest the possible safeguards, if any. (10 marks) Module C (December 2014 Session) Page 8 of 11
Question 6 (13 marks approximately 23 minutes) In a recent global internal audit summit conference, one of the speakers, who is the Chief Internal Auditor of a global Fortune 500 company, said An internal control system can only provide reasonable assurance but not absolute assurance. Fraud can always exist even when a company has a perfect internal control system. Do you agree with this statement? Explain your view. (4 marks) Situation (i) You are the auditor of the trading branch of a multinational company which has only five employees working in its Hong Kong office. The multinational company sets a good tone at the top. All books and records of the branch are prepared and maintained by one accounting staff member using the spreadsheet software, Microsoft Excel. The annual turnover and profit of the Hong Kong branch for the year are approximately HK$20,000,000 and HK$300,000 respectively. Situation (ii) You are engaged to audit a principal subsidiary of a listed company. The prior year s audited results indicated that all key controls in place at the subsidiary were operating effectively. During the interim audit, the management confirmed that there had been no change of processes and key personnel who operate the key processes. The annual turnover of the subsidiary is approximately HK$500,000,000. Situation (iii) The same facts as in situation (ii), except that during the interim audit, the management confirmed that there were changes in the purchase processes during the year. In addition, the potential understatement of accounts payable is considered as a significant risk by the engagement team. Suggest and explain your audit approach for each of the above situations. Would you recommend a test of details, a test of controls, or a combination of both in your suggested audit approach? (9 marks) Module C (December 2014 Session) Page 9 of 11
Question 7 (9 marks approximately 16 minutes) What are the three key characteristics of fraud? (3 marks) A low profile Hong Kong listed company has over 70% of its issued shares held by the Chief Executive Officer ( CEO ) and an executive director ( ED ). Both the CEO and the ED are from very wealthy backgrounds. They are heavily involved in the daily operations of the listed company. All sales and purchase transactions have to be approved by the CEO and the ED. The CEO and the ED review the financial results with the respective department heads on a weekly basis. The company s board of directors emphasizes ethical behaviour. The board usually sets an achievable budget. Meeting the financial budget is also not the only criterion in assessing employees performance. The company has maintained a healthy and stable performance in the past five years and a relatively high dividend pay-out ratio compared with similar companies in the industry. Assume you are the audit engagement manager assessing the risk of fraud at this listed company. Discuss and explain your risk assessment based on the three key characteristics of fraud. (6 marks) Question 8 (10 marks approximately 18 minutes) Explain the difference between an auditor s expert and a management s expert. (2 marks) Your client has a shopping arcade in Beijing that is classified as an investment property in accordance with HKAS 40 Investment Property, and carried at fair value. The management has a policy to re-value the shopping arcade at each financial year end date. The valuation is performed by the management s internal property consultant. Discuss and explain your proposed audit approach to ascertain the valuation assertion of the investment property. The management s internal property consultant is considered to be the management s expert. (8 marks) Module C (December 2014 Session) Page 10 of 11
Question 9 (8 marks approximately 15 minutes) Big Bulb Limited ( Big Bulb ) is a trading company in Hong Kong and has a subsidiary in China. Its ultimate holding company is in the United Kingdom ( UK ). Its principal activity is the trading of LED lighting components. It purchases substantially from its subsidiary in China. The subsidiary manufactures the LED components and sells them to the ultimate holding company in the UK through Big Bulb or directly to third parties. Your firm has just been appointed as the new auditor of Big Bulb. Assume you are the audit manager auditing Big Bulb. You have read last year s audited financial statements of Big Bulb and identified that there are numerous related party transactions disclosed in the notes to the financial statements. What audit planning procedures would you propose in assessing the risk of material misstatements with the regard to the company s related party transactions? Note: You are in the planning stage of the Big Bulb audit. No marks will be given to answers related to audit procedures carried out during the audit execution stage. (8 marks) * * * END OF EXAMINATION PAPER * * * Module C (December 2014 Session) Page 11 of 11