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Part 3 Examination Paper 3.1(HKG)

Audit and Assurance Services (Hong Kong) June 2003 Answers

1 ABC

(a) Principal audit risks

Construction industry

The majority of building contracts undertaken may be individually material to the operating result, assets and liabilitiesreported in the financial statements. Audit risk will be increased if detection risk is not rendered sufficiently low. Forexample, sampling risk will be increased if audit evidence is drawn from only a few rather than all major contracts.

Contracts of longer durations are inherently riskier than shorter ones because there is greater uncertainty about theirultimate outcomes.

Fixed fee contracts can transform what initially appear to be profitable contracts into loss-making contracts (e.g. due toescalating costs).

Expected losses should be recognised in full and immediately, even if construction work has not yet commenced(HKSSAP2.123 Construction contracts).

The risk of bad and doubtful debts is particularly high where the product meets individual customers specifications. Ifa debt goes bad, the related building in the course of construction may have little value unless another purchaser canbe found for it.

Site accidents may result in costs (e.g. if construction is delayed and penalties are incurred). Actual liabilities may beunderstated and contingent liabilities not disclosed if there are breaches of health and safety or environmentalregulations.

Inherent risk is high because, for example, constructions may be defective (e.g. through structural design faults,subsidence, etc). This may result in material losses/unrecorded liabilities arising from penalties, legal action, restitutioncosts, etc.

Going concern risks

Fewer local government contracts increase the risk that the going concern assumption may not be appropriate. If ABCdoes not have enough contract work:

idle, owned assets (plant, equipment, etc) may need to be disposed of; and

labour may need to be laid off.

If the skilled labour force is curtailed it may be difficult for ABC to re-recruit it at a later date.

The time it takes to complete significant building contracts (i.e. months, years) places a considerable strain on workingcapital requirements. ABCs accounting system should bill customers accurately and on a timely basis.

Percentage of completion method

The percentage of completion method of recognising revenue and profit on contracts in progress is inherently riskybecause of the degree of subjectivity in its application and its susceptibility to manipulation and misstatement.

Cost overruns increase the proportion of stage of completion and so increase the % profit taken.

The reliability of the financial statements depends on the accuracy of the estimates of:

contract revenue; costs; and stage of completion.

Financial reporting risks include the risks associated with each of these as follows:

Unsuitable estimates of contract revenue e.g. overestimating performance incentives for early contract completion;

Inaccurate estimates of contract cost e.g. reliance on inaccurate or incomplete cost data;

Inappropriate measures of the stage of completion e.g. using the costs of materials purchased where they are held ininventory and not yet used in the contract (the stage of completion will be overestimated).

Costs incurred to the balance sheet date

Contracts must be considered on a contract by contract basis (HKSSAP2.123). ABCs accounting and internal controlsystem must be adequate to relate direct costs to specific contracts.

Major construction sites may be individually material to the financial statements (in terms of the assets held and costsincurred at the balance sheet date). Therefore, material misstatement could arise if, for example, contracts which havebeen undertaken have not been recorded (i.e. omitted contracts).

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Material costs attributed to each contract may be misstated if there are poor physical controls over the materialsrequisitioned to each site. For example, materials delivered to site before they are required for construction may be stolenand/or damaged.

Direct costs assigned to each contract may be misstated if transfers between them are not accurately recorded. Forexample, if hired plant is used at different sites on different days (or materials are transferred between sites because ofa delay in delivery of an order to a site).

Misclassification between capital and revenue expenditure could result in material misstatement. For example if:

hired assets are treated as owned (and capitalised and depreciated); or finance leases are treated as operating leases.

Indirect expenses (attributable overheads) may be misstated if 70% of direct costs is not an accurate approximation ofthe extent to which head office expenses relate to production (i.e. construction) rather than marketing, selling oradministration. ABCs accounting/costing system should identify those relevant costs which relate to the preparation oftenders, material procurement, labour administration (including the quantity surveyors salary), etc.

The 70% overhead absorption rate (of indirect costs) may be insufficient (i.e. results in under-absorption) as fewercontracts have been started in the year than budgeted.

If costs to the balance sheet date are understated and estimated costs to completion are an extrapolation of costs to date,then any foreseeable loss may be underprovided (or attributable profit overstated).

Costs may be misstated if an accurate cutoff is not established. For example, subcontracted labour will be invoiced in

arrears and may include hours worked six weeks ago (say) if the subcontractors employees are late in submitting theirtime sheets.

Any variations arising (e.g. due to change in customer specification) should be agreed between the customer and ABCin writing (e.g. in a Variation Order). (Similarly, any remeasures, where an estimated bill of quantities has been revisedto reflect actual quantities, must be agreed between ABC and the customer.)

Estimated costs to completion

Tutorial note: This is clearly a risk area as it was the cause of the prior year auditors report modification.

Profit on any contract should only be recognised when a favourable outcome can be estimated reliably and withreasonable certainty (HKSSAP2.123). Contracts must be sufficiently complete in order to support estimates tocompletion and assess the likelihood of outcomes.

Losses on contracts should be recognised immediately and in full (HKSSAP2.123) and cannot be offset againstanticipated profits on other contracts (except where a group of contracts should be treated as a single construction inaccordance with HKSSAP2.123).

Lack of sufficient evidence and information to support the clients estimated costs to completion has previously givenrise to a qualified audit opinion (i.e. except for). Unless the matter is resolved the risk of errors arising (inherent risk)remains very high.

The audit team alone may not possess the skills and knowledge necessary to measure the work to date on all materialcontracts (which will contribute to the calculations of estimated costs to completion). Hence it is almost certain thatsome reliance will be sought to be placed on the work of the quantity surveyor.

Costs may not be incurred in direct proportion to contract activity (e.g. foundation work may represent 20% of total costsbut only 10% of contract activity). Estimated costs to completion may be misstated if they are extrapolated solely fromcosts to date.

Specific (direct) costs to completion may be forecast by contract (e.g. by costing the work necessary to complete thecontract). The risk of misstatement is high if:

controls over the budgetary system are poor (e.g. management do not review variances); or the quantity surveyor has little experience of certain types of building work (e.g. bridges).

Costs to completion may be underestimated if the value of work completed at the balance sheet date (which measuresstage of completion) is overstated. Management may be biased towards overstatement (of the stage of completion) asthe value at the balance sheet date determines reported revenue, and ultimately profit.

The extent to which penalty and retention clauses are used may affect the time (and costs) to completion. In particular,original timetables may be extended with costs (when ABC will be able to pass on costs to the customer) or withoutcosts.

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(b) Reliance on quantity surveyor

Tutorial note: The need for an expert has already been determined and the clients expert is appropriately qualified and

experienced. The question is therefore not whether to rely on the expert but how much? (i.e. extent).

Nature

The auditors responsibility (to obtain audit evidence sufficient to draw conclusions therefrom) is in no way diminished by anyreliance being placed on the work of the quantity surveyor. Reliance may be sought to be placed on the quantity surveyor:

in his rle as a management control within the clients system of internal controls (supervising monthly counts andbudgetary control of costs); and

as an expert providing one source of audit evidence on total cost to completion.

Extent

The extent of audit reliance on the quantity surveyors rle as an internal control will depend on the results of evaluating itsoperation. For example, if as a result of the surveyors supervision the incidence of discrepancies between book and physicalmaterial inventories at sites is seen to decrease, substantive procedures on year-end quantities may be reduced.

As the risk of contract costs being materially misstated is high (especially with regard to estimated costs of completion) itwould be inappropriate to place too much reliance on the surveyor. However, the information for all the contracts in progressat the year end is likely to be sufficiently complex to warrant that some reliance be placed on the judgement of the surveyor(as an expert).

Sufficient evidence should be available to form an opinion on the direct costs incurred to the balance sheet date andattributable overheads without the need for any reliance to be placed on the surveyor. However, as lack of evidence to supportthe estimated costs to completion was the reason for last years audit qualification, reliance will be sought on the expertsfindings in this area.

The better the quality of the quantity surveyors documentation and evidence, the greater the reliance which may be placedon his work.

ABCs customers (especially the local government departments) are likely to employ the services of their own quantitysurveyor expert to agree the stage of completion (and progress payments falling due). More reliance should be placed on thework of ABCs expert if customers agree progress billings than if they dispute them (e.g. over the stage of completion reached).

The surveyor is an employee of the client and therefore not independent. His status on the management team may:

increase the perceived objectivity impairment (because he may be unduly influenced by management); or

reduce it, in that he is afforded a sufficiently high organisational status to withstand any pressures from managementwhich conflict with his professionalism.

(c) Audit work

Tutorial note: Total costs to completion are defined in the question (see point (3) of the quantity surveyors tasks).

General

Review board or other minutes for evidence of:

management controls over contracts;

significant problems (e.g. delays, claims, penalties).

Discuss the status of all major contracts (whether started or not) with the management team, including the chief financeofficer and quantity surveyor.

For loss-making contracts, compare the total costs to completion against the original budget and discuss with thequantity surveyor and contract site manager the reason for the overrun (the site manager may contradict or confirm thequantity surveyors assessment of the situation).

For contracts completed after the year end, compare the actual costs to completion against the surveyors estimates toassess the reliability (or otherwise) of the experts schedules.

Agree the direct costs incurred to the balance sheet date per the surveyors year-end schedules to the contract accountbalances in the general ledger. Confirm the validity and correct accounting treatment of any material reconciling items(e.g. for cutoff adjustments).

Direct costs Materials

Select a sample of material and direct expense costs debited to the individual contract accounts and vouch to:

suppliers invoices (for costs wholly attributable to a contract); or

materials requisitions (for building supplies requisitioned from central stores); or

transfer notes (for materials transferred from another site/contract).

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Visit and physically inspect all major contract sites at or around the year end:

to ascertain whether the materials used/on site are at least consistent with book records (e.g. if glazing hascommenced, a glass material cost should be included in the contract cost record);

to estimate, in broad terms, their stage of completion (e.g. foundations only, how many floors, whether glazing orroofing commenced).

From the quantity surveyors schedules, by contract, select (a sample of) the most significant materials cost estimates,

and compare with original cost estimate (e.g. bill of quantities). Substantiate managements explanations of anysignificant variances (e.g. inspect variation orders).

Direct costs Labour

Agree a sample of labour costs debited to contract accounts to:

a payroll analysis (for ABCs employees); and

subcontractors invoices (for bought-in labour).

For a selected payroll agree a sample of labour costs analysed to projects by:

reperforming the clients calculations;

agreeing the allocation of individual employees hours to supporting time sheets/site foremens reports.

Assess the reasonableness of the quantity surveyors estimated labour costs (e.g. by comparison with average monthlypayroll and subcontract costs). If labour costs appear very low, ask management whether there are plans to curtail theworkforce, or if there are significant new contracts which have been tendered for.

Evaluate the reasonableness of any manpower planning charts in the light of recent cut-backs in local governmentcontract activity.

Compare projected labour rates with current rates and confirm that any increases are in line with the industry averages,budgeted salary increases, trade union contracts, etc.

For major contracts, compare the proportion of labour costs to material costs, to the year end and to completion anddiscuss any significant fluctuations with the quantity surveyor.

Direct costs Other

Review costs charged to contracts for completeness (e.g. ensure all contracts have professional fees attributed to them).

Agree significant professional fees (e.g. architects and legal fees) incurred to invoices.

For a sample of on-going contracts agree costs to the balance sheet date, extrapolate to completion and comparepredicted total with the quantity surveyors schedules. For example:

agree portable building hire charges to invoices and project over expected contract duration;

agree operating lease charges for plant and equipment to lease agreements and discuss with the quantity surveyorhow assets leased for longer than contract durations will be used;

recalculate depreciation charges;

agree insurance premiums to policies and confirm that the type, amount and duration of cover is appropriate.

Attributable overheads

Obtain a schedule of all head office expenses for the year, analysed between production and non-production. (Thequantity surveyor should have requested this information as a basis of scheduling the attributable overheads.)

Agree the classifications in the above analysis (e.g. a payroll clerks salary should be attributable to the costs of contractsbut advertising costs should not).

Compare the actual split of construction related overheads to total head office overheads with the 70% used incalculating attributable overheads. If materially different, year-end contract values should be recalculated to actual (andthe standard changed for the forthcoming year).

Compare the total of overheads attributed to contracts during the year with the construction overheads incurred duringthe year. Consider whether the quantity surveyors future estimates have taken into account the reduction in contractactivity and the additional burden of under-absorbed overheads on existing contracts.

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2 FERRY

(a) Top down approach

In the emerging business risk methodologies, the top down approach to risk assessments is one whereby the general risksare assessed first and then the more specific risks are evaluated:

The auditor gains a greater understanding of managements current and future business strategy, core businessprocesses, key performance indicators and associated risks and controls in place.

The top down approach involves the auditor comparing the expectations developed that are based on this assessmentwith the performance and position reflected in the financial report. (This can be contrasted with the financial riskapproach, where the auditor assesses inherent, control and detection risk, and then under takes testing within transactionor business cycles and from these samples infers back to the population a bottom up approach.)

The term top down is therefore used to describe the approach to an audit as a whole (i.e. as an audit methodology). However,it is also used to describe the approach to the stages that make up the audit process (e.g. planning, risk assessment, internalcontrols, etc).

It means taking a big picture approach before tackling the details. For example:

When planning an audit using a top down approach, knowledge of the business starts at the top with thoroughdiscussions with management and preliminary analytical procedures on the financial statements (say). From an in-depthunderstanding of the clients business as a whole and then its key processes, the auditor then focuses on the details of

risky transactions and balances. The overall audit plan summarises how the audit is to be conducted at a high level, whilst the detail is provided in the

supporting (lower) audit work programs.

Materiality assessment is described as top down when it is judged in relation to the financial statements as a wholeand then allocated to particular account balances (when assigning tolerable error).

A top down approach to internal controls considers first the highest level of controls (e.g. monitoring controls), then thegeneral controls (also called pervasive controls) and lastly the specific procedures.

Similarly the evaluation of the control environment is evaluated from top to bottom (i.e. firstly at a senior managementlevel, then at the manager level, and finally at the operational level).

In a top down approach to a group audit, the primary focus will be on risks that are significant to the group as a whole andthen the risks that are significant to each subsidiary.

The term is also used to describe the involvement of the audit team, for example that a business risk audit is partner led (i.e.from the top).

(b) Business risks (c) Processes for managing

Tutorial note: As part (c) is clearly related to the requirement of part (b), it is appropriate that a tabular approach be

adopted.

Rights to operate

Competition

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The rights to operate, which provide assurance thatFerry is a going concern for the time-being, are for alimited period (only 51/2 years of the 9 years remain).This casts doubts over the long-term future prospects

of Ferry. Terms and conditions attached to the rights may

threaten Ferrys operational existence if, for example,there are any circumstances under which the rightscould be withdrawn.

Accept at the present level (as one that has to be borne)but bear in mind (e.g. when making strategic decisions)the impact that managements actions could have onany renewal of the rights.

Relevant terms and conditions should be communicatedto all staff so they are clear about the importance of theirareas of responsibility.

Although at the moment there is none, anycompetition in the future (e.g. from a bridge crossingor if the right were to become non-exclusive) couldreduce profitability.

Monitor the progress of plans for bridge building orrelevant road expansion projects.

Reduce the risk by increasing the reliability andreputation of Ferrys service, improving comfort etc (e.g.in air-conditioned lounges).

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Age of Ro-Ros

Environmental Protection Regulations

Fuel prices

Weather

Economy

Service levels

WORKING

2 boats 40 vehicles 6 crossings per day 365 days = c. 175,000 vehicles.Therefore 70,000 represents 40% capacity.

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The age of the Ro-Ros (20 years) will have a bearingon fuel consumption and other costs (e.g. repairs andmaintenance).

Although a major refurbishment has only relativelyrecently been undertaken, Ferry should manage its cashflows and borrowing capability (e.g. bank loan facility) tocarry out repairs as and when needed.

Weather conditions may delay or cancel crossings.Actual and potential customers may prefer to drive ifthey face disruptions and uncertain journey times.

Manage the impact of the risk/modify the businessactivity. For example, driving conditions may behazardous if weather conditions are so bad as to disruptthe crossing so offer facilities in comfortablesurroundings in which travellers can break their journey.

Currently 70,000 vehicles a year is c. 40% capacity(W). Although capacity has almost doubled over twoyears, the demand for travel is likely to be reduced ifthere is an economic downturn (especially ifjourneying is for holiday/leisure).

Keep tariffs (i.e. prices) under review and respond tochanges in the economy and demand patterns. Forexample:

charge premiums at peak and busy periods;

offer discounts for advance bookings;

introduce a loyalty scheme for frequent users.

Ferrys service is described as efficient and timely.Deterioration in service levels is likely to result in lossof customers, revenue and goodwill.

Ferrys reputation may suffer if there are complaintsabout the facilities provided through franchisearrangements.

Ferry should benchmark how frequently it operates, andif crossings are on time, against a comparable Ro-Roferry service operating in similar weather conditions.

Ferrys contractual arrangements with franchiseesshould ensure that:

the franchisees bear the risks of non-performance (e.g.through penalty payments); and

Ferry can terminate contracts expeditiously and seekalternative providers.

Increases in fuel prices will reduce profitability. Incorporation of surcharges into the price structure sothat significant increases can be passed on to thecustomers.

Hedging against the effect of energy price (and exchangerate) risks through forward contracts.

Ferry will have to comply with emissions standardsfrom next year. Costs must necessarily be incurred tomeet Environmental Protection Regulations.

Quite apart from the emissions standards, fuel leaksor other waste spills (e.g. of sewage) may result insubstantial fines.

To reduce the risk of disruption to scheduled crossingsand to ensure that the Ro-Ros are not withdrawn fromuse (for non-compliance), Ferry should:

ensure funds are available for the investment inoverhauling the engines (or whatever is required);

plan the timing of the overhauls when business is at arelatively low volume taking only one Ro-Ro out ofuse at a time;

notify customers in advance of any necessary changesin schedule (and apologise for any inconvenience);

monitor and record the amount and frequency of

spills, etc (e.g. arising on refuelling).

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Loss of subsidy

Passenger safety

Crew safety

Disaster

Safety management

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Ferry may be financially dependent on the subsidywhich it receives. If information in the quarterlyreturns is not submitted on a timely basis, cash flowswill deteriorate as the local transport authorityspayments of the subsidy will be delayed.

Inaccuracies in the returns (e.g. through error) may

result in payments being withheld altogether.

Numbers returned could be fraudulently overstated toinflate the amount of subsidy received.

Ferrys information system must have internal controlsnecessary to provide accurate and timely information onthe number of vehicles carried.

An internal audit function could assist in providingassurance to management about the reliability of theinformation being submitted to the authority.

Although passenger safety is of paramountimportance, associated costs are likely to be onerous.

Passengers may prosecute Ferry for personal injury ordamage to or loss of property.

A fatal accident could irreparably damage Ferrysimage and result in a huge financial liability.

Costs of providing a safe service should be reflected inthe prices charged (e.g. including an insurancepremium).

Ferry should disclaim liability where appropriate (e.g. forvaluables left in unattended vehicles).

Staff training should be on-going with regular safety drillprocedures (e.g. in manning the use of lifeboats).

Ferry will have difficulty recruiting and maintainingthe services of appropriately qualified crew membersif it does not have sufficient regard for their healthand safety.

Work rosters should ensure, for example, that:

crew members take breaks between journeys;

there is adequate cover when crew are sick or takingleave.

A serious accident (e.g. fire), collision or breakdownmay threaten operations in both the short and longer-term.

External consultants could be engaged to develop amodel to simulate unwanted outcomes (e.g. collisions)and their potential impacts (e.g. loss of life).

Recommendations for risk management could includethe deployment of on-board equipment or rapid responsefrom an external emergency unit.

The application for a safety management certificatewill be turned down if there is insufficient informationto support Ferrys conformity to documentedprocedures.

Ferry must have documented procedures. Adherence tothem must be monitored (e.g. through captains logs)and their effectiveness reported to management.

An internal audit function could monitor and review thesafety management system and make recommendationsfor improvements.

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3 DEXY

(a) Non-cancellable lease

(i) Matters

The principal issue is whether the lease payments should be:

capitalised (as an asset) and amortised; or

expensed as incurred.

HKSSAP2.114 Leases requires that a finance lease should be recognised as an asset and a liability. Operatinglease payments should be expensed in the income statement on a straight line basis over the lease term (or othersystematic basis representative of the pattern of benefits consumed).

Whether the non-cancellable lease is a finance or an operating lease depends on its economic substance ratherthan its legal form. Indicators of a finance lease are less likely to apply to this lease than an item of equipment(say). For example, seven years of use of a floor of a new office block development will certainly not be for themajor part of such an assets inherently long life.

$770,000 represents 21% of total assets. This is likely to be considered material as the issue is whether this assetshould be recognised in its entirety, or not at all.

Whether $770,000 is the present value at inception of the lease (as required by HKSSAP2.114 in determining theamount recorded as an asset) or as calculated as at the balance sheet date (say).

The basis of setting the discount rate used to calculate the present value if there is no rate implicit in the lease.

$130,000 represents 4% of profit before tax. Not expensing the annual lease payment may, in isolation, beconsidered not material. Also, as the impact on the income statement is off-set by $110,000 amortisation plusfinance charge, the net effect on profit before tax is insignificant. (There is no difference over the life of the asset.)

The terms of the lease. For example:

whether or not there is any option to renew the lease at any time which suggests that Dexy would occupy thepremises for the duration of the suites economic life;

whether title to the premises could under any circumstances be eventually transferred to Dexy.

The extent to which Dexy bears the risks and rewards of ownership. For example, whether Dexy is responsible forpayments of business rates, office maintenance, repairs, insurance, etc. Also whether Dexy has the right to sub-let

office space to an independent party or whether Dexy can, for example, partition the office space without thelessors consent.

A finance lease gives rise to a depreciation expense. Dexys depreciation policy (i.e. straight line) should beconsistent with equivalent owned assets. Unless there is reasonable certainty that Dexy will obtain ownership bythe end of the lease term, seven years will be appropriate (being the shorter of the lease term and the assets usefullife).

The reason why Dexys management should wish to capitalise the lease if it is an operating lease.

Tutorial note: The issue is usually the other way around i.e. that management want to keep lease liabilities off

the balance sheet by treating finance leases as though they are operating leases.

If, after examining the evidence, it appears that the lease should have been treated as an operating lease theauditors opinion should be qualified except for for non-compliance with HKSSAP2.114.

(ii) Audit evidence

The suite of offices on the 13th floor that they exist and are used by Dexy.

The contract setting out the lease terms to establish its legal form (more likely to be an operating lease than afinance lease) and interpret its economic substance.

The nature and amount of office expenditure incurred by Dexy in respect of these premises, agreed to invoices,management charges, etc. (to gauge to what extent the risks and rewards of ownership are borne by Dexy ratherthan the lessor.)

Recalculation of the present value of the minimum lease payments (should be as at inception of the lease).

Recalculation of the pre-tax cost of capital of the discount rate used (if there is no rate implicit in the lease).

Agree a $110,000 amortisation charge for the year to the income statement.

Agree the completeness of disclosure of the minimum lease payments. For example:

$130,000 not later than one year;

$520,000 later than one year and not later than five years; and

$130,000 later than five years.

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(b) Advertising costs

(i) Matters

$350,000 budgeted expenditure represents 109% profit before tax and is therefore material.

However, the amount which is being deferred ($125,000) is only 39% of profit before tax and 03% of total assetsand therefore immaterial, when considered in isolation.

Whether deferral of expenditures (as compared with immediate write off) constitutes a change in accounting policy.

If so, whether it has been treated as such in accordance with HKSSAP2.102 Net profit or loss for the period,fundamental errors and changes in accounting policies (i.e. an estimate of the prior period prepayment adjustedagainst retained profit). If so, the impact on the current year income statement will be negligible.

If $125,000 is time-apportioned from six months expenditure, the actual annual cost could amount to an

(4 125k) 350koverspend ofc. 40% ( = 429%)350k

Advertising is an expense incurred to provide future economic benefits, but no intangible asset is acquired orcreated that can be recognised (because it is indistinguishable from internally-generated goodwill). It is thereforeexpensed when it is incurred (HKSSAP2.129 Intangible assets).

HKSSAP2.129 does not prohibit the recognition of prepaid advertising expenditure. For example, costs incurred inDecember for advertisements which will go out after 31 March 2003, are prepaid.

To the extent that costs incurred represent product catalogues which have not been distributed at 31 March theyshould be included in inventory rather than prepaid expenses (although the amounts involved are immaterial).

The extent to which any relationship can be established between advertising expense incurred and revenue arising.For example, if revenue in April June clearly corresponds to the New Year catalogues issued before 31 March2003, this would support deferring the costs of those catalogues at the balance sheet date. (Similarly advertisingcosts.)

If the prior period is not restated, the main impact of the change in policy will be a one-off reduction in the expensecharged to the income statement, in the year in which the change takes place. Thereafter, assuming advertisingcosts do not fluctuate significantly from one year to the next, the annual expense will be comparable year on year.(There will be a rising trend if annual expenditure increases year on year.)

The reason why Dexys management should want to make the change. For example, if there has been significantoverspend on the advertising budget (see earlier calculation), carrying forward some of that cost will lessen theimpact on the income statement.

(ii) Audit evidence

Current year annual budget, by month, compared with prior year(s) and actual monthly costs incurred during theyear to 31 March 2003 compared with budget and prior year. To see if there is evidence of under-budgeting/over-spending that might have prompted the change in accounting policy.

Supporting invoices for major items of expense incurred in June and December (e.g. for the design of theadvertisements and the printing of the product catalogue, etc)

The make-up of $125,000 prepayment. If actual costs approximate to budget and similar amounts are spent inDecember as in June, the prepayment at 31 March 2003 for the three months to 30 June would be expected tobe only c. $90,000 (i.e. 350,000 4).

The number of product catalogues held and included in the inventory valuation at the balance sheet date. (The$125,000 includes the cost of catalogues in inventory so it would be double-counted.)

Artwork for the advertisements designed before the year end but not placed until after the year end to confirmthat the expense incurred should be deferred to the next accounting period.

(c) Painting

(i) Matters

$135 million represents 37% of total assets per draft financial statements (i.e. including revalued amount) andis therefore material to the balance sheet.

Tutorial note: The impact on PBT is not assessed because it has no impact on the income statement.

The painting is an asset i.e. a resource held by Dexy arising from past events (a purchase) and from which futureeconomic benefits are expected to flow (e.g. when the investment is realised through an eventual sale).

The asset has been held for 50 years and unless it is now held with a view to sale should be classified as non-current (HKSSAP2.101 Presentation of financial statements).

Managements future intention to hold or sell this asset, to determine its classification as current or non-current.

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Dexys going concern status and financial position. (Managements intention could be to hold the asset but as it isnot used in day-to-day operations it would be the ideal asset to dispose of to raise finance.)

The painting is clearly not held for use in the production or supply of goods or services. So unless it is held forrental to others or for administrative purposes, it is not an item of property, plant and equipment (as defined byHKSSAP2.117). It is therefore not subject to an annual depreciation charge.

Whilst it was displayed in the reception office it may (arguably) have been a furnishing for administrative purposes.However, as it has now been removed outside of the business premises its accounting treatment appears not to be

covered by HKSSAP2.117.

There is no HKSSAP dealing specifically with such assets held for their investment potential.

HKSSAP2.113 Accounting for investment properties though not applicable (as the investment is clearly not inproperty) may provide a suitable benchmark for Dexys accounting treatment.

Whether management intends to adopt a fair value model (i.e. to maintain it at fair value in the financial statementsand include gains or losses arising on change in fair value to net profit or loss for the period) or regards this as aone-off revaluation.

To where in equity has the surplus been credited (e.g. a revaluation or other non-distributable reserve)?

How the change in measurement policy could otherwise be treated (if not as a current year revaluation surplus).For example, applying HKSSAP2.113 transitional provisions, the credit should be to the opening balance ofretained earnings. Comparative information should not (cannot!) be restated because fair value was not previously

disclosed publicly (because it was not known).

Tutorial note: Neither the benchmark or allowed alternative treatments for changes in accounting policies under

HKSSAP2.102 Net profit or loss for the period, fundamental errors and changes in accounting policies apply.

HKSSAPs (e.g. 2.113 and 2.117) do not permit selective revaluation of assets. Therefore, if Dexy holds any otherpaintings they too must be revalued.

Whether the taxation authority might seek to tax the CEO now holding the asset.

(ii) Audit evidence

Historic cost agreed to prior year working papers and financial statements.

The revaluation report of the independent appraisal company, in particular, the assumptions made. For example,

if the fair value is one which could realistically be achieved only through auction rather than a private sale. Insurance documents, stating the amount insured and any related conditions (e.g. security arrangements) and

confirming that it is covered in its current location.

Correspondence with the insurers including the evidence the insurers required to confirm to their satisfaction thevalue of the painting. For example, whether the insurer relied on the revaluation report prepared for Dexy, orwhether the insurer commissioned a further independent valuation.

Physical inspection of the painting at the chief executives residence and review of the security measures in place(as compared with those operating over the office environment).

Confirm the adequacy of the disclosure made in the financial statements, in particular, the measurement basisdescribed in the accounting policy note.

Written representation from the CEO that the painting is in his safekeeping.

Written representation from the management board confirming their intention to hold or sell the painting. If holding,then their intention to have the painting valued annually (or otherwise).

Tutorial note: Marks will be awarded for suitable points about placing reliance on an independent expert valuer (e.g.

to confirm the painting as an original). However, candidates should be mindful of the cost of such evidence and the

availability of alternative evidence, as suggested above.

4 ICEHOUSE

(a) Perceived limitations in the standard unmodified auditors report

It is difficult for a private shareholder to understand its meaning because it:

assumes knowledge of the audit process; and

is jargonised.

For example, it does not say what Standards (on Auditing) are. An individual Standard could be a document on an entiretopic, or just a paragraph of bold print. Also, Standards are referred to before what constitutes an audit is explained.

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Terms which might be regarded as jargon include:

reasonable assurance; material; misstatement; test basis; accounting principles; and true and fair view.

Although some of these terms are defined in Auditing Standards (e.g. materiality), others are not (e.g. true and fair view).Even relatively informed shareholders do not appreciate that reasonable assurance is merely a high level of assurance andnot an absolute guarantee.

The financial statements to which the auditors report refers is of ten only a small part of a much larger document (an AnnualReport). What is it all for? How much is required by statute? What are the auditors responsibilities for it? The auditorsresponsibility, as stated, to express an opinion ... based on our audit, perhaps does not sound like much.

One of the perceived limitations of using standard wording (generally) is that it is something routine which does not reflectthe exercise of professional judgement. Institutional shareholders may believe that the rigid format of a standard auditorsreport is a constraint on the auditor being able to say what they really mean.

Tutorial note: Marks will be awarded for other legitimate criticisms. For example, that it is not very readable (the readability

index is high).

(b) Explanation of shortcomings

Has there been a limitation on scope?

The however ... in the middle of the explanation of the scope of the audit suggests that what follows is some sort ofreservation about what has just been stated. In a scope paragraph this would be expected to be a description of a limitationon scope. However, a limitation on scope is normally introduced with the wording except as discussed (below), we conductedour audit in accordance with ....

The matter described concerns additional evidence having been discovered during the current year audit (to 30 September2001) which suggests a lack of evidence in respect of the prior year.

It is unclear from the wording the evidence available to us whether:

the evidence has been made available to the auditor for the first time (e.g. it was previously withheld); or

the auditor is claiming credit for having discovered new evidence.

Splitting the description of what an audit includes (between the first and third paragraphs) adds further confusion.

Emphasis of matter

An emphasis of matter is suggested by:

the inclusion of additional information into the scope paragraph; and

the cross-reference to a note in the financial statements.

It is not clear whether Note 22 relates to transactions in the previous paragraph or something unrelated.

The addition of an emphasis of matter paragraph does not affect the auditors opinion. When emphasising a matter it ispreferable to:

include such a paragraph afterthe opinion paragraph; and

state that the auditors opinion is not qualified with respect to it.

The reference to Note 22 is before the opinion paragraph and, although it would be reasonably inferred, there is no positiveconfirmation that the auditors opinion is not qualified.

Going concern

The opinion paragraph introduces doubts about going concern by referring to the loss on its operations.

The last paragraph, being after the opinion paragraph, appears to be of the nature of an emphasis of matter (as explainedabove) of a fundamental uncertainty except that:

there is no cross-reference to a note; and

there is no statement that the auditors opinion is not qualified with respect to it.

If the absence of a cross-reference is because there is no disclosure (of the significant doubts cast on the entitys ability tocontinue as a going concern) the audit opinion should be modified on grounds of disagreement over inadequate disclosure(i.e. except for).

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Although the opinion paragraph is unqualified, the use of the word adverse in the last paragraph could potentially beconfused with an adverse opinion. Given the apparent circumstances (i.e. adjustments in relation to prior year, operatinglosses, net liabilities, lack of disclosure), it is conceivable that an adverse opinion may be appropriate (i.e. the financialstatements do not give a true and fair view).

The opinion paragraph should be a statement of the auditors opinion (belief) but the last paragraph makes two referencesto managements beliefs. There is no affirmation that the auditor concurs with those beliefs nor expression of disagreementthat they are unfounded.

Timeliness/date of report

The auditors report is dated 19 January 2003 on the financial statements for an accounting period ended 30 September2001 i.e. nearly 15 months after the balance sheet.

The report should be dated as at the completion date of the audit (SAS 600). The reader is therefore informed that the auditorhas considered the effect in the financial statements and on the report of events and transactions of which the auditor becameaware of that occurred up to that date. For example, the entity has not ceased to trade or been liquidated in 2002.

The lateness should concern the reader because the reason for it is not explained (e.g. whether due to lack of evidence orserious doubts about going concern).

Prior period implications

The omission of transactions from the prior years records could:

be due to a cutoff error (e.g. omission of purchase invoices);

indicate fraudulent reporting (e.g. deliberate suppression of liabilities from being recorded);

have resulted in the understatement of an accounting estimate.

Whatever the circumstance the matter is presumably material, otherwise the auditors report should not refer to it.

If the evidence available this year was not available last year, but should have been reasonably expected to be available, thescope of the prior year audit would have been limited. This should have resulted in a modified opinion in the prior yearsauditors report. If the matter has properly been resolved the current report does not ordinarily refer to it but an emphasisof matter paragraph may deal with the situation if it is material to the current period.

It is not stated whether the adjustments have been made to the prior years financial statements as reflected in thecorresponding figures, or in the current periods financial statements. The absence of any except for opinion means that theauditor concurs with the adjustments having been made.

The opening balance of retained earnings should only have been adjusted (and comparative information restated) if the matteramounted to a fundamental error (HKSSAP2.102 Net profit or loss for the period, fundamental errors and changes inaccounting policies).

Tutorial note: The only other circumstance in which opening balances are adjusted is when there is a change in accounting

policy which is not relevant here.

Conclusions

Tutorial note: The Q is set in the context of a client asking for clarification of the meaning of the auditors report and

appropriate marks will be awarded for drawing a conclusion on the preceding analysis.

The auditors report draws attention to two apparently unrelated matters: the prior years financial statements and the goingconcern basis.

Although the prior period matter may have been correctly dealt with as an emphasis of matter, a clearer description of theproblem and a statement where the adjustments have been made would have assisted the reader. Also, it should have beenafter the opinion paragraph and a statement made that the opinion was not qualified in this respect.

Whatever the going concern issue, it is inappropriately dealt with.

5 DURAN

(a) Ethical and professional issues

The review, on an ongoing basis, of existing clients is a safeguard. For example, Duran is a listed company which shouldnot be retained if recurring fees from it exceed 10% of Depeches gross practice income. Annual review is a safeguardif Durans fees exceed 5% (but are less than 10%).

In making a decision to retain a client, Depeche must consider:

its independence and ability to serve Duran properly; and

the integrity of Durans management.

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(1) Hospitality

Depeches objectivity may be threatened, or appear to be threatened, by acceptance of goods, services or hospitalityfrom Duran, unless the value of any benefit is modest.

The audit staff have already accepted the hospitality. Their objectivity should not have been impaired provided thatthe meals were appropriate to the normal courtesies of social life.

However, undue hospitality is likely to be regarded as a corrupt practice, which could be indicative of fraudulent

activities having taken place. As the staff needed to work late to meet the deadlines, an alternative to Duran buying in the refreshments would

have been for the audit team to make their own arrangement and for Duran to have been re-charged the expense.

(2) Financial reward

Professional accountants in public practice should be and appear to be free of any interest which might beregarded, whatever its actual effect, as being incompatible with integrity, objectivity and independence.

The bonus was not accepted in respect of the audit managers involvement. Therefore there is no obvious threatto his objectivity.

The bonus may be perceived to be a reward (or bribe) for having not detected or reported on a matter andacceptance of it may cast aspersions on the audit teams integrity.

The bonus represents an increase in the audit fee and the gross cost to Duran should be included in the amountdisclosed in the note to the financial statements as auditors remuneration.

The bonus should be excluded from the fee when considering the recurring element.

Has this situation arisen in respect of previous Duran audits? Was the subject of such bonuses mentioned beforethe audit fieldwork was completed? If the audit team had any expectation that a bonus might be awarded to themit is likely that there will be a perception that their objectivity could have been impaired.

Has the situation created an expectation that such bonuses could be a feature of this audit? Acceptance of thebonuses may have created problems for Depeches practice management as it may be more difficult to allocateaudit staff to other assignments if they have a preference for the Duran audit.

That the bonus was not accepted at the manager level suggests that this was considered to be a threat to objectivity.This consideration and the decision to accept the bonus for other staff should have been documented.

(3) Client/auditor integrity Frankie Sharkeys apparent disregard for environmental legislation should have been taken into account when

making a risk assessment of Durans control environment. It may cast doubt on his integrity.

The audit of Duran should have been carried out with due regard to:

SAS 120 Consideration of laws and regulations in an audit of financial statements; and

SAS 610 Communications of audit matters with those charged with governance.

For example, if the illegal dumping became apparent during the audit but was not known at the planning stage,consideration should have been given to:

the frequency of the illegal act, how long it has been going on and what measures, if any, had been taken toconceal it from the auditors;

the potential financial consequences (e.g. fines, penalties, enforced discontinuation of operations andlitigation);

whether the potential consequences require disclosure;

whether risk assessments made at the planning stage need now to be revised;

the validity of management representations.

Matters to be communicated to those charged with corporate governance (i.e. the audit committee) include:

the potential effect on the financial statements of any significant risks and exposures, such as pendinglitigation, that are required to be disclosed in the financial statements (this could arise from the illegaldumping); and

other matters warranting the attention of those charged with governance, such as questions regarding

management integrity.Tutorial note: Although the fines are only small, the boycotting of Durans products or other adverse

publicity could have a detrimental effect on the companys operations.

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It is of potential concern that the matters have not been included in the final report unless the engagement partnerknows, for example, that the matter has already been brought to the audit committees attention (e.g. in an internalauditors report).

Does the draft report constitute an audit working paper? If it is retained on file it should clearly explain why it wasnot incorporated into the final report (and whose decision it was to exclude the managers or partners). If thereis no apparent justification for its exclusion, the integrity of the audit manager and/or engagement partner may bequestioned.

(b) Available safeguards

Tutorial note:Available safeguards will be appropriate if they eliminate the threats or reduce them to an acceptable level.

The firms guidance on receiving hospitality should be reviewed and amended as necessary. It may be that on-goinghospitality is refused, if construable as excessive.

Review of the engagement partner s decision to accept the bonus on behalf of the staff. For example, whether the firmsquality assurance policies and procedures required him to consult with other partners.

Audit staff and the client should be advised that the bonus was a one-off and not to be repeated.

Senior staff (the two qualified seniors and two supervisors) should not be assigned to the audit for the year to 31December 2003.

Involving a second partner to review the conduct of the audit and advise staff involved of any concerns they have about

their independence from Duran and the integrity of Durans management.

If the engagement partner has been involved in the audit for a number of years (say seven), it may be time to rotate theassignment.

Discuss issues of independence with Durans audit committee and obtain written confirmation that they are aware ofthe potential threats posed by public interest, fees, hospitality, etc and that they are satisfied that the firms safeguardsare adequate.

Advice whether or not the audit of Duran should continue

The Duran audit should be retained only if a partner of Depeche unconnected with Duran independently reviews thesafeguards available and considers them to be adequate.

Alternatively: If the safeguards available are not adequate to maintain independence, Depeche should withdraw from the

audit.

6 AUDIT FAILURES

Introduction

Possible audit failure, though not a new subject for discussion, has come under wider and closer scrutiny since the EnronCorporation filed for bankruptcy in December 2001. When well known companies fail, confidence in the stability of the capitalmarkets falls. The collapse of Enron brought down share values across the world. Now regulators, the public and the professionare seeking solutions to the concerns raised.

Audit failure

There are many ways in which an audit may be said to have failed. For example, when auditors give a clean report on thepublished accounts of a company which then ceases to be a going concern. Thus, it is the publics perception that the audit (and

auditor) will have failed if: shareholders are not warned about going concern issues and so lose the value of their equity investments;

a fraud is not detected (even though the auditor has not been negligent in complying with auditing standards) butsubsequently emerges.

Misconceptions about the auditors responsibilities for going concern and fraud are a major component of the expectation gapwhich exists between what users of financial statements expect (often unreasonably) and what auditors can reasonably be expectedto deliver.

There will be an audit failure when an auditor does not adhere to a basic principle or carry out an essential procedure in accordancewith Statements of Auditing Standards (SASs). For example, if an auditor issues an unmodified opinion knowing that it isinappropriate, that is negligent.

Auditor failure can also arise through incompetence. For example, where the auditor does not have sufficient understanding of the

risks involved in the reporting of earnings of dot.coms or measuring fair values.

In general, the audit can be said to have failed when, for whatever reason, it fails to provide that assurance which gives credibilityto the financial information needed by the capital markets and other legitimate users.

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Issues raised

Significant concerns have been raised about many issues including:

responsibilities for the detection of fraud;

the rigor of financial reporting and auditing standards;

auditor independence;

monitoring, enforcement and regulatory mechanisms in the profession; and

the quality of corporate governance.

Professional developments before Enron (e.g. the issue of SAS 110 The auditors responsibility to consider fraud and error in anaudit of financial statements and SAS 610 Communications of audit matters with those charged with governance) are unlikelyto console shareholders or unpaid creditors.

The capital market and its regulators have become more sceptical about the value of the auditors role and the credibility of thefinancial statements in the wake of scandals which reveal too cosy relationships between companies and their auditors. Inparticular:

the provision of other non-audit services for fees which far outweigh audit fees; and

senior finance executives being former auditors.

Frameworks of principles (e.g. IFACs Professional Code of Ethics) are just theory to many who now call for an end to self-regulation of the profession and demand much stricter legal regimes of monitoring and enforcement (however unworkable).

Auditors are likely to be perceived to be at fault when legalistic, rules-based standards facilitate creative accounting practices whichdevalue and even undermine their judgement. Footnotes to accounts may be in very small print, not because they are less relevantthan the larger print, but intentionally because it is harder to read. So, for example, telecom companies have included swaps ofcapacity (hollow swaps) as sales, even though no cash changes hands. This may be acceptable within national financial reportingstandards and disclosed in the notes and therefore satisfy the true and fair requirement on which the auditor forms an opinion.However, real earnings are clearly inflated to a normal person.

Although stock exchange listing provisions may require a minimum number of independent directors to sit on audit committees(e.g. in the US, UK, Netherlands, etc) this does not mean that they will have sufficient expertise to be effective in providingcorporate governance.

Possible responses

There is already wide support for the application of International Accounting Standards in financial reporting. By embracing one

set of such principles-based standards on a global basis, the auditing profession can dismiss the rules-based approaches whichcan currently undermine an auditors judgement. ACCA, for example, supports a think global: act local view. That is, that solutionsneed to be agreed and co-ordinated at a global level but introduced and controlled at a national level. National regulators need tobe persuaded to rise above issues of their sovereignty and give up some element of control over domestic issues in return forparticipation in, and influence over, global developments.

Some commentators believe that an International Accounting Standard on the principal of substance over form is much neededand long overdue. (However, others might argue that the IASBs regard for it as a qualitative characteristic of financial statements,as set out in The Framework, lends to it more fundamental importance than a standard.)

Support for International Standards on Auditing issued by the International Federation of Accountants (IFAC) is also increasing. InJanuary 2002, IFAC issued a revised Code of Ethics for Professional Accountants which takes a framework (i.e. principles-basedrather than rulebook-based) approach. Although this is not effective for auditors reports dated before 31 December 2004, supportfor early application and national adoption could be agreed and co-ordinated at a global level.

The profession should undertake a review of the regimes for monitoring compliance with professional guidance (e.g. the JointMonitoring Unit for UK statutory work and mandatory peer reviews in the US) and the enforcement mechanisms which supportthem.

On the issue of auditor independence it has been suggested that:

a limit could be placed on the time which auditors may hold appointments; and

auditors be prohibited from undertaking consulting work.

Although these measures have been debated for many years and already operate at a national level in some countries, they havebeen discounted as a global solution. An alternative approach is to make relationships between reporting entities and their auditorsmore transparent. For example, by:

making audit appointments less dependent on executive directors through the greater involvement of non-executive directors,the audit committee and institutional shareholders;

limiting the nature and extent of other services which can be offered to listed and other public interest clients;

requiring fuller disclosure of audit fees, including expenses, and other fees in the financial statements;

a mandatory review by audit committees of the independence of the external auditors and the publication of a statement thatthey are satisfied with their findings.

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It has also been suggested that audit firms should be prohibited from providing audit services to clients where senior audit staffhave left the audit firm to take up executive positions within the client company. This might be implemented by prohibiting stafffrom leaving to join client companies within a minimum specified period from having been personally involved with the audit.However, this may not be practicable as employment contracts which prevent auditors from leaving their firms for 18 months (say)may not be enforceable.

It is often argued that one way in which the profession could respond to issues which contribute to the expectation gap is toeducate users to overcome misconceptions about the audit process. So for example, the standard wording of auditors reports has

been revised to refer to the applicable financial reporting framework. However, although the auditors report tells the user what anaudit is it does not explain what it is not. Perhaps it is time for the auditors report:

to state, explicitly, that it does not guarantee going concern; and

to include a disclaimer of responsibility for the detection of fraud.

Perhaps one of the reasons for genuine audit failure (e.g. where the auditor lacks competence) is because too much is expectedfrom the average auditor in terms of knowledge and experience of business risks, IT, systems, etc. Although the syllabuses ofprofessional qualifications are periodically revised, to be made more relevant, and qualifications can be made harder, thecompetence of those who are already qualified must also be assured (e.g. through compulsory continuing professional developmentand statutory licence renewal procedures).

Conclusion

Audit failure is perceived to be linked, directly or indirectly, with corporate failures. So, if company failures are unavoidable, audit

failures will happen however effective the auditing professions response.

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Part 3 Examination Paper 3.1(HKG)

Audit and Assurance Services (Hong Kong) June 2003 Marking Scheme

Marks must only be awarded for points to answering the question set. Unless otherwise indicated, marks should not be awarded forrestating the facts of the question.

For most questions you should award 1/2 a mark for a point of knowledge, increased to 1 mark for the application of knowledge and11/2 marks for a point demonstrating the higher skill expected in Part 3.

The model answers are indicative of the breadth and depth of possible answer points, but are not exhaustive.

Most questions require candidates to include a range of points in their answer, so an answer which concentrates on one (or a few) pointsshould normally be expected to result in a lower mark than one which considers a range of points.

In awarding the mark to each part of the question you should consider whether the standard of the candidates answer is above or belowthe pass grade. If it is of pass standard it should be awarded a mark of 50% or more, and it should be awarded less than 50% if itdoes not achieve a pass standard. When you have completed marking a question you should consider whether the total mark is fair.

Finally, in awarding the mark to each question you should consider the pass/fail assessment criteria:

Adequacy of answer plan Structured answer Inclusion of significant facts Information given not repeated

Relevant content Inferences made Commercial awareness Higher skills demonstrated Professional commentary

In general, the more of these you can assess in the affirmative, the higher the mark awarded should be. If you decide the total mark isnot a proper reflection of the standard of the candidates answer, you should review the candidates answer and adjust marks, whereappropriate, so that the total mark awarded if fair.

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Marks

1 (a) Principal audit risks

Generally 1/2

mark for identification +

1 mark each point of explanation max 12

Ideas

Industry

impact on financial statements inherently uncertain outcomes fixed fee contracts B&DD implications for WIPGoing concern less work working capital requirementsPercentage of completion method subjectivity impacts on revenue, profits/losses, etc judgement in projecting costs to date to completion % how determined? HKSSAP2.123Costs to BS date materials exist?

direct costs correctly allocated? overheads appropriate apportionment? consequence for foreseeable loss provision cutoff e.g. on subcontract labourEstimated costs to completion PY qualification high inherent risk need for an expert cost v contract activity management bias/level of judgement

(b) Nature and extent of reliance on quantity surveyor

Generally 1 mark each point contributing to an explanation max 5

Ideas (SAS 520)

Nature reliance v audit opinions/responsibility as an internal control as a source of audit evidence (expert)Extent results of evaluating ICs materiality/risk of misstatement complexity of information/level of judgement sufficiency of complementary evidence/alternative sources expert skills

(c) Audit work on total costs to completion

Generally 1 mark each point max 8

Ideas

Actual (to date) v estimated (to completion) Direct materials Direct labour Other direct Indirect costs

25

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27

Marks

2 (a) Top down approach


Ideas

Business risk methodology Business focus v financial statements/audit focus

Top = overview v bottom = detail In planning In risk assessment In materiality assessment In evaluating internal controls In group audits

(b) Principal audit risks

Generally 1/2

mark for identification +

1 mark each point of explanation max 10

Ideas

Environment risks competition weather economy accident, collision, breakdownFinancial risks Ro-Ro costs fuel prices loss of subsidyCompliance risks rights to operate non-compliance with environmental regulations waste spills safety management

Operations risks poor service levels (e.g. catering, booking, timely operation) passenger safety employee-related issues (e.g. crew safety)

Tutorial note:Although in practice an analysis of the risks would be structured around suitable classifications of risk (e.g.

those suggested above) many candidates will identify the risks as they come to them in reading through the scenario. To

show that this is acceptable, the model answer has been left in such an order. However, candidates struggling to identify

sufficient risks in the scenario could have drawn on a classification to give them ideas on what to look for.

(c) Risk management processes


IdeasAccept the risk low impact risks benchmark (or could reduce risk)Reduce the risk by implementing improved internal controls staff training hedge against it (e.g. fuel prices)Avoid unacceptable risks non-complianceTransfer the risk by insurance (amount/type) contractual risk sharing (with franchisees)

Recovery plan disaster scenarios25

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Marks

3 (i) Matters

Generally 1 mark each commentmaximum 6 marks issue (a)4 marks (b) and (c) max 12

Ideas

materiality (assessed)

relevant HKSSAPs (e.g. 2.102, 2.113, 2.114, 2.117, 2.129) and The Framework risks (e.g. FS assertions capital v revenue, ownership, existence) responsibilities (e.g. directors to safeguard assets) implications for auditors report

(ii) Audit evidence

Generally 1 mark each item of audit evidence (source)maximum 6 marks issue (a)4 marks (b) and (c) max 12

Ideas (SAS 400) oral vs written internal vs external

auditor generated procedures (AEIOU)1

max 20

(a) max 8(b) max 6(c) max 6

20

1SAS 400 identifies 5 procedures for obtaining audit evidence: Analytical, Enquiry, Inspection, Observation and compUtation

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Marks

4 (a) Comment on perceived limitations

Generally 1 mark each comment max 5

Ideas

What are Standards (on Auditing)? Standards referred to before an audit is explained Jargon (reasonable assurance, material, misstatement test basis, accounting principles true and fair view)

Annual report v financial statements Readability Auditors responsibility (not much?) Standard wording = no judgement

(b) Matters to be considered (before expressing an opinion)


Ideas

Limitation on scope? v Inherent uncertainty/Emphasis of matter? Lack of evidence intentionally suppressed? Split description of an audit

Reference to note No statement that opinion not qualified Going concern Fundamental uncertainty? v Disagreement? Adverse Timing/datePrior period Cause of omission Prior year auditors report modified? How adjusted? Emphasis of matter HKSSAP 2.102

15

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Marks

5 (a) Ethical and professional issues


Ideas

General 5 10% fees for listed co review review = a safeguard (independence & integrity)

(1) Hospitality threat to objectivity corrupt practice(?) when acceptable (social courtesy)

(2) Financial reward (= bonus) manager v other staff participation bribe (?) audit fee (not recurring element) practice management implications

(3) Client/auditor integrity SAS 120 SAS 610 reason for exclusion from final report

(b) Appropriateness of available safeguards

Generally 1 mark each safeguard and1 mark each comment thereon max 5

Ideas

Review (policies, procedures) Second partner involvement Rotation (partner/senior staff) Audit committee involvement

For advice clearly based on adequacy of available safeguards 1

15

6 Discussion of audit failure

Generally 1 mark a point up to max 15

Ideas (illustrative)

Introduction (why it is topical) Enron

Audit failure (possible) Going concern Fraud Expectation gap

Creative accounting practices Competence Credibility

Issues raised Adequacy of accounting/auditing standards Role in corporate governance Framework (principles) v rulebook approaches Enforcement mechanisms (e.g. peer reviews)

Possible responses Global acceptance of standards (e.g. IAS) Code of Ethics Independent monitoring Transparency

Training/CPD requirements 15

2003 june (answer)

Documents