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, HKICPA Final Examination

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Module C - Auditing and Information Management

Course Notes plus Q&A

June 2010

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FTMS Hong Kong

HKICPA Final Examination Module C - Course Notes

1) ABOUT THE HKICPA FINAL EXAMINATION

The Final Examination (FE) will test the ability of candidates to deal competently with professionaltype situations, involving the drawing together and application of knowledge and skills from any part of the professional programme module syllabus, across all fields of competency, thereby demonstrating a level of competency appropriate to a competent practitioner.

Objectives of this revision course:

Know the exam format and past years exam topics

Examination techniques and strategies - Eg. approach to case study Updates on auditing standards and knowledge

Revising through key areas

Practice questions and answers

i) FORMAT OF EXAMINATION

The duration of the exam is six hours and it is separated into two papers (Paper I and II), one conducted in the morning, and the other, in the afternoon. The format of each paper is as follows:

a) Section A - Case Study (which will consist of 4 to 5 questions, 75 marks)

b) Section B - Essay (which will usually consist of one question, 25 marks)

All questions are compulsory. The auditing questions usually appear in section A (probably in a case study Q1 with many parts with module C taking some parts eg Qie, if, 19) of the morning Paper I, taking up to 25 marks. Then the remaining 25 marks will be from a Q2 (25 marks) from section A or occasionally a standalone question in Section B of the afternoon paper. The total for Module C marks will be about 50 C:!:. 5) out of the total of 200 marks.

ii) MODULE C OVERVIEW

a)

Professional and ethical considerations (ClP 4 and 6.2) Code of Ethics

Fundamental principles of ethics

Ethics for Professioanl Accountants in public practice Threats to independence and safeguards

QC practices and procedures

Professional Appointment (change in auditor) Confidenti a I ity

b) Audit Process

Assessing risk of material misstatements (ClP 8) Responses to assessed risks (ClP 9.1 and 9.2) Audit planning (ClP 7)

Audit evidence, including assertions (ClP 7) Analytical procedures

Evaluation and review (opening balances and comparatives, going concern) Internal control systems - Evaluation and testing (ClP 8.2 and 9.3)

Using the work of others (other auditors, experts, internal auditors - ClP 11) Fraud, non-compliance with laws (CLP 12)

c) Assignment (ClP 11 and 14)

Group audits

Audit-related services (reviews, agreed-upon procedures, compilations) Assurance services (new topic added since June 2003 session)

Internal audit, outsourced services

Performance, Compliance audits

These notes are prepared by FTMS lecturing team. They are for the sole use of FTMS students attending HKICPA FE 1

courses in Hong Kong. For questions, please email tohkicpa@ftmsaf.com.hk

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d) Completing the audit and reporting (CLP 13)

Post balance sheet events

Final review

Audit reports

Going concern

e) Information risk management (new CLP 15 since February 2006 diet)

Risks and controls in IT systems

How IT affects the audit

Use of CAATs in auditing (Old CLP 15.5 is now shifted to CLP 9.6, no change in content)

(iii) ANALYSIS OF SPECIAL TOPICS FOR MODULE C

For the coming FE in June 2010, HKICPA has already issued the list of special topics. Below is a list of past few FE special topics and comparing them with the new June 2010 list, it is clear that certain topics will probably be examined this round and students can start preparing for these topics. The following topics are important for this June 2010 exams:

a) b) c) d} e) f}

g)

Ethics for auditors (PAPP) - independence, safeguards, confidentiality (especially CLP 4.3 and 4.4)

Assessing risk and procedures in response to those risks (CLP 8.4 onwards and 9) Understanding the entity and its environment (CLP 8.1 to 8.3)

Auditing opening balances {new CLP 12.6 = old 12.2}

Auditing fair value (new 8.8 and 10.4 = old CLP 10.5) -7 W ~ -furteJ h\ ~t ~ .

Managerial, operational or procedural processes in organization (not directly linked to CLP but more likely a topic under CLP 5.7 plus CLP 14)

Implement information systems and communications within technological and cost constraints (CLP 15)

o

(bold items are newly added special topics for this coming exam)

Let's review the past few FE diets' special topics below (italics items were newly added item in that

exam diet): .

Special topics for December 2009 exams

1)

Professional Ethics

Regulatory framework of professionalism and the fundamental principles of HKICPA's Code of Ethics for Professional Accountants

Independence and assurance engagement

2) Audit of Financial Statements - Methodologies and Processes Assessing the risks of material misstatement

The auditor's procedures in response to assessed risks Understanding the entity and its environment

External confirmation and enquiry

Auditing fair value

Fraud, laws and regulations

Designing information system for organization needs including security considerations.

These notes are prepared by FTMS lecturing team. They are for the sale use of FTMS students attending HKICPA FE ·2

courses in Hong Kong. For questions. please email tohkicpa@ftmsaf.com.hk

FTMS Hong Kong


Special topics for June 2009 exams

1) Professional Ethics

Regulatory framework of professlonallsrn and the fundamental principles of HKICPA's Code of Ethics for Professional Accountants

Code of ethics for professional accountants in public practice Independence and assurance engagement

2) Audit of Financial Statements - Methodologies and Processes Assessing the risks of material misstatement


Analytical procedures for the purpose of risk assessment Other assurance and non-essarence engagements Information management and technology

Special topics for December .2008 exams

1)

Professional Ethics


Code of ethics for professional accountants in public practice Code of ethics for professional accountants in business

2) Audit of Financial Statements - Methodologies and Processes General principles governing the audit of financial statements Assessing the risks of material misstatement


Analytical procedures for the purpose of risk assessment Communication of audit matter with those charged with governance Fraud, laws and regulations

Other assurance engagements

Information management and technology




Code of ethics for professional accountants in public practice Code of ethics for professional accountants in business

2) Audit of Financial Statements - Methodologies and Processes General principles governing the audit of financial statements Assessing the risks of material misstatement


Audit of accounting estimates

Related party transactions

Using the work of an expert

Communication of audit matter with those charged with governance Fraud, laws and regulations

Non-assurance engagement



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Regulatory framework of professionalism and the fundamental principles of HKICPA's Code of Ethics for Professional. Accountants

Code of ethics for professional accountants in public practice Independence - Assurance engagements

2) Methodologies and Processes - Audit of Financial Statements General principles governing the audit of financial statements Assessing the risks of material misstatement

The auditor's procedures in response to assessed risks Audit of accounting estimates

Related party transactions

Using the work of an expert

Considering the work of internal auditing


1)

Professional Ethics


Code of ethics for professional accountants in public practice Independence - Assurance engagements

2) Methodologies and Processes c- Audit of Financial Statements General principles governing the audit of financial statements Engagements on related services

Assessing the risks of material misstatement

The auditor's procedures in response to assessed risks Initial engagement - opening balances

Audit of accounting estimates

Auditing fair value measurement and disclosure Using the work of an expert

Considering the work of internal auditing


1)

Professional Ethics (CLP 4)


Describe the fundamental principles of the Code of Ethics

Identify and evaluate specific situations that could pose a threat to compliance with the fundamental principles of Code of Ethics by a professional accountant in public practice and in business

Independence - Assurance engagements

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2) Methodologies and Processes - Audit of Financial Statements

Explain the framework governing assurance and non-assurance engagements Audit of financial statements

Engagements on related services

Assessing the risks of material misstatement Initial engagement - opening balances

The auditor's procedures in response to assessed risks Audit of accounting estimates

Fraud, laws and regulations

Are the special topics reliable?



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Let's take the latest December 2009 special topics - the following were the listed special topics and were examined in the actual exam (50 marks in total for module C, 25 marks for each paper) Independence and assurance engagement (Paper 11 Q2c = 5 marks)

Assessing the risk of MM at assertion level and procedures to response to the risks (Paper 11 .

Q2b = 12 marks) .

Fraud, laws and regulations (Paper II Q2a = 8 marks)

Understanding the entity and its environment (Paper I Q1e and 19 = 18 marks) Info system and security consideration (Paper I Q1f = 7 marks)

What were on the December 2009 special topics but were NOT examined? Auditing fair value and external confirmation. Note that auditing fair value appeared again in this June 2010 special topics list so it is likely to be examined this June.

2} FE EXAM TECHNIQUES AND STRATEGIES (IN RELATION TO MODULE C)

The following skills are important:

r=>. • Knowledge and understanding (i.e. comprehension) - as conveyed by candidates'

explanations;

• Application i.e, how candidates use the information given in the question to relate theory to practice;

• Analysis i.e. the ability to make distinctions and inferences, and draw conclusions.

It is widely recognised that there is more to passing exams than recalling facts, terms, definitions, etc. You must practise your examination technique to convey the skills other than knowledge which the examiners and their markers will be looking for when assessing the quality (rather than the quantity) of your answers.

a) UNDERSTAND THE REQUIREMENTS

Before attempting any question, and in order to impress the markers, you need to understand the examiner's requirements.

i)

.~ ..

Read the requirement

Always read the requirement (at the end of the question) first, never the 'scenario'. The longer the question, the more vital it is that you observe this guidancel It is a waste of time to start by reading a question from beginning to end because you will not appreciate the relevance of the 'scenario' until you know what the examiner is asking you for.

.A further advantage of this recommended approach is that it reduces the risk of answering the question you wanted to see rather than the question set by the examiner. This risk is greatest when the scenario, if it is read first, suggests an examinable topic which is not central to the examiner's requirement.

ii) Highlight 'Instructions' and 'Content'

Nearly all requirements (and parts thereof) have an 'instruction' (e.g. 'describe') and 'content' (e.g. 'procedures'). The instructions tell you how your answer should be written; the content tells you what you should be writing about.

Examples of Instructions

• 'Describe' l.e. 'set out the characteristics of. Use brief sentences but give more depth than if the instruction was 'state'.


courses in Hong Kong. For questions, please email tOhkicpa@ftmsaf.com.hk

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• 'Explain' i.e. make plain, clarify, elucidate. For example, defining a term does not explain it, but providing an illustration may do so.

• 'State' i.e .. express in words. Use one short sentence (bullet point) to make each answer

point.

• 'Discuss' i.e. give balanced views on and conclude (where appropriate).

• 'List' i.e. make a list of like things.

• 'Justify' i.e. give reasoning.

• 'Identify' e.g. from the scenario. This requirement is often implied rather than expressly stated.

For example, 'Describe the risks ... .' requires that the risks be identified before they can be described.

• 'Comment' i.e. make observations, appraise and/or examine (critically).

• 'Suggest' i.e. propose or put forward.

Examples of Contents

Although you will not have yet looked at the scenario, you can jot down any potentially relevant mnemonics, 'ideas lists' or other aide memoirs which you find useful. The following commentary is offered not only to help you think about what is called for, but also to offer guidance on how to respond directly.

• 'Procedures' and 'Work' (may be preceded by the word 'audit') i.e. what you should do - requires actions. For example, there are five audit procedures in SAS 400, Audit Evidence, namely Analyse, Enquire, Inspect, Observe and compUte (mnemonic: 'AEIOU'). Do not be constrained by such ideas lists - think of similar and related actions (e.g. review, ask, confirm, circularise, compare, calculate, etc).

()

• 'Matters', 'Factors' (also 'Issues' and 'Considerations') are things to be taken account of - which must therefore be of relevance. In the context of a planning question these might include risks (see below), materiality, reliance on internal controls, timescale, etc.

• 'Internal controls' (or simply 'controls' or 'internal control procedures') i.e. what the entity (not the external auditor) should be doing to prevent things going wrong. SAS 300, Risk Assessments and Internal Control, identifies two levels of control:

1. the control environment (e.g. audit committee, organisational structure, management supervision, internal audit and segregation of duties); and

2. control procedures, specifically:

-limiting direct Physical access to assets and records

- approving Accounting reconciliations

- making Comparisons e.g. physical counts against accounting records

- checking· Arithmetical accuracy of records ()

- Maintaining and reviewing control accounts and trial balances \ .... _

- Approving and controlling documents

- controlling Computer information systems. (mnemonic PAC-A-MAC)

• 'Evidence' i.e. what you want to know, as auditor. To generate ideas think about:

1. sources of evidence (i.e. internal, external, written, oral, auditor-generated); 2. - the procedures by which they are obtained ('AEIOU' above); and

3. the financial statement assertions about which evidence is sought. Eg occurrence, completeness, valuation, cut off etc (see CLP 7.3.2)

• 'Implications', 'Effect', 'Impact' and 'Consequences' i.e. what difference, if any, does it make?

• 'Risks' eg risk of material misstatement in the financial statements (from an auditing perspective). Candidates should be able to distinguish between and assess both risk of MM at FS level and those at the assertions level.

• 'Why' and 'Reasons' call for justification. Think 'because .. .' or 'due to ... .'.

• 'Enquiries' i.e. questions (Begin, for example, with What', 'How', 'Why' and end with a'?')



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• 'Objectives' e.g. of controls. For ideas consider 'CAVE' i.e. Completeness, Accuracy and Validity (of transactions) and Existence (of resulting assets and liabilities). One way of addressing objectives is to respond 'To ensure that ... good things happen (or bad things do not happen)'.

• 'Weaknesses', 'Limitations' 'Disadvantages' etc. Respond with 'negative' words like 'no', 'poor', 'difficult'. Similarly for 'Advantages', 'Benefits' etc use 'positive' words like 'good', 'easy'.

b) READ THE CASE STUDY SCENARIO

Ensure that you appreciate the following:

• Your 'role' within the scenario (e.g. as senior, manager, reporting partner).

• The dates involved (e.g. the year end, reporting deadline, current date, etc). In FPE exams, you will likely be given 'real time' dates - so if you are sitting an exam in December and planning an audit for the year ending 31 December - that is imminent!

• The 'status' of the client e.g. whether it is: - new or existing;

- large or small;

- likely to have an internal audit department.

• . The nature of the client's business. If relevant, this will give you an insight into the potential factors and problems which you will be required to discuss.

For example, a heavy industrial engineering business is likely to have complex inventory and work in progress, while a travel agent would have minimal inventory but would require a system to deal with advance bookings, the taking of deposits and the calculation of commission.

• The extent to which the client operates a computerised system, which will affect the tone and jargon of your answer to a question concerning, for example, internal controls.

c) PLAN YOUR ANSWER

~

The importance of adequate planning cannot be over-emphasised. Fail to plan, plan to fail.

Adequate planning leads to an organised logical structure to your answer, incorporating all the points you can come up with and highlighting your powers of analysis and communication.

A lack of planning leads to a disorganised illogical jumble of scraps of thoughts and ideas, causing you to omit key elements of the question and repeat an~wer points already made.

How much planning is needed on each question depends, in the main, on just two factors:

i) How much the requirement and scenario are broken down into parts - the more this is already done for you, the less you need to do.

ii) The marks allocation. In general, the more marks allocated, the more planning will be required.

When you are familiar in exam techniques, planning answers should take only a few minutes.

Ensure that you read the question thoroughly, as discussed in 2 above. Highlight key points or note them down to ensure that you incorporate them in your answer.



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Plan your answer in whatever way you prefer: some people like to use 'mind maps' or 'spidergrams' and put everything on the page 'and then assemble it into order; others prefer to put down key headings and then allocate points to them as they work through the question.

If you jot down an answer plan do so on your answer script, rather than YOW question paper, so you can submit it. Clearly head up the page 'answer plan' or 'workings'.

d) WRITE THE ANSWER

If you have adequately read, thought and planned, this should be the easiest part of the whole exercise. Points to remember:

• Use underlined headings and subheadings (generated by the requirement and any breakdown of the scenario into parts) to produce a logical and structured answer.

This approach is effective in providing focus for your answer and enhances presentation. (you should not reword the requirements into introductory sentences as recommended by some (former) examiners and tutors because, not only is it time-consuming, it does not earn marks and candidates fail to identify the key words and so fail to focus on the question set.)

• Maintain a sentence structure and keep sentences and paragraphs short and succinct.

• Explain and define where necessary (e.g. if writing to a layman, explain phrases such as 'inherent risk' briefly: 'inherent risk, that is the susceptibility of an item in the accounts to misstatement .. .').

• Try to achieve a good standard of English. Note that although you will not lose marks for spelling mistakes and poor grammar, you may lose marks if your answer paints cannot be understood by the marker.

• Allow plenty of space to present your answer and, if your writing is difficult to read, write on every other line.

Candidates often ask "how much should I write". Your examiner is not interested in volume. So do yourselves (and your markers) a favour - answer the question set and thinkabout the relevance of what you are writing.

e)

SUMMARY

o

When attempting an exam style and standard question, always practise exam technique so that it is second nature to you by the time of the real exam.

• Spend time thorouqhly reviewing your answer against the 'model' answer and make a note of the points you missed. (Do not be despondent if some of the answers you encounter do not follow the guidance of this article - historically 'model' answers are written solely to convey technical content rather than exam technique.)

• Study the examiner's comments on candidates performance in previous exams, areas of weakness and suggestions for improvements.

• Practice 'effective writing' in all your studies - it is not unique to answering auditing questions!

These notes are prepared by FTMS lecturing team. They are for the sale use of FTMS students attending HKICPA FE 8

courses in Hong Kong. For questions, please email tohkicpa@ftmsatcom.hk

FTMS Hong Kong


3) KEY AREAS FOR THIS COMING FE EXAM (MODULE C SPECIAL TOPICS)

3.1) PROFESSIONAL ETHICS (CLP 4)

Always a question, usually.5 marks.

Special topic added for this diet is Professional Accountants in Public Practice (CLP 4.3). Who is he? Audit

iW/W1(jW

What are the ethical issues facing this group of CPAs? <J

Approach to answering FE ethi@ question:

First, we need to be aware of the 5 fundamental principles:

1,0, C, C, P - Can you recall them (CLP 4.2)?

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C O'M~Q_~~lQ_ canf{dj\\.iltl\\~ P ~·fUd()~o.\ be~~~iG\N( ~dat)m ~~) -) ~cnMMct

Once we see the principle reflected in the case, then we need to identify the threat that may influence or affect how the auditor (Professional Accountants in Public Practice) will behave. Eg if the auditor received an expensive gift from the client, the self interest threat may come in and it may threatened his objectivity when he performs the audit later.

Threats for compliance with the code of ethics (CLP 4.2.3, details in CLP 4.3.1)

a) Self-interest threat
b) Self-review threat (~PEI cot ~ j ffl1Q{xtJ djC«!je~ .
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c) Advocacy threat
d) Familarity threat
e) Intimidation threat See below table for a summary:

Self-Interest

When carrying out the audit, the auditors review work that their own firm has undertaken previously, e.g. preparing accounts or making a valuation.

The auditors' own personal interest, e.g. the auditors may fear the loss of fees.

Self-review

f the auditors get involved in disputes concerning the client, they may nd up acting for or against the ciient, which undermines the appearance of objectivity



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HKICPA Final Examination Module C ~ Course Notes

Familiarity If the auditors are involved with the client for a long time, they may
become unduly sympathetic towards directors and management and
thus too inclined to trust their unsupported word.
Intimidation The auditors may be deterred from acting objectivIty by threats,
actual or perceived. Next step aftering identifying the threat .

The code did not require auditors to eliminate the threat totally. In fact some threats can never be removed (eg we collect fees from the client we audit = there is always a self interest threat). But the code wants us to evaluate the significance of the threat and if it is significant, we have to put in safeguards to reduce the threat to an insignificant level.

Safeguards against these threats can be classified into three board categories:

a)

Safeguards created by the profession, legislation or regulation. Eg. CPD requirement, education, training and practical experience for entry into the profession, corporate governance regulations, professional auditing standards, practice monitoring, disciplinary procedures.

b) Safeguards in the work environment, which is broken down into firm-wide safeguards and engagement specific safeguards.

Common safeguards in the work environment include:

Within the client, the person appointing/approving the appointment of the auditor is not the management. Eg r~p?rtin~ to the chair~an (an independent non-executive director)

of the audit committee (~~~ 11\ OOL(A€_ . C1t~M\"CQ.)

Use different partner/manager or a separate eaK-! to perform non-audit work to the same ..

~.\.\il:audit client .1cl. u.p

t~\Firm's policies and proceduresVWith'regard to ac, independence

Monitoring of the policies and procedures mentioned above to ensure staff are aware of them and comply with them drt+nrl

Independent partner/Second partner review V~,~::'~

Rotation of senior personnel (eg audit partner every 7 years for listed clients) Discussing/Disclosing to management or audit committee of the client Removing the staff from the team

c) Safeguards within the client's systems and procedures (eg. on appointment of auditor or firm performing other services, firm's corporate governance structure that provides oversight regarding the audit firm's services)

Specific issues for the professional accountant in public practice (CLP 4.3)

a) Fees -\\<> . ~~-\ -\.1tfI - ~ ~

Amount of fees - CLP 4.3.5 !Ili "'\\\~~ 10 ~;Ii41 ~l-l \)$ ~ J,,"i1Jv .tWr J\-.-/ka_ jd, G'V ~

- If it's too hi9~ . 7l'~ ~ 1 III -11& lit yl .f etUJ1K, . {f

~~M( - Ifit'stooIOW'1I'(W\A\lf~ -1 ll/"~h ~ ~ v.&dHl~~' t~V& ~ ~I /

9_~J.\ &\ 6- Contingent fees- CLP 4.3.5.1 Odvc'l,svp OV lPO J~{,(£.- r": ~ Jb-i1._'

. 'j (h [ff y( tMU,{lf~ ~ . . .'

Referral fees or commissioq (it is alright pr~d "'(ft dlicLos~ ~_ I :ht," ~ j~ .~ altJ ftAW VI.P-IJJ

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b) Independ~nce (CLP 4.4) --1 ~. ef ~d..0?0Y--deKQ·.

You must go through CLP 4.4.3 to 4.4.9 on the seven different situations where independence may be threatened and what safeguards can we put in to minimise the threat.

);> Financial interests (CLP 4.4.3)

);> Loans and guarantee (CLP 4.4.4) ~ liN \3o..nk Q.1 q Dlcl ~(GJ~ );> Family and personal relationships (CLP 4.4.5)

Immediate family member - director of the assurance client (CLP 4.4.5.1)

Immediate family member - employee with direct and significant influence over the subject matter (CLP 4.4.5.2)

Close family member (CLP 4.4.5.3)

Persons other than an immediate or close family member (CLP 4.4.5.4)

Person other than a director or employee with direct and significant influence (CLP 4.4.5.5)

>- Employment with assurance clients (CLP 4.4.6)

r>. A member of assurance team joined the assurance client (CLP 4.4.6.1)

A member of assurance team will or may join the assurance client (CLP 4.4.6.2)

>- Serving as an officer or director on the Board of assurance clients (CLP 4.4.7) Director of an assurance client (CLP 4.4.7.1)

Company secretary of an assurance client (CLP 4.4.7.2)

);> Long association of senior personnel with assurance clients (CLP 4.4.8) Financial statement audit clients that are listed entities (CLP 4.4.8.1)

>- Provision of non-assurance services to assurance clients (CLP 4.4.9) Preparing accounting. records and financial statements (CLP 4.4.9.1) Valuation services (CLP 4.4.9.2)

Provision of taxation services to financial statement audit clients (CLP 4.4.9.3) Provision of IT systems services to financial statement audit clients (CLP 4.4.9.4) Corporate finance and similar activities (CLP 4.4.9.5)

See Q1 to Q5 at the back of this set of notes now.

/> c)

Professional Appointment (CLP 4.3.3 or 6.2.8)-

New client or continuing client - points to consider:

ICE

a} Integrity of client - consider the integrity of client management, possibility of illegal activities, factors or issues that could cast doubt on the integrity of management. Eg Reason for changing auditor (if this is a new appointment), stress and pressure, refuse to pay fees to auditor, non-compliance with laws and regulations.

b) Competence and due care, : ~ reJWA..CQ, tlJW.N~d¥ of ~~ I h(o.t~ crt- -fk d).A.(/r~

c) Ethical requirements - evaluate any threats to compliance with code of ethics (if yes, what

safeguards are in place to reduce the threats?) ~ old %1c ali A ().ro.., &q) ~lJ) Q 171 &,3

Include the discussion of professional clearance procedures (only if this is a new engagement; also known as changes in professional appointment). We need to contact the current/existing auditors. (what if the case (in one of the module C exam) said that the SOLE partner in charge of the audit

died - do we still need to write in for clearance? If not, what alternative procedures can we perform?)

-7 Some common factors to consider before accepting an engagement:



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Integrity of client (mgt). Usually not much info. given but we have to interpret the case. Some factors to consider include the company's size and operation and also their plan to go public. Motivation for mgt bias in reporting. Pressure to show good results?

Who is the current auditor - we need to seek clearance from them. Permission to be given by company otherwise, cannot accept appointment

Consider the risks. Eg: Lawsuit, government policies (or politics) going concern, cash flow problem, overtrading

Management experience and knowledge - Young company? New mgt team.

Company may be subjected to extensive law and regulations. Eg banking, health and safety, element of public interests.

Experience and technical knowledge of the audit firm in the industry. Anyone in the firm, esp, the audit partner, familiar with this type of industry?

Ability to service the client well (meeting their deadlines, able to understand their. business and

recommend improvements to their IC when necessary) ()

We need to assess whether we can serve as the principal auditor. We should consider whether

our own participation is sufficient for us to act as the principal auditor (HKSA 600).

If client planning for listing next year. Are we able to continue to service the company when they get listed? Again our firm size, the issue of audit fees (undue dependence on one client rule?)

Independence problems? Rules of independence, any issues or possible threat to the fundamental principles?

Conflict of interests? (CLP 4.3.4)

d) The ethical issue of confidentiality (CLP 4.6)

A CPA acquiring information in the course of his professional work should neither use, or appear to use, that information for his personal advantage or for the advantage of a third party.

A CPA must make clear to a client that he may only act for him if the client agrees to disclose in full to !~ the member all information relevant to the engagement.\ ... J

Where a CPA agrees to serve a client in a professional capacity, both the CPA and the client should

be aware that it is an implied term of that agreement that the CPA will not disclose the client's affairs

to any other person save with the client's consent within the terms of certain recognised exceptions.

What are those exceptions?

Obligation to disclose - If a member knows or suspects his client to have committed an offence of treason he is obliged to disclose all the information at his disposal to a competent authority. Local legislation may also require auditors to disclose other infringements.

Freedom to disclose - In certain cases voluntary disclosure may be made by the member where:

• Disclosure is reasonably required to protect the member's interests

• Disclosure is required by process of law

• There is a public duty to disclose

• To comply with technical standards and ethical requirements

• To comply with the quality review of a member or professional body

• To respond to an inquiry or investigation by a member body or regulatory body



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HKICPA Final Examination , Module C - Course Notes

If a member is requested to assist the police, the tax authorities or any other authority by providing information about a client's affairs in connection with enquiries being made, he should enquire under what statutory authority the information is demanded

Unless he is satisfied that such statutory authority exists, he should decline to give any information until he has obtained his client's authority. If the client's authority is not forthcoming and the demand for information is pressed, he should not accede unless advised to by a solicitor.

Disclosure in the public interest

The courts have never given a definition of 'the public interest'. This means that again, the issue is left to the judgement of the auditor. It is often therefore appropriate for the member to seek legal advice.

The guidance states that there are several factors that the member should take into account when deciding whether to make disclosure. They should consider:

•

The size of the amounts involved and the extent of likely financial damage Whether members of the public are likely to be affected

, The possibility or likelihood of repetition

The reasons for the client's unwillingness to make disclosures to the authority The gravity of the matter

Relevant legislation, accounting and auditing standards Any legal advice obtained

,~ .'

•

•

.'

•

•

These notes are prepared by FTMS lecturing team, They are for the sale use of FTMS students attending HKICPA FE 13


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3.2) Understanding the entity and its environment, assessing the risk of material misstatements (Risk of MM) = CLP 7 and 8

Definition of risk (= CLP 7.1)

The risk of material misstatement can cover: - at financial statement level·

- at assertion level

a) Risks of MM % the fin~ncial statement level (see Q6b) -) (l~ 7.l, & ·tt, t.

Dl-rd. J f1_o.} (9"1.£ til. '1) I Q1Rb

Risks of material misstatement at the overall financial statement level refer to risks of material misstatement that relate pervasively to the financial statements as a whole and potentially affect many assertions.

Risks at the financial statement level may derive in particular from a deficient control environment.

In addition to a Weak control environment, other conditions m<»[ also lead to higher risks of misstatement at the financial statement level. This may include~ggressive business strategies, significant business risks arising fron@::hanges or complexity of business operations, or unusually, high 0

pressures on performance measures and review. CS;J

Ex~ples of factors that affect the risk of MM at the overall financial statement level: • W management integrity (eg mgt override internal controls)

· ! management experience and knowledge .

• unusual pressures on management (eg. Plans to go public listing, bonus tied to sales or profit)

• nature of entity's business (eg. Financial institution involved with derivative trading:£! ._('",Jj(lr( -f, (;.. ('Ili ~ VAr.-]

• . industry factors (eg. Industry undergoing major regulatory and reporting changes) fc r-{!.q!A(~m

(1) IItlit'.ll -fi-.Q_ (ukt_+ M'lv\

b) Risk of MIVT<JUhe assertion level ~ )W\Q V~JI,t~ GtU\lQ(}vt'~,~ AA.~~ ~vr.J.~. . L

\._ DlbC) '-·a \ \ "YJ lr\!J\\\ ~{Q(/\,1A..V, (Vl yQJV~:NIJe ~ nSl"

Risks of material misstatement at the assertion level for classes for transactions, account balances, I

and disclosures need to be considered because such consideration directly assists in determining the

nature, timing and extent of further audit procedures at the assertion level necessary to obtain

sufficient appropriate audit evidence.

At the assertion level, the risk comprised of two components:

Inherent Risk

C)

Inherent risk refers to the susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that could be material. either individually or when aggregated with other misstatements, before consideration of any related controls ..

Examples of higher inherent risks: ;1 V~~ of fl

• it may be higher for complex calculations or for accounts consisting of amounts derived from accounting estimates that are subject to significant estimation uncertainty

•

technological developments might make a particular product obsolete, thereby causing inventory to be more susceptible to overstatement

•

a lack of sufficient working capital to continue operations or a declining industry characterized by a large number of business failures



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Control Risk

Control risk is the risk that a misstatement that could occur in an assertion about a class of transactions, account balance or disclosure and that could be material, either individually or when aggregated with misstatements, will not be prevented or detected and corrected on a timely basis by the entity's internal control.

There is a higher chance of the error remaining undetected when there is high control risk. If the company has good internal controls, there is a high chance that the control system will detect a material error. Therefore good internal controls lead to lower control risk. (A lower control risk is where there is a good internal control system)

The use of assertions

The management of the client is responsible for the fair presentation of financial statements that reflect the nature and operations of the client. In representing that the financial statements give a true and fair view (or are presented fairly, in all material respects) in accordance with the applicable financial reporting framework, management implicitly or explicitly makes assertions regarding the

~ recognition, measurement, presentation and disclosure of the various elements of financial statements and related disclosures.

Assertions used by auditor to consider the different types of potential misstatements fall into the following categories:

Assertions about classes of transactions and events for the period under audit:
Occurrence Transactions and events that have been recorded have occurred and
pertain to the entity
Completeness All transactions and events that should have been recorded have been
recorded
Accuracy Amounts and other data relating to recorded transactions and events
have been recorded appropriately
Cutoff Transactions and events have been recorded in the correct accounting
period
Classification Transactions and events have been recorded in the proper accounts Assertions about account balances at the period end:
Existence Assets, liabilities, and equity interests exist
Rights and The entity holds or controls the rights to assets, and liabilities are the
obligations obligations of the entity
Completeness All assets, liabilities and equity interests that should have been
recorded have been recorded
Valuation and Assets, liabilities, and equity interests are included in the financial
allocation statements at appropriate amounts and any resulting valuation or
allocation adjustments are appropriately recorded These notes are prepared by FTMS lecturing team. They are for the sale use of FTMS students attending HKICPA FE 15


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Assertions about presentation and disclosure:
Occurrence and Disclosed events,' transactions, and other matters have occurred and
rights and pertain to the entity
obligations
Completeness All disclosures . that should have been included in the financial
statements have been included
Classification and Financial information is appropriately presented and described, and
understandability disclosures are clearly expressed
Accuracy and Financial and other information is disclosed fairly and at appropriate
valuation amounts c) Significant risk

Significant risk is an identified and assessed risk of material misstatement that, in the auditor's judgement, requires special audit consideration.

» Significant risks relating to non-routine transactions

Non-routine transactions are transactions that are unusual, due to either size or nature, and that therefore occur infrequently. Risks of material misstatement may be greater for significant non-routine transactions arising from matters such as the following:

Greater management intervention to specify the accounting treatment

Greater manual intervention for data collection and processing

Complex calculations or accounting principles

The nature of non-routine transactions, which may make it difficult for the entity to implement effective controls over the risks

» Significant risks relating to judgmental matters

Judgemental matters may include the development of accounting estimates for which there is significant measurement uncertainty.

Risks of material misstatement may be greater for significant judgemental matters that require the development of accountingestlmates, arising from matters such as the following:

CJ

Accounting principles for accounting estimates or revenue recognition may be subject to differing interpretation; and

Required judgment may be subjective or complex, or require assumptions about the effects of future events.

The auditor shall determine whether any of the risks identified are, in the auditor's judgment, a significant risk. In exercising this judgment, the auditor shall exclude the effects of identified controls related to the risk.

In exercising judgment as to which risks are significant risks, the auditor shall consider at least the

following: - .

(a) Whether the risk is a risk of fraud;

(b) Whether the risk is related to recent significant economic, accounting or other developments and, therefore, requires specific attention:

(c) The complexity of transactions;



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(d) Whether the risk involves significant transactions with related parties;

(e) The degree of subjectivity in the measurement of financial information related to the risk, especially those measurements involving a wide range of measurement uncertainty; and

(f) Whether the risk involves significant transactions that are outside the normal course of . business for the entity, or that otherwise appear to be unusual.'

d) Risks for which substantive procedures alone do not provide sufficient appropriate audit evidence (automation risk)

Where routine business transactions (e.g. revenue, purchase and cash receipts or cash payments) are subject to highly automated processing with little or no manual intervention, it may not be possible to perform only substantive procedures in relation to the risk.

Audit evidence may be available only in electronic form, and its sufficiency and appropriateness usually depend on the effectiveness of controls over its accuracy and completeness.

In respect of some risks, the auditor may judge that it is not possible or practicable to obtain sufficient appropriate audit evidence only from substantive procedures. Such risks may relate to the inaccurate or incomplete recording of routine and significant classes of transactions or account balances, the characteristics of which often permit highly automated processing with little or no manual intervention.

In such cases, the entity's controls over such risks are relevant to the audit and the auditor shall obtain an understanding of them.

Approach to answering the risk of MM question in FE exam:

Firstly, define the risk. Is it FS level risk? If not, assertion level, define the relevant assertions, is it significant risk?

Next, give a brief list of what are the factors that would normally increase that risk.

Then, you need to go back to the case study and identify the factors or events or transactions that will affect the risk that you are assessing.

Finally, have a conclusion, If the question asked you to assess, you must say whether the risk is HIGH, MEDIUM or LOW.

Practice lots of questions on this topic - See 06 to 013.

3.3) Procedures in response to the assessed risks (CLP 9)

ForFS level risk = We have overall responses (CLP 9.1)

HKSA 315 states the following overall responses (4 + 1 points):

emphasising to the team the need to maintain professional scepticism assigning more experienced staff or those with special skills or using experts providing more supervision,

incorporating additional elements of unpredictability in the selection of further audit procedures to be performed, or

the auditor may make general changes to the nature, timing, or extent of audit procedures as an overall response, for example, performing substantive procedures at period end instead of at an interim date.

These notes are prepared by FTMS lecturing team. They are for the sole use of FTMS students attending HK1CPA FE 17


FTMS Hong Kong


For assertion level risk= We have to amend the nature, timing and extent of procedures (CLP 9.2)

The auditor should design and perform further audit procedures whose nature, timing, and extent are responsive to the assessed risks of material misstatement at the assertion level. The purpose is to provide a clear linkage between the nature, timing, and extent of the auditor's further audit procedures and the risk assessment.

In designing further audit procedures, the auditor considers such matters as the following:

The significance of the risk.

The likelihood that a material misstatement will occur.

The characteristics of the class of transactions, account balance, or disclosure involved.

The nature of the specific controls used by the entity and in particular whether they are manual or automated.

Whether the auditor expects to obtain audit evidence to determine if the entity's controls are effective in preventing, or detecting and correcting, rnaterlal misstatements.

Again practicing and review how the FE examiners wrote those substantive procedures are important for the exam! (see 06 to 013)

3.4)

Initial engagement - opening balances (CLP 12.2) H~tlo

In conducting an initial audit engagement, the objective of the auditor with respect to opening balances is to obtain sufficient appropriate audit evidence about whether:

Opening ba~s contain misstatements that materially affect the current period's financial statements;~

Appropriate accounting policies reflected in the ope~' g balances have been conslstently applied in the current period's financial statements, or changes thereto are appropriately

accounted for and adequately presented and disclos in accordance with the applicable financial reporting framework.

(HKSA 510)

The natur@xtent of audit procedures necessary to obtain sufficient appropriate audit evidence

regarding opening balances depend on such matters as: .

a) b)

The accounting policies followed by the entity

The nature of the account balances, classes of transactions and disclosures and~\ the risks of material misstatement in the current period's financial statements J

The significance of the opening balances relative to the current period's financial statements

Whether the prior period's financial statements were aUdited§f so, whetherthe predecessor auditor's opinion was modified

V;Udit pro~ on opening balance

CD >-

The auditors shall read the most recent financial statements, if any, and the predecessor auditor's report thereon, if any, for information relevant to opening balances, including disclosures.

The auditor shall obtain sufficient appropriate audit evidence about whether the opening balances contain misstatements that materially affect the current period's financial statements by:

(a) Determining whether the prior period's closing balances have been correctly brought



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forward to the current period or, when appropriate, have been restated;

(b) Determining whether the opening balances reflect the application of appropriate accounting policies; and

(c) Performing one or more of the following:

1. Where the prior year financial statements were audited, reviewing the predecessor auditor's working papers to obtain evidence regarding the opening balances;

ii. Evaluating whether audit procedures performed in the current period provide evidence relevant to the opening balances; or

iii. Performing specific audit procedures to obtain evidence regarding the opening balances.

(For details of ci to clii, see below)

® cil

Reviewing the predecessor auditor's working paper

r=>: When the prior period's financial statements were audited by a predecessor auditor, the current auditor must read the most recent financial statements and predecessor auditor's report for information relevant to opening balances.

The current auditor may be able to obtain sufficient appropriate evidence regarding opening balances by performing this review depending on the professional competence and independence of the predecessor auditor.

ell)

Audit evidence obtained from current period audit

. For current assets and liabilities, some audit evidence about opening balances may be obtained as part of the current period's audit procedures. For example, the collection (payment) of opening accounts receivable (accounts payable) during the current period will provide some audit evidence of their existence, rights and obligations, completeness and valuation at the beginning of the period.

For non-current assets and liabilities, some audit evidence may be obtained by examining the accounting records and other information underlying the opening balances. In certain cases, the auditor may be able to obtain some audit evidence regarding opening balances through

~ confirmation with third parties, for example, for long-term debt and investments. In other cases, the auditor may need to carry out additional audit procedures.

In the case of inventories, however, the current period's audit procedures on the closing inventory balance provide little audit evidence regarding inventory on hand at the beginning of the period. Therefore, additional audit procedures may be necessary.

Performing audit procedures on the valuation of the opening inventory items (review NRV selling price of inventory made in the first few months of the year)

Performing audit procedures on gross profit and cut off (first few days of the year)

ciii) Performing additional audit procedures

In the above examples of inventory, the additional audit procedures that can be performed include:

Observing a current physical inventory count and reconciling it to the opening inventory quantities

These notes are prepared by FTMS lecturing team. They are for the sale use of FTMS students attending HKICPA FI;: 19

courses in Hong Kong. For questions, please emall to hkicpa@ftmsaf.com.hk

FTMS Hong Kong


Special issues related to opening balances

1) Material misstatements in opening balances

If the auditor obtains audit evidence that the opening balances contain .misstatements that could materially affect the current period's financial statements, the auditor shall perform such additional audit procedures as are appropriate in the circumstances to determine the effect on the current period's financial statements.

2) Accounting policies consistently applied in the current period

The auditor shall obtain sufficient appropriate audit evidence about whether the accounting policies reflected in ~pening balances have been consistently applied in the current period's financial statements, and hether changes in the accounting policies have been appropriately accounted for and adequa presented and disclosed in accordance with the applicable financial reporting framework.

3) Effect of a modification to the predecessor auditor's opinion

If there was a modification to the opinion, the auditor must evaluate the effect of the matter giving rise to the modification in assessing the risks of material misstatement in the current period's financial statements.

Audit conclusion and reporting

;?- Unable to obtain evidence

If the auditor is unable to obtain sufficient appropria~e~dit evidence regarding the opening balances, the auditor shall express a qualified opinio~disclaim an opinion on the financial

statements, as appropriate. .

;?- Misstatement in opening balance

If the auditor concludes that the opening balances contain a misstatement that materially affects

the current period's financial statements, and the effect of the misstatement is not appropriately accounted for or not adequately presented or disclosed, the auditor shall express a qualified 0

oPinio~n adverse opinion, as appropriate. ', _ _}

;?- Inconsistency of accounting policies

If the auditor concludes that:

(a) the current period's accounting policies are not consistently applied in relation to opening balances in accordance with the applicable financial reporting framework; or

(b) a change in accounting policies is not appropriately accounted for or not adequately

presented or disclosed in accordance with the applicable financial reporting framework,

the auditor shall express a qualified oPinion(§)an adverse opinion as appropriate.'

If the prior period auditor's report was modified, the auditor should consider the effect on the current period's financial statements. For example, if there was a scope limitation in the prior period, but the matter giving rise to the scope limitation has been resolved in the current period, the auditor may not need to modify the current period's audit opinion.



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Modification to the opinion in the predecessor auditor's report

If the predecessor auditor's opinion regarding the prior period's financial statements included a modification to the auditor's opinion that remains relevant and material to the current period's financial statements, the auditor shall modify the auditor's opinion on the current period's financial statements.

3.5) Auditing accounting estimates, including fair value accounting estimates, and related disclosures (old CLP 10.4 and 10.5)

The objective of the auditor is to obtain sufficient appropriate audit evidence about whether:

a) accounting estimates, including fair value accounting estimates, in the financial statements, whether recognized or disclosed, are reasonable; and

b) related disclosures in the financial statements are adequate in the context of the applicable

financial reporting framework. H~A.tlf:O

Risk assessment procedures required

r=-;

When performing risk assessment procedures and related activities to obtain an understanding of the entity and its environment, including the entity's internal control, the auditor shall obtain an understanding of the following in order to provide a basis for the identification and assessment of the risks of material misstatement for accounting estimates:

(a)

The re uirements of the a licable financial re ortin framework relevant to acc~~~ tlV\~~

estimates, including related disclosures- J: \'ltWi. . t'G) 1) r~ Tu 111,;+ I( i~

ft_ ( All~)1 I U I!(IJrc.!\!3 t'f or-. Px 17~ /aw.tl t:l ./1

How management identifies those transactions, eventsf:'~~o~~itions that may 9ivJ crhe(w.b{Q Dl c rise to the need for accounting estimates to be recognized or disclosed in the financial ibm &,{.~u.N(Q. statements. In obtaining this understanding, the auditor shall make inquiries of

management about changes in circumstances that may give rise to new, or the need to

revise existing, accounting estimates

(b)

(c)

How management makes the accounting estimates, and an understanding of the data

on which they are based, including: .

i. The method, including where applicable the model, used in making the accounting estimate;

~ ii. Relevant controls;

iii. Whether management has used an expert;

iv. The assumptions underlying the accounting estimates;

v. Whether there has been or ought to have been a change from the prior period in the methods for making the accounting estimates, and if so, why; and

vi. Whether and, if s~bf~oW mfnag~~fnt !:s assessed the effect of estimation M Il

uncertainty.' 1.)J~1I.t~r:~e~ wvo\+~. ~~ ~O -1 (AA'Vl~ ~ ~hi~~ (~k Ue~ C)

OfI.lY, (:"'clo.U~\.c_o.t~e 7lJ-rT \ Ift./nk h"I'Iyfl'._byt..e ~l\fa~)\ tuP.

9 JI.!la~rxr'h l ~(e:;'UIJ~.~~ V {QCQ.WFtM (A~Q

Identifying and ssessing the risks 01 mlterial misstatement .l(tf~ ow.r~ 'V'f"11 :oR.\.. '. ,

, . J AWv..QUJr -- I\(Q] ((~,tlY!{~ft£U~ l.d~ ..v~

The auditor is required to assess the entity's process for determining accounting ~ ffm~eJ~f%:I~~inW ~~~ reta4 fair value measurements and disclosures and the related control activities and to assess the arising

risks of material misstatement. h rM~<!llfi.i

In identifying and assessing the risks of material misstatement, the auditor shall evaluate the degree Ml{Jf (]j1IJf2j{ I

of estimation uncertainty associated with an accounting estimate. ~ l¢< .

The degree of estimation uncertainty associated with an accounting estimate may be ~\,~~p Whl

influenced by factors such as: ffVi 'lh.lJl{6t,

:-ftv-Q '

The extent to which the accounting estimate depends on judgment


courses in Hong Kong. For questions, please email tOhkicpa@funsaf.com.hk

FTMS Hong Kong

HKICPA Final Examination Module C M Course Notes

The sensitivity of the accounting estimate to changes in assumptions

The existence of recognized measurement techniques that may mitigate the estimation uncertainty (though the subjectivity of the assumptions used as inputs may nevertheless

give rise to estimation uncertainty)..A\~~.~~--) A-'<~'K '* Q\\~tt ~S!~

The length of the forecast period, and the relevance of data drawn from past events to forecast future events

~~. "-

The availability of reliable data from external sources CB\~~~

The extent to which the accounting estimate is based on observable or unobservable

inputs .

Examples of accounting estimates that may have high estimation uncertainty include the following:

Accounting estimates that are highly dependent upon judgment, for example, judgments about the outcome of pending litigation or the amount and timing of future cash flows dependent on uncertain eJents many years in the future.

~ ~~.eKP~ ()

Accounting estimates that are not calculated using recognized measurement techniques.

Accounting estimates where the results of the auditor's review of similar accounting estimates made in the prior period financial statements indicate a substantial difference between the original accounting estimate and the actual outcome.

Fair value accounting estimates for which a highly specialized entity-developed model is used or for which there are no observable inputs.

Responses to the assessed risks of material misstatement

Based on the assessed risks of material misstatement, the auditor shall determine:

(a) Whether management has appropriately applied the requirements of the applicable financial reporting framework relevant to the accounting estimate; and

(b) Whether the methods for making the accounting estimates are appropriate and have been applied consistently, and whether changes, if any, in accounting estimates or in the method for making them from the prior period are appropriate in the circumstances.'

Audit procedures will depend heavily on the complexity of the fair value measurement. Where the fair value equates to market value, the auditor should be able to verify this with reference to the market or by using the work of an expert.

In responding to the assessed risks of material misstatement, the auditor shall undertake one or more of the following, taking account of the nature of the accounting estimate:

(a) Determine whether events occurring up to the date of the auditor's report provide audit evidence regarding the accounting estimate

(b) Test how management made the accounting estimate and the data on which it is based. In dOing so, the auditor shall evaluate whether:

I. The method of measurement used is appropriate in the circumstances; and

il. The assumptions used by management are reasonable in light of the measurement objectives of the applicable financial reporting framework.



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~~-) (e)

\l.\t0\

(d)

Test the operating effectiveness of the controls over how management made the accountlnq estimate, together with appropriate substantive procedures

Develop a point estimate or a range to evaluate management's point estimate.

See below for the details of each of the above 4 steps:

(ay..,. Events occurring up to the date of the auditor's report

Determining whether events occurring up to the date of the auditor's report provide audit evidence regarding the accounting estimate may be an appropriate response when such events are expected to occur and provide audit evidence that confirms or contradicts the accounting estimate.

(~)..,. Testing how management made the accounting estimate 0 0. ~) .

Testing how management made the accounting estimate and the data on which it is based may be an appropriate response when the accounting estimate is a fair value accounting estimate developed on a model that uses observable and unobservable inputs.

It may also be appropriate when, for example:

The accounting estimate is derived from the routine processing of data by the entity's accounting system.

The auditor's review of similar accounting estimates made in the prior period financial statements suggests that management's current period process is likely to be effective. The accounting estimate is based on a large population of items of a similar nature that

individually are not significant. .

(C) ..,. Testing the operating effectiveness of controls

Testing the operating effectiveness of the controls over how management made the accounting estimate may be an appropriate response when management's process has been well-designed, implemented and maintained, for example:

Controls exist for the review and approval of the accountinq estimates by appropriate levels of management and, where appropriate, by those charged with governance.

The accounting estimate is derived from the routine processing of data by the entity's accounting system.

Testing the operating effectiveness of the controls is required when:

(a) The auditor's assessment of risks of material misstatement at the assertion level includes an expectation that controls over the process are operating effectively; or

/

(b) SUbstantive procedures alone do not provide sufficient appropriate audit evidence at the assertion level.

l cl) ~ Developing a point estimate or range

Auditor's point estimate or auditor's range is the amount, or range of amounts, respectively derived from audit evidence for use in evaluating management's point estimate.

Developing a point estimate or a range to evaluate management's point estimate may be an appropriate response where, for example:

An accounting estimate is not derived from the routine processing of data by the

These notes are prepared by FTMS lecturing team. They are for the sale use of FTMS students attending HKICPA FE 23 courses in Hong Kong. For questions, please email tohkicpa@ftmsaf.com.hk

FTMS Hong Kong


accounting system.

The auditor's review of similar accounting estimates made in the prior period financial statements suggests that management's current period process is unlikely to be effective.

The entity's controls within and over management's processes for determining accounting estimates are not well designed or properly implemented.

Events or transactions between the period end and the date of the auditor's report contradict management's point estimate.

There are alternative sources of relevant data available to the auditor which can be used

in making a point estimate or a range. /~~~ 'j~~OO\

Further substantive procedures to respond to significant risks ~ ~

Management's reeponse to the estimation uncertainty that give rise to significant risks

For accounting estimates that give rise to significant risks, in addition to other substantive procedures performed to meet the requirements of HKSA 330, the auditor shall evaluate the following:

(a) How management has considered alternative assumptions or outcomes, and why it has rejected them, or how management has otherwise addressed estimation uncertainty in making the accounting estimate.

(b) Whether the significant assumptions used by management are reasonable.

(c) Where relevant to the reasonableness of the significant assumptions used by management or the appropriate application of the applicable financial reporting framework, management's intent to carry out specific courses of action and its ability to do so.'

Indications of possible management bias

» Nature of management bias

Management bias is a lack of neutrality by management in the preparation of information. The. susceptibility of an accounting estimate to management bias increases with the subjectivity involved in making it.

» Required audit procedures on possible management bias

The auditor shall review the judgments and decisions made by management in the making of accounting estimates to identify whether there are indicators of possible management bias. Indicators of possible management bias do not themselves constitute misstatements for the purposes of drawing conclusions on the reasonableness of individual accounting estimates.

» Examples of indicators of possible management bias with respect to accounting estimates include:

Changes in an accounting estimate, or the method for making it, where management has made a subjective assessment that there has been a change in circumstances.

Use of an entity's own assumptions for fair value accounting estimates when they are inconsistent with observable marketplace assumptions.

Selection or construction of significant assumptions that yield a point estimate favorable for management objectives.



FTMS Hong Kong


Selection of a point estimate that may indic.ate a pattern of optimism or pessimism.

Obtaining written representation from management

The auditor shall obtain written representations from management and, where appropriate, those charged with governance whether they believe significant assumptions used in making accounting estimates are reasonable.

Examples of representations in the rep letter will include representations:

About the appropriateness of the measurement processes, including related assumptions and models, used by management in determining accounting estimates in the context of the applicable financial reporting framework, and the consistency in application of the processes.

That the assumptions appropriately reflect management's intent and ability to carry out specific courses of action on behalf of the entity, where relevant to the accounting estimates and disclosures.

That disclosures related to accounting estimates are complete and appropriate under the applicable financial reporting framework.

That no subsequent event requires adjustment to the accounting estimates and disclosures included in the financial statements.

See Q8, Q20 and Q21.



FTMS Hong Kong

HKIC?A Final Examination Module C - Course Notes

't25 3.6} Managerial, operational or procedural processes in Organisations-~~ &\Lt{·(j\)Y\-RP\.n, f\.rl-

CJ . ~Y lvo-rW\.\LMJ\

What is this new topic about? = Internal audit (CLP 14.8), operational audit (value for money audit = / /. CLP 14.9) or reviewing internal control system and processes to identify weaknesses and

({ recommending improvements to those processes so as to achieve the objectives of the organisation:

tlY~ l See Q14 to Q17. .

Therefore, we need to read up on CLP 8 on the subsection related to "Internal Control", including

control environment and control activities. y2,::;:'

Can we recall the 5 elements of an internal control system? For the last Dec 2009 FE paper, a 12 marks question in the morning Paper 1(= Q14) was asked on the control environment of the company. We must also be familiar on the other 4 elements of the internal control system.

1) Risk Assessment
2) Communication of information
3) Control activities -1Q\~-\ \l
,~
4) Monitoring :,~ We must also be prepared to perform other assurance and non-assurance services to our client who needs someone to review their processes, or to perform certain agreed upon procedures.

Assurance Engagement not dealing with historical financial information (CL? 5.7)

HKSAE 3000

(clP[q-9)

Compliance audit, performance audit and value for money (VFM) audit ~

A value for money audit is concerned with obtaining the best possible combination of services for the least resources. It is therefore the pursuit of 'Economy', 'Efficiency' and 'Effectiveness' - sometimes

referred to as the three 'Es'. r mil"l\lV\~t eot{ of ~['J\ v.Mt\.9. .p~v.nr\~ ~o.'M ot ffv\.

Economy relates to least cost. The systems in an organisation should operat~ at a minimum cost

associated with an acceptable level Of. risk. l.-ll?,.J' " I th.

riJ'G\'(r-.t ·jl,\~I.AI~D\-"{'f\'\Ml'r\ ~~ (}v S«tkQ.. t)VVI\IN\/ WlWI.;'MQQ mrLM . ,

Efficiency relates to the best use of resources. The goals and objectives of an organisation should be accomplished accurately and on a timely basis with the least use of resources.

Effectiveness provides assurance that organisational obje~~els~iII be achieved.

Review of interim financial reports (CL? 14.1)

HKSRE 2410 - Engagement whereby the auditor reviews the financial statements and states whether anything has come to his attention which would indicate that the accounts do not give a true and fair view.

The objective of a review engagement is therefore to enable the auditor to state whether, on the basis of procedures which DO NOT provide all the evidence that would be require in an audit, anything has come to the attention to the auditor's attention that causes the auditor to believe that the financial statements are not prepared in accordance with an identified reporting framework. (ie negative assurance).

A review engagement provides a moderate level of assurance through the issue of a negative opinion, pursuant to an accountability relationship, to help establish the credibility of a written assertion or set of assertions ..



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Procedures for a review engagement (see CLP 14.1.4 for details) Work would generally consist of:

analytical review

inquiries of management about accounting methods and unusual items agreeing financial statements to underlying accounting records

The procedures that will be involved in this review engagement include:

Obtaining an understanding of the entity's business and the industry in which it operates.

Inquiries concerning the entity's accounting principles and practices.

Inquiries concerning the entity's procedures for recording, classifying and summarising transactions, accumulating information for disclosure in the financial report and preparing the financial report.

Inquiries concerning material assertions in the financial report.

Analytical procedures designed to identify relationships and individual items that appear unusual.

Conclusion and Reporting (CLP 14.1.5)

Negative assurance (negative format of reporting)

Example of review report (see CLP 14.1.7)

We have reviewed the accompanying interim balance sheet of ABC Pte Ltd at 31 December 2007 and the related statement of income and cash flows for the six-month period then ended. These interim financial statements are the responsibility of the company's management. Our responsibility is to express a conclusion on these interim financial statements based on our review.

We conducted our review in accordance with HK Standard on Review Engagements 2410 issued by the ·HKICPA. This standard requires that we plan and perform the review to obtain moderate

.. ~ assurance as to whether the financial statements are free of material misstatement. A review is limited primarily to inquiries of company personnel and analytical procedures applied to financial data and thus provides less assurance than an audit. We have not performed an audit and, accordingly, we do not express an audit opinion.

Based on our review, nothing has come to our attention that causes us to believe that the accompanying interim financial statements is not prepared, in all material respects, in accordance with HK Financial Reporting Standards.

Auditor sign Date Address

See Q19.

The following two engagement are non-assurance engagements (examined in June 2009): @. Agreed Upon Procedures (see CLP 14.4) 01!

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An agreed-upon procedures engagement, in which the party engaging the members or the intended user determines the procedures to be performed and the members provide a report of factual findings as a result of undertaking those procedures, is not an assurance engagement.

While the intended user of the report may derive some assurance from the report of factual. findings, the engagement is not intended to provide, nor do the members express, a conclusion that provides a level of assurance.

Rather, the intended user assesses the procedures and findings and draws his or her own conclusions. However, members may undertake an engagement that is similar to an agreed-upon procedures engagement but which does result in the expression of a conclusion that provides a level of assurance.

(1~ - ~"'vctt\CQ_

Engagements to compile financial information (CLP 14.7)

The accountant uses his accounting expertise to collect classify and summarise financial information. Such work is often required for sale traders or partnerships with no statutory audit obligation.

Level of assurance? No assurance is given as to the accuracy of the information, however users

(--..,_,

are thought to enjoy some benefit because the service has been performed with due competence )

~

and care. This must be made clear in the report.

Therefore, auditor should comply with the Codes of Ethics required by HKICPA.

Should ensure terms of engagement are clear. Should plan and document his work.

See Q18.

o



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3.8) Implementing information sy~tems within technological and cost constraints (CLP 15)

Which system? 3 types of systems.

a) Stand-alone PC (CLP 15.2) '":I ~ Ii~ -60 ~~

• Characteristics

Stand-alone PCs can be operated by a single user or many users at different times accessing the same or different programs on the same computer. The user of a stand-alone PC that processes accounting applications performs many functions. While typically not knowledgeable about programming, users may often use third-party or off-the-shelf software packages such as electronic spreadsheets or database applications.

• Internal Controls

In the stand-alone PC environment, users with only basic data processing skills can implement application programs relatively quickly, triggering issues such as the adequacy of systems' documentation or access control procedures.

Such users may not regard controls over the application implementation process as important or cost-effective. In such circumstances, because the financial information is processed on a computer, users may tend to place unwarranted reliance on it.

Internal control in a stand-alone PC environment includes:

~ Organisational policies and procedures

Effective policies and procedures for the acquisition, implementation, operation and maintenance of stand-alone PCs can enhance the overall control environment. A failure to implement such policies may lead to the entity using out of date programs and to errors in the data and the information derived from them, and may lead to an increased risk of fraud.

Such policies and procedures include the following:

Acquisition, implementation and documentation standards User training

Security, back-up and storage guidelines Password management

Personal usage policies

Software acquisition and usage standards Data protection standards

Program maintenance and technical support

An appropriate level of segregation of duties and responsibilities Virus protection

~ Physical protection of equipment and media

They can be physically protected by:

Locking them in a protective room, cabinet or shell

Using an alarm system that is activated if the PC is disconnected or moved from its location

Fastening the PC to a table

Policies outlining the proper procedures to follow when travelling with a laptop or using it off premises

Encryption of key files

Installing a locking mechanism to control access to the onloff switch Implementing environmental controls to prevent damages from natural disasters



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Protect removable (disk/CD) or non-movable (hard disk) storage media

~ Program and data integrity

..

The following techniques can limit access to programs and data to authorized personnel:

Using passwords

Implementing an access control package Using of removable storage media

Using hidden directories and files

Using encryption

~ Continuity of operations

The user retaining copies of the operating systems, programs and data, with at least one copy stored at a secure location away from the PC

Access being available to alternative equipment within a reasonable time given the use and importance of the underlying system

•

Effect of Stand-alone PC on accounting and related internal controls

o

~ General controls - segregation of duties

Initiating source documents

Authorizing source documents

Entering data into the system Processing data that have been entered Changing programs and data

Using or distributing output

Modifying the operating systems

~ Application controls

Effective controls include the following:

Programmed control procedures, such as limit checks

A system of transaction logs and batch balancing, including follow up and resolution of

any exceptions/\ Direct supervision 0 A reconciliation of record counts or hash totals

Control may be established by an independent function that generally:

Receives all data for processing

Ensures that all data are authorized and recorded Follows up all errors detected during processing Verifies the proper distribution of output

Restricts physical access to application programs and data

• Effect of Stand-alone PC environment on audit procedures

~ Usually, not cost effective to test controls, therefore the emphasis is to do more ST.

~ But of course, if the company has established controls procedures that can reduce control risk, CT may be appropriate.

These notes are prepared by FTMS lecturing team. They are for the sole use of FTMS students attending HKICPA FE 30·


FTMS Hong Kong


b) Online system ~ ~ Q 1.3

I

• Architecture of an online systems

Types of terminal devices

~ General purpose terminals

Basic keyboard and screen - used for entering data without any validation within the terminal and for displaying data from the computer system on the screen.

Intelligent terminal - used for the functions of the basic keyboard and screen with the additional functions of validating data within the terminal, maintaining transaction logs and performing other local processing.

pes - used for all of the functions of an intelligent terminal with additional local processing and storage capabilities

~ Special purpose terminals

Point-of-sale devices - used to record sales transactions as they occur and to transmit them to the main computer.

Automated teller machines - used to initiate, validate, record, transmit and complete various banking transactions.

Hand-held wireless devices for entering data from remote locations

Voice response systems - used to allow user interaction with the computer over a telecommunications network based on verbal instructions issued by the computer

• Types of online systems

~ On-line/real-time processing - individual transactions are entered at terminal devices, validated and used to update related computer files immediately

~ On-line/batch processing - individual transactions are entered at a terminal device, subjected to certain validation checks and added to a transaction file that contains other transactions entered during the period.

~ On-line/memo update (and subsequent processing) - individual transactions immediately update a memo file containing information that has been extracted from the most recent version of the master-file.

~ On-line/inquiry - restricts users at terminal devices to making inquiries of master-files

~ On-line downloading/uploading processing - transfer of data from a master-file to an intelligent terminal device for further processing by the user.

• Characteristics of on-line computer systems

~ On-line data entry and validation

~ On-line access to the system by users ~ Possible lack of visible transaction trail

~ Potential access to the system by non-users, including programmers and other third parties



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}> General controls

Controls may include the use of passwords and specialized access control software, such as on-line monitors, that maintains control over the menus, authorization tables, passwords, files and programs that users are permitted to access.

It may include physical controls such as the use of key locks on terminal devices, locked computer rooms and inactivity timeouts.

Controls over passwords - procedures for the assignment and maintenance of passwords to restrict access to authorized users

System development and maintenance controls - additional procedures to ensure that essential controls are included in the system during its development and maintenance.

Programming controls

Transaction logs

Firewalls

>- Application controls

Pre-processing authorization

Terminal device edit, reasonableness and other validation tests Input error reporting and handling

Cut-off procedures

File controls

Master file controls

Balancing

Control may be established by an independent function that generally: {> Receives all data for processing

{> Ensures that all data are authorized and recorded {> Follows up all errors detected during processing {> Verifies the proper distribution of output

{> Restricts physical access to application programs and data

•

Effect of on-line system on accounting and related internal controls

o

>- Factors that may reduce the risk of errors occurring because of the entity's use of online systems

Performing data entry at or near the point where transactions originate reduces the risk that the transactions will not be recorded

Immediate correction and re-entering of invalid transactions reduces the risk that such transactions will not be corrected and resubmitted quickly

Data entry performed by individuals who understand the nature of the transactions involved may be less prone to error that when performed by individuals unfamiliar with the nature of the transactions

Processing transactions immediately reduces the risk that they will be processed in the wrong accounting period



FTMS Hong Kong


Authentication and authorization carried out at or near the point where transactions originate reduces the risk of impersonation or other unauthorized access to or manipulation of data

» The risk of errors in on-line computer systems may be increased for the following reasons:

Locating terminal devices throughout the entity increases the opportunity for unauthorized use of a terminal device and the entry of unauthorized transactions

Online terminal devices may provide easier opportunity for unauthorized users such as:

-¢- Modification of previously entered transactions or balances

-¢- Modification of computer programs

-¢- Access to data and programs from remote locations

If online processing is interrupted for any reason, there may be a greater chance that transactions or files may be lost and that the recovery may not be accurate and complete

Online access to data and programs from remote sites through telecommunications may provide greater opportunity for access to data and programs by unauthorized persons.

• Effect of on-line system on audit procedures

» It is likely that the auditors will test general and application controls before placing greater reliance on internal control.

» The implementation review may be more effective than reviewing the application after installation. It may provide the auditors with an opportunity to request additional functions or sufficient time to test audit procedures in advance of the system's use.

» Procedures carried out during the planning stage may include:

The participation on the audit team of individuals with technical proficiency in online computer systems and related controls

Identification of any new remote access facilities

Preliminary determination, during the risk assessment process, of the impact of the system on the audit procedures

» Audit procedures performed may include tests of the controls over the online applications.

Where the entity permits access through the internet, audit procedures can include tests of firewalls and other authorization and access controls, as well as tests of transaction processing.

» Procedures performed after processing has taken place may include:

Tests of controls over transactions logged. by the online system for authorization, completeness and accuracy

Substantive procedures covering transactions and processing results rather than tests of control, where the former may be more cost-effective or where the system is not welldesigned or controlled

Reprocessing transactions as either a test of control or a substantive procedure

These notes are prepared by FTMSlecturing team. They are for the sole use of FTMS students attending HKICPA FE 33


FTMS Hong Kong


c) Database system

• Architecture of database systems

~ A database is a collection of data that is shared and used by many different users for different purposes.

~ Database system consists of (a) the database and (b) the database management system.

~ The software that creates, maintains and operates the database is referred to as DBMS software. It facilitates the physical storage of the data, maintains the interrelationships between the data, and makes the data available to application programs.

• Characteristics of database systems

Database systems are distinguished by two important characteristics: -

~ Data sharing

A database is composed of data set up with defined relationships and organized to permit many users to use the data in different application programs. Individual applications share the data in the database for different purposes.

~ Data independence

In a database system, a single file of data is used by many applications, with data redundancy kept to a minimum. The DBMS records the data once for use by various application programs. This creates a need for data sharing and a need for data independence from application programs.

These characteristics ordinarily require:

~ The use of a data dictionary

Because various application programs need to access these data, a software facility is required to keep track of the location of the data in the database. This software within the DBMS is known as a data dictionary.

A data dictionary provides functions such as:

A facility to create or modify data definitions·

Validation of the data definitions provided to ensure their integrity

Prevention of unauthorized access or manipulations of the data definitions Interrogation and reporting facilities that allow the database administrator inquiries on the data definitions

to make

~ The establishment of a data resource management

Data resource management forms an essential organizational control in ensuring data integrity and compatibility. In a database environment, the methods of informational control and usage change from an application-oriented approach to an organization-wide approach. The use of the same data by various application programs emphasizes the importance of centralized coordination of the use and definition of data and the maintenance of their integrity, security, accuracy and completeness.

It includes a data administration function and a database administration function.

Data administration



r>.

U

FTMS Hong Kong

HKICPA Final Examination . Module C ~ Course Notes

{- The development and implementation of a data resource management strategic plan and policies, which support the entity's business plans by achieving cost-effective use of the organization's data.

{- The creation and maintenance of a corporate data model or architecture

{- The coordination and integration of system data models

{- Obtaining agreement among users about definitions and format of data

{- Resolving conflicts about incompatible representation and data

{- Establishing a corporate-wide data dictionary and managing the organization's naming and definition standards

{- Establishing data standards and procedures for:

Data naming Data usage

• . Data security

Data definition compilation Data modeling

Providing training and consulting to users and the data IT team members concerning all aspects of data resource management

Database administration

{- Defining the database structure and the description of the data model {- Maintaining data integrity, security and completeness

{- Coordinating computer operations related to the database {- Monitoring system performance

{- Providing administrative support


General controls

};> Standard approach for development and maintenance of application programs

Definition standards are established and monitored for compliance

Data backup and recovery procedures are established and implemented to ensure database availability

Various levels of access control for data items, tables and files are established to prevent inadvertent or unauthorized access

Controls are established to ensure accuracy, completeness and consistency of data elements and relationships in the database

Database restructuring procedures are followed when making logical, physical and procedural changes



FTMS Hong Kong

HKICPA Final Examination Module C - Course Notes.

~ Data model and data ownership

A single data owner should be assigned responsibility for defining access and security rules, such as who can use the data and what functions they can perform.

Assigning specific responsibility for data ownership helps to ensure the integrity of the database.

» Access to the database restricted through access controls. These restrictions apply to individual, terminal devices and programs.

» Segregation of duties - the responsibilities for performing the various activities required to design, implement and operate a database are divided among technical, design, administrative and user personnel.

~ Data resources management

~ Data security and database recovery

• Effect of databases on accounting and related internal controls

Database systems provide the opportunity for greater reliability of data through the following factors:

~ Improved consistency of data is achieved because data are recorded and updated only once.

» Integrity of data will be improved by effective use of facilities included in the DBMS.

» Other functions available with the DBMS can facilitate control and audit procedures.

• Effect of databases on audit procedures

The auditor may consider the effect of the following on audit risk in planning the audit:

~ The relevant access controls

~ The DBMS and the significant accounting applications using the database

~ The standards and procedures for development and maintenance of application programs using the database

» The data resource management function

» Job description, standards and procedures for those individuals responsible for technical support, design, administration and operation of the database

» The procedures used to ensure the integrity, security and completeness of the financial information contained in the database

» The availabilityof audit facilities within the DBMS

» The procedures used to introduce new versions of the database into operation


courses in Hong Kong. For questions, please email tohkicpa@ftmsaf.com.hk .

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Audit procedures may include using the functions of the DBMS to;

~ Test access controls ~ Generate test data ~ Provide an audit trail

~ Check the integrity of the database ~ Provide access to the database

~ Obtain information necessary for the audit

Computer-Assisted Audit Techniques (CAATs) (old CLP 15.5)

Auditing techniques that use the computer as an audit tool are known as Computer-Assisted Audit Techniques (CAATs).

What can CAATs do? (CLP 15.5.1)

Extracting samples

r>. Particularly interval sampling and monetary unit sampling (

Casting

The auditor will normally want to cast the payroll, the nominal ledger, the sales and purchase ledgers.

Re-performing calculations

Particularly useful for complicated transactions, for example leases.

Flowcharting

The auditor could use the computer to produce a flow chart of the system logic. This would be much easier to amend if necessary than a manual flow chart.

Analytical review

Interrogation software could extract figures for analytical review, put them into a 'shell' and calculate ratios. Could develop more sophisticated programs to allow analytical review to be used as a substantive test.

Detecting changes to the program code

r The computer could compare the original program code to that currently being used on a line by line basis and highlfght any differences.

Sequence checking

The computer could review documents to identify gaps and/or duplicates in the sequence.

A description of CAATs (CLP 15.5.2)

Package/Purpose Written Programs

These are audit software consists of computer programs used by the auditor to process data from the entity's accounting system. These computer programs may be developed by the auditor, client or independent suppliers. When client developed programs are used they must be tested and controlled by the auditor. The auditor uses the software to examine the company's computer files and extract

information or re-perform calculations. .



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Embedded Audit Routines

A fictitious entity or collection of entities is created, e.g. fictitious customer. Transactions are then posted to the fictitious entity as part of normal processing, and the actual results compared with the predetermined results at regular intervals.

Data is usually coded to prevent the test data being input into real accounts and get mixed with other real transactions.

Test data

Data is submitted as machine code by the auditors for processing by the enterprise's computer system. The data is coded with mistakes which the controls should detect. The auditor predicts the results of his tests in advance and then compares the actual and predicted results.

The auditor needs to gain reasonable assurance that the system used to run the test data is the same as that used throughout the year for normal processing, perhaps by testing general controls or by running the test data at different times during the year.

Considerations in the use of CAATs (CLP 15.5.3)

, i '-.__/

In determining whether to use CAA Ts, we should consider:

IT knowledge, expertise and experience of the audit team Availability of CAATs and suitable computer facilities and data Impracticability of manual tests

Effectiveness and efficiency

Timing

See Q9ii, Q11d, Q15b, Q22 and Q23

END OF NOTES



FTMS Hong Kong

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4) REVISION QUESTIONS AND ANSWERS

Q1) Indepdendence in other services (FE JunE!',2009 Paper II) ~) hv 64~ ..reNV(~

~ Nfl ~vrt- fo a.(~~ ~"L

You are the auditor of NSI. NSI's Management has asked you to carry out a due diligence review on JXL's income statement for the year ended 31 December 2008. In particular, NSI's Management would like you to carry out procedures of an audit nature and to report on factual findings for them to assess lanalyse JXL's underlying financial performance.

Discuss any independence issues arising as the auditor of NSI and the safeguards that could be applied if you accept this due diligence engagement. . (10 marks)

The due diligence engagement will involve finding information, analysing it, commenting upon past performance and identifying risks and possibly opportunities in connection with the target (JXL). Providing such services to an audit client would not of itself create an independence threat. In most cases, any threats to independence from such services will clearly be insignificant.

A threat to independence could occur, however, if NSI does not have the knowledge, experience and ability to make appropriate decisions based on the findings of the due diligence. In such circumstances, it might be tho):lght that the auditor had made the relevant decision (for example a decision to ~uire the target) 1 Making a management decision for an audit client would give rise to a

self interes~intimidation threat, and the auditor needs to safeguard against a reasmonable perception r. J

of such a threat. \) f E'.l. \M!. Sv::~ 'J?~ f.. b~) ik~ IhQ i\'.%- b.Q !?(l1fUl t :

~ f -t'iWM! -{ht eVl£vJ; ]h ~~ a .f\1171~ o\Jllt rgom-NtJ6\T/GY\.

A ~est ttlr~could arise if due diligence work is carried out on a oasis where ttle fee is contingent (either wholly or partially) upon whether the proposed acquisition proceeds.

A elf review threa ould also arise if the due diligence engagement generates an accounting entry and be re evant to an audit judgement. An example of this would be if the due diligence work includes calculating the value of income (e.g. construction contract revenue) or expenses (e.g. employee benefits, tax provision, bad debt provisions etc) which will subsequently be used to make the accounting entries in NSI's consolidated financial statements if the acquisition proceeds., , r:"110Av!

I r' /'9;f:1; JX l::: . .l\.VN (ll ()

The following are examples of safeguards against the above independence threats:

Ensuring NSl's management has the knowledge, experience and ability to form its owri views and make its own decisions.

rt\ Agreeing in the due diligence engagement contract that: (1) you are not responsible for making \.!/ any decision on behalf of NSI, and you cannot act or negotiate on behalf of NSI or otherwise act as management; and (2) the due diligence work will not constitute an audit or non-audit assurance engagement. This restricts NSl's expectations and reduces the likelihood of any attempt at intimidation.

- Q Obtaining client approval of the engagem ent from those charged with govema7J,~ at- -fk_ yl>_1I.W!~ Q VI'aw\; -, Segregation of the audit team from the due diligence team.

Restriction on the fee arrangement (absent of contingent fee element).

~ Having another practitioner to review any subsequent material audit judgement which is related to the due diligence findings.

-@) Having another practitioner to review whether sufficient and adequate safeguards have been in place to ensure independence.

~ \JJ£ l~~CWk--W_ 1lli"'-1 ftv ~tt t" ~ d{{f5Q~Q


courses in Hong Kong. For questions. please email tOhkicpa@ftmsaf.com.hk

FTMS Hong Kong

HKICPA Final Examination Module C- Course Notes

02) PAIB ethics (FE Dec 2008 Paper I) 1 ~ ~

Determine how you, as a certified public accountant and an employee of company granted share options, ensure compliance with the Code of Ethics for Professional Accountants.

'. (8 marks)

A certified public accountant needs to observe the Code of Ethics for professional accountants issued by the HKICPA.

As a professional accountant in business, I may have financial interests which would give rise to threats to compliance with the Code of Ethics.

As the holder of the Group's share option, self-interest threats may arise as the value of the options (or the shares after conversion) could be directly affected by decisions made by me as an employee of the Group.

In order to ensure compliance with the Code of Ethics, I need to first evaluate the significance of the threat. This evaluation will include an assessment of the significance of my financial interests, my role and responsibilities within the Group, etc.

If threats are other than clearly insignificant, safeguards should be' considered and applied as necessary to eliminate or reduce them to an acceptable level. Safeguards I would apply include:

1) Consultation with the HKICPA ;

2) Following the Group's internal policies with respect to disclosure of interests and trading activities;

3) Obtaining up-to-date education on ethical issues;

4} Familiarity with the legal restrictions and other regulations around potential insider trading.

Last but most importantly, as a professional accountant in business, I should neither manipulate information nor use confidential information for personal gain.

~~\~(Q c~

Q3) Gifts and hospitality ethics (extracted from FE June 2008 Paper II) ~ (,l

Mr. Lee, the CEO of C-Group Ltd, is a big fan of the Hong Kong Philharmonic Orchestra. In order to show appreciation to C-Group's suppliers, he has bought 2 tickets for an upcoming "J {{tit V· concert for each of C-Group's significant suppliers. Your engagement partner has received 2

t~~ tickets from Mr. Lee with a total value of HK$400 and has asked you to find out whether there

4W- are any ethical concerns in receiving gifts from a client. (5 marks)

, J '~~'\L~Secti?n, 260 of the code of ethics for professional accountant sets out guidance on gifts and

\ c:..:~ll ~~'hospltailty.

An offer of a gift or hospitality from a client ordinarily gives rise to threats to compliance with fundamental principles. For example, self-interest threats to objectivity may be created if a gift from a client is accepted.

The threat in this case appears to be inSignificant due to the nature, value and intent behind the offer

as follows: ~

1) The offer of the concert ticket from C Group is extended to all suppliers. 1'lA1 J .<1~~

2) The value of the concert tickets is not significant. ([}N.IfJ~v\J\J \ (

3) There is no specific intent to influence our audit. ~ i ~~ /'" t<J-1.lJ.Q

However, before accepting the offer, we should apply proper safeguards such as: 'I1(Y_V\ vvvvlll

1} Checking to ensure that the offer is made to all suppliers ..t.(.. , JJ

2) Seeking our in-house independence department approval ~ tM 3i;~ x - \) {f ~

~lrt ~4 ~yal\

J\A~\Il'\'lv 1i ~to.~

These notes are prepared by FTMS lecturing team, They are for the sole use of FTMS students attending HKICPA FE 40


FTMS Hong Kong


Q4)

Confidentiality ethics (extracted from FE Dec 2006 Paper II) elf' q.b).

Your uncle is the General Manager of Future Media, a competitor of A-Group. During a recent family gathering, your uncle invited you to a Christmas dinner as he is eager to find out about A-Group's expansion plans and he has hinted that you will receive a large.Christmas present

from him. Discuss what you would do and why. (5 marks)

Very often, professional accountants will obtain sensitive client information when performing the duties of external auditors. As professional accountants, we need to comply with the code of ethics issued by the HKICPA.

In accordance with the Code of Ethics for Professional Accountants. information acquired in the course of professional work should not be disclosed except where: (((P~b.':l.. + 4-.6 ,3)

- Disclosure is permitted by law and is authorised by the client or tile employer; Disclosure is required by law such as in the course of legal proceedings;

Where there is a professional right or duty to disclose, when not prohibited by law.

A professional accountant should maintain confidentiality of client matters, and should not discuss such matters in other circumstances, including social functions and therefore, it is unacceptable to

r> share A-Group's expansion plan with my uncle for my personal advantage in receiving a large

Christmas gj~\ ~/M AAl~ ~ O(Q~t -Jt.e d+t

Q5) Performing valuation service (extracted from FE Dec 2009 Paper II Q2c) ~ Hv t .e.+et.el\(Q -

XYZ & Co. (XYZ) is the auditor of FAL and you are the responsible audit manager. You and the audit partner are about to meet with the board of directors next week. Before the meeting, the directors have enquired if they could engage XYZ to perform a valuation of the derivative financial instruments outstanding as at the year end for accounting purposes. (5 marks)

A self-review threat will arise if we perform a valuation of the derivative financial instruments for incorporation into FAL's financial statements.

Since the derivative financial instruments are material and the valuation will likely involve a certain degree of subjectivity, the self-review threat created could not possibly be reduced to an acceptable level by the application of any safeguard.

Accordingly, we should not accept the engagement to perform a valuation of FAL's derivative financial instruments in this situation.

r--,

I



FTMS Hong Kong


Q6) Power Supply (modified from Dec 2006 FE Paper I)

Power Supply is a company incorporated in Hong Kong. It is listed on the Stock Exchange of Hong Kong. Power Supply's principal shareholder holds approximately 35% of its share capital and about 45% is held by a number of institutional investors. The remaining shares are held by individual investors. Power Supply, together with its subsidiaries as a group, is principally engaged in the generation and distribution of electricity in Hong Kong, Mainland China and Asia Pacific.

Operations in Hong Kong ~ 7 % ~li.2._ m,

At 30 September 2005, about 63% of Power Supply's assets were located in Hong Kong; and about '):l.;/ e~~ 80% of its earnings for the year then ended came from Hong Kong. Power Supply operates ~~Kgeneration units located in Hong Kong with a total capacity of approximately 6,300 megawatts. All these generating units are owned by Generators Company Limited ("GCl"), in which Power Supply

has a 40% equity interest. The sale business of GCl is to generate and sell electricity to Power Supply. Power Supply owns and operates transmission and distribution lines of approximately 12,000 kilometres, distributing electricity power to 2.2 million customer accounts, representing approximately 80% of Hong Kong's total population. Power Supply also has a 25% equity interest in a Mainland China nuclear power plant ("NPP"); 70% of this plant's output is sold to Power Supply, which is then distributed to Power Supply's customers in Hong Kong.

The principal source of revenue is tariffs receivable from customers and dividends received from its investment in GCl, NPP and other jointly controlled entities and associated companies. The principal expenditures are purchases of electricity from GCl (in HK$) and NPP (in US$), depreciation of transmission and distribution lines acquired from overseas manufacturers (in US$) and employee costs (in HK$).

Power Supply's Hong Kong operations have been governed since 1964 by a contractual arrangement with the government. The current agreement took effect in 1993 and will expire in 2008. In general, the agreement requires that Power Supply's annual profit should be capped at 13.5% of the average carrying amount of its fixed assets and that tariffs should be reviewed and approved by the government. The government wishes to ensure that service to the public is adequate, efficient, of high quality and at the lowest reasonable cost.

Power Supply also undertakes to improve its environmental performance, promote efficient energy use, reduce emissions and explore renewable energy sources.

Operations in Mainland China

Power Supply has a number of investments in Mainland China, with equity interests ranging from 25% to 49%. Except for NPP which sells 70% of its output to Power Supply, all these jointly controlled entities or associates operate independently.

During the year ended 30 September 2005, jointly controlled entities and associates in Mainland China contributed approximately 9% to Power Supply's profit before financing and taxation for the year.

Operations in the Asia Pacific region

Power Supply has a power plant in Australia of 1,480 megawatts and a power plant in India of 655 megawatts; both are wholly owned. The principal source of revenue of these two wholly owned subsidiaries is tariffs receivable from customers in the respective countries.

The principal expenditures are purchases of fuel, depreciation of plants and employee costs. During the year ended 30 September 2005, wholly owned subsidiaries in Asia Pacific contributed approximately 12% and 15% in revenue and operating profit respectively to the income statement.

Power Supply also has a number of jointly controlled entities/associates in Taiwan and Thailand, with equity interests ranging from 22.4% to 50%. Jointly controlled entities and associates in Taiwan and Thailand contributed approximately 4% to Power Supply's profit before financing and taxation for the year.


courses In Hong Kong. For questions, please email tOhkicpa@ftmsaf.com.hk

FTMS Hong Kong


ABC & Co has been the .audltor of Power Supply and all its subsidiaries since its incorporation. Overseas subsidiaries in Australia and India are audited by ABC & Co's . network firms. Assume that you are the audit manager responsible for the audit of Power Supply's financial statements for the year ended 30 September 2006, Ms. June Leung.

Required:

a) Document the factors you will consider in assessing ABC & Co's independence with respect to this multi-location audit. Describe possible safeguards within ABC & Co which will assist ABC & Co in meeting the independence requirements:

lj{\ly l'Q-tG"Q\I\(Q_ (5 marks)

b) Document your assessment of the risks of material misstatement at the financial statement level, with clear descriptions of the factors you have considered and your

conclusion: (10 marks)

c)

Determine the approach you would adopt, including a brief description of the procedures you would perform, in examining the valuation and allocation assertion of

Power Supply's property, plant and equipment. (10 marks)

Total: 25 marks

Q6) Suggested Answers

a) ABC & Co's independence

In accordance with the Code of Ethics for Professional Accountants, in the case of an assurance engagement, it is in the public interest and therefore, required by this Code of Ethics,that members of assurance teams, firms and, network firms be independent of assurance clients.

Independence requires independence of mind, which is the state of mind that permits the expression of an opinion without being affected by influences that compromise professional judgement, allowing an individual to act with integrity, and exercise objectivity and professional scepticism.

Independence also requires independence in appearance, which is the avoidance of facts and circumstances that are so Significant that a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, would reasonably conclude a firm's, or a member of the assurance team's, integrity, objectivity or professional scepticism had been

com prom ised, .

As this is a multi-Jocation audit with the use of our network firms in Australia and India, it is important r=>; that the members of our overseas assurance team and the network firms are also independent of Power Supply.

As Power Supply has a number of subsidiaries, jointly controlled entities and associated companies, it is important that we obtain a complete list of Power Supply's related parties in order to assess our independence.

It is also necessary to obtain a complete list of Power Supply's derivative instruments such as cover warrants of Power Supply's shares.

Safeguards within ABC & Co include the following:

Internal policies and procedures to communicate and monitor compliance with firm policies and procedures as they relate to independence.

Policies and procedures in place to communicate and monitor independence compliance of its network firms.

Policies and procedures that will enable the identification of Power Supply's related parties.



FTMS Hong Kong


b) Risks of material misstatement at the financial statement level

In accordance with HKSA 315, an auditor is required to assess the risks of material misstatement at the financial statement level. The risks of material misstatement at the overall financial statement level refers to the risks of material misstatement that relate pervasively to the financial statements as a whole and affect many assertions.

Risks of material misstatement at the overall financial statement level often relate to the entity's control environment. Therefore, it is important that we obtain an understanding of Power Supply's control environment in order to assess the risks of material misstatement at the financial statements level.

As part of the risk assessment as described above, we should determine which of the risks identified are, in the our judgment. risks that require special audit consideration (Le. significant risks), The following are the significant risks identified:

Complex structure - Power Supply has a very complex structure with a number of subsidiaries, jointly controlled entities and associates in multiple locations. There will be a number of issues including: allocation of goodwill to business segments and its impairment;

whether investments are joint ventures, subsidiaries, or investments accounted for using the equity method;

whether special purpose entities are accounted for appropriately.

Regulatory framework - Power Supply operates in a highly regulated environment which has the following impact on the financial statements:

there are likely to be industry-speclflc accounting policies and practices which require expert

knowledge; .

Power Supply is governed by a contractual arrangement with the government. An understanding of the regulatory framework is required in order to assess the impact on Power Supply's operations and financial reporting.

Related party transactions - Power Supply engaged in significant transactions with its related parties. Risks exist such as:

Whether all related parties have been identified;

Whether all related party transactions have been identified and accounted for appropriately.

Due to the factors identified above, we consider the risks of material misstatement at the financial statement level to be high.

c}

Audit approach and procedures in examining the valuation and allocation assertion of Power Supply's property, plant and equipment (note question is repeated again in June 2008 FE exam)

Valuation and allocation refers to the assertion that property, plant and equipment are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.

This assertion can be further broken down into two specific audit objectives:

Property, plant and equipment are recorded only when appropriate capitalization criteria are

met; .

Property, plant and equipment are properly valued in accordance with the measurement model selected.

The risks of material misstatement of the valuation and allocation are considered higher due to the following factors:

1) Property, plant and equipment accounted for 70% of Power Supply's total assets;

2) Power Supply's annual profit is capped at 13.5% of the average carrying amount of its fixed assets;



FTMS Hong Kong


3) Depreciation rates and impairment assessment are subject to management estimates which

are more difficult to substantiate. .

In order to obtain audit evidence to draw reasonable conclusions on which to base the audit opinion, we are required to obtain an understanding of Power Supply's control environment, including its control activities.

As property, plant and equipment are Power Supply's most significant assets, internal controls are likely to be in place to reduce the risks of material misstatement. To rely on Power Supply's internal controls, we will need to test the controls to assess their design and operating effectiveness.

We are also required to plan and perform substantive procedures to be responsive to the related assessment of the risks of material misstatement. Substantive procedures include substantive analytical procedures and test of details.

IDe.

Substantive analytical procedures would be as follows:

Return on assets with comparison to prior years (i.e. trend analysis) and industry average

(Le. benchmarking); j ell P

Cost per unit of transmission and distribution lines with comparison to prior years and industry -¥l

r> average.

(Candidates may make other suggestions provided they are reasonable.)

Due to the higher risk of this assertion, performing tests of controls and SUbstantive analytical procedures will not be sufficient to provide audit evidence. The following test of details should be performed:

1) Review the appropriateness of Power Supply's capitalisation policy and review additions to ensure compliance with the capitalisation policy;

2) Review the appropriateness of Power Supply's estimates in establishing its depreciation policy such as useful life, residual value, etc and recalculate depreciation expense on a test basis;

3) Review Power Supply's impairment testing and assess the reasonableness of the calculation of the recoverable amount;

4) Discuss with management to understand any site restoration or reinstatement requirements.

5) Review management's estimate of the costs of dismantling and removing the transmission and distribution lines.



FTMS Hong Kong


Q7) Auditing inventories (adapted from June 2007 FE Paper I)

GCS group is a supermarket and mega mall business, and it uses a point of sale system at all its retail outlets. You are the manager responsible for the GCS group audit. Assess the risks of material misstatement of inventory by assertions. Determine the approach you would adopt

and the procedures you would perform in examining GCS group's inventories. (15 marks)

Q7)Suggested Answers

In accordance with HKSA 500, the auditor should use assertions for account balances in sufficient detail to form a basis for the assessment of risks of material misstatement and the design and performance of further audit procedures.

The following is our risk assessment by assertion:

CD Completeness means that all the inventory of GCS group is reported in the balance sheet. Risk is considered high as GCS group's inventory is located in more than 3,000 outlets in 15 provinces.

Q) Existence means that inventory reported in the balance sheet physically existed. Risk is considered high as:

inventory is located in more than 3000 outlets in 15 provinces.

retail goods have a higher inherent risk of unreported loss due to theft.

Q) Valuation and allocation means that the carrying amount of GCS group's inventory is measured accurately according to the relevant accounting standards. Risk is considered high as:

the company has a broad range of products which will increase the chance of costing errors. .

competition is becoming more intensive and some products may be selling below costs. ( ['fItJ"" ~- eMf .

Risks of material misstatement can be reduced if GCS group has implemented effective internal k jtv\~) controls. Therefore, it is important to obtain an understanding of the entity and its environment,

including its internal controls in preventing or detecting and correcting material misstatements at the

assertion level.

Audit procedures can be classified as tests of controls and substantive procedures.

hit J!K A combined approach of test of controls and substantive analytical procedures is likely to be the most

t\1NA efficient way to obtain audit evidence since:

~ 1~"''''£A.dt.,. 1) As inventory management is important for any retail business, there are likely to be sufficient

t'l I" internal controls in place on inventory movement and costing

2) Besides, since GCS group's inventory is located in more than 3,000 retail outlets and there is a broad range of products, substantive audit procedures by themselves may not be the most efficient way to provide sufficient audit evidence.

3) Since risks of material misstatement of inventory are considered high, substantive procedures are always required to obtain sufficient appropriate audit evidence.

The following procedures will be performed to address risks of material misstatement as discussed above:

1) Existence and completeness:

"'1 )' - . Test controls over inventory movement and the perpetual inventory record.

C \ 1 - Review controls and procedures of GCS group's cyclical counts. Observe a number of cyclical counts during the year and perform test counts.

Review accuracy of perpetual inventory records by reviewing variance between cyclical counts performed during the year and the perpetual inventory record.

Perform stocktake procedures at various retail outlets at year-end date.

Send Accounts Payable confirmation to manufacturers and wholesalers to ensure completeness of inventory.

Review purchase terms and test goods in transit at year-end.



FTMS Hong Kong


2)

Valuation and allocation

Test controls over inventory costing and write-down. [1

Perform inventory turnover analysis. }

Review inventory aging reports for slow moving items. 1T· Perform testing of inventory net realizable value.



FTMS Hong Kong

HKICPA Final Examination Module C N Course Notes

Q8) Auditing share options (extracted from Dec 2007 Paper I)

With regard to the amount of share option expense to be record~q in TCCL's books, document your risk assessment and the proposed audit approach. + ~~

T (10 marks)


The risk of material misstatement associated with the Teel share option expense is considered medium/high due to the following factors:

a) The fair value of Teel share options is not readily available and is subject to complex computation using valuation models.

b) Significant management assumptions and estimates are used in determining the fair value which can be subjective and difficult to substantlate.

c) Valuation of share options requires expert knowledge. TCCl management may not have the required expertise to carry out share option valuation.

We, as the auditors of TeCl, are required to obtain sufficient audit evidence that fair value measurements and disclosures are in accordance with HKFRS.

~lk~~ {is part of the understanding of Teel and its environment, including its internal control, we should hr'!. < obtain an understanding of Teel's process for determining fair value measurements and disclosures 1 I!f\ such as the selection of a valuation model, and the identification of and support for significant

assumptions used. . .

As the valuation of share options is considered complex and the risk. of material misstatement is considered high, our audit approach will be substantive in nature. The following procedures will be performed:

a) Obtain and review the share option scheme / plan to ensure that the valuation performed reflects

the terms of options granted. .

b) Review the expertise and experience of TCCl personnel who determined and performed the fair value measurement.

c) Evaluate whether the Black Scholes model used is appropriate for the purpose of establishing the fair value of the share option granted.

d) Obtain documentation supporting management's assumptions. Evaluate whether the 0 assumptions used provide a reasonable basis for the fair value measurement.

e) Test the mathematical accuracy of the calculation performed.

f) As the valuation of share options requires expert knowledge, we will consider the use of our internal valuation expert in reviewing the valuation performed or in making an independent estimate of the fair value.

g) Perform sensitivity analysis to identify particularly sensitive assumptions.

h) Obtain written representation from management regarding the reasonableness of significant assumptions.



FTMS Hong Kong


. .

Q9) Auditing payroll expenses (extracted from Dec 2007 Paper II Q2ai) -7 H~ .

~(\ -1 r.(~!!iitwfi\lY\ -j Ww tiCK

(Case partially extracted from FE Dec 2007 Paper II) f-'~'-

Human capital is the most significant asset of the Group. In fact, payroll expenses account for more than 50% of the Group's operating expense. All the directors and senior management are considered crucial to the Group due to their significant experience in the hotel industry. The continuous success of the Group also depends on its ability to attract and retain a group of trained employees who are experienced in the provision of various hotel-related services. In order to retain these employees, the Group offers attractive remuneration including housing allowances, performance bonuses, defined benefit pension schemes, stock options and various other incentive schemes. Salaries are paid on a semi-monthly basis on the 5th of each month for the pay-period from the 16th to the 30th and on the 20th of each month for the pay-period from the 1 st to 15th. The Group uses PeopleSmart, a specialised payroll system, for the processing of its payroll. Approval of the semi-monthly payroll is done electronically by PeopleSmart.

The Group's performance bonus scheme for its senior management is quite complicated. In order to motivate its senior management, each individual's bonus scheme is tailor-made and measurement of performance is based on a matrix of controllable variables for each individual's role, position and

,r--, responsibilities.

The Group is subject to numerous government employment regulations in the PRC including minimum wage requirements, overtime, working conditions and work permit requirements. The Group has a strong Human Resources team to ensure that all employment regulations are complied with.

Required:

Davies & Co CPA have been the auditors of Luxe since its IPO. This year, a new engagement partner has been assigned to the audit of Luxe due to partner rotation. You are the audit manager of the LUxe audit for the 2006 year end. The new engagement partner has asked you to write notes on:

(i) the assessment of the risks of material misstatement of payroll related expenses of the

accuracy assertion as well as the proposed audit procedures; and (13 marks)

(ii) factors to consider in using computer-assisted audit techniques (CAATs) and possible

CAATs in auditing payroll related expenses. (7 marks)

r> Q9)

Suggested Answers

i) . Audit of Luxe payroll related expenses

Accuracy refers to the assertion that payroll related expenses have been calculated and recorded appropriately.

The risk of material misstatement of the accuracy assertions are considered high due to the following factors:

1) Payroll expenses account for more than 50% of the Group's operating expenses.

2) The Group's performance bonus scheme is complex.

3) The Group needs to comply with numerous government employment regulations in the PRC such as minimum wages and overtime, etc which have an impact on its payroll calculation.

4) Payroll expenses relating to defined benefit pension plans and the stock option scheme requires expert knowledge.

5) Certain payroll expenses such as the pension and stock option are subject to management estimates and assumptions.



FTMS Hong Kong


As payroll expenses are significant, internal controls are likely to be in place to reduce the risks of material misstatement.

Also, as payroll expenses are significant, substantive procedures are always required to obtain sufficient appropriate audit evidence.

Therefore, a combined approach will be adopted, following two sets of procedures:

1. Tests of controls:

Understand, evaluate and validate Luxe's payroll approval process such as approval of the semimonthly payroll, approval of the performance bonus calculations, overtime, etc.

Understand, evaluate and validate Luxe's control of compliance with employment regulations.

Understand, evaluate and validate application controls in the PeopleSmart system

Any other valid tests of controls procedures.

2.

Substantive procedures:

Perform analytical procedures such as fluctuation analysis, payroll per head count, etc.

Perform reasonableness test of payroll expenses.

Obtain and review reports issued by independent external valuer and actuary.

Evaluate the reasonableness of estimates and assumptions used for pension and stock options.

Test the mathematical accuracy of payroll calculations such as minimum wages, overtime, performance bonuses, etc

Review and test reconciliation of payment of salaries, bonuses, etc to expenses recorded.

ii)

When planning an audit, the auditors may consider an appropriate combination of manual and r>;

computer assisted audit techniques. In determining whether to use CAATs, the factors to consider ~.__)

include:

The IT knowledge, expertise and experience of the audit team to ensure that there is sufficient knowledge to plan, execute and use the results of CAATs.

The availability of CAATs, suitable computer facilities and the necessary computerbased information systems and data.

Impracticability of manual tests due to complex processing, lack of hard evidence or volume of data.

Whether effectiveness and efficiency of audit procedures would be improved.

Timing of audit work and time available to perform the audit

The entity's general controls that may contribute to the integrity of the computer systems and CAATs.

With respect to the auditing of payroll-related expenses, the following CAATs may be used:

These notes are prepared by FTMS lecturing team. They are for the sale use of FTMS students attending HKICPA FE 50 courses in Hong Kong. For questions, please email tOhkicpa@ftmsaf.com.hk

FTMS Hong Kong


Controls:

Tests of general controls, for example, testing the set-up or configuration of the operating system for the PeopleSmart software.

Tests of application controls, for example, the electronic approval of the semi-monthly payroll in PeopleSmart.

Substantive procedures:

Analytical procedures such as identifying significant fluctuations of semi-monthly payroll or identifying inconsistencies such as large and unusual payments.

Sampling programs to extract payroll data for audit testing.

Tests of details such as recalculation of overtime payment.



FTMS Hong Kong


Q10) Auditing financial instruments (ex~racted from Dec 2009 Paper II Q2b)

r:1 Au -I${W.nCQ._·

In respect of derivative financial instruments, discuss the financial statement assertions that

are particularly subject to higher risk of material misstatement of FAL's financial statements and propose the substantive audit procedures to address the risk. (12 marks)


The financial statement assertions that are considered to have a higher risk of material misstatement ~~ ,t.J

are: _ n Ffo_tU\ ri£~ -1 fuNO\rftm OMW kwt r#\ ~~1.ed -7 ~VI~D PA- (e(p~

a) ~- all derivative financial instruments have been identified and accounted for. This has a significant risk of material misstatement considering the control breakdown (the fact that foreign currency contracts were executed without proper authorisation) that had happened due to fraud during the year. Those assessed risks of material misstatement due to fraud are significant risks according to HKSA 240.

b) Valuation and allocatio - all identified derivative financial instruments have been properly va ued. This has a significant risk of material misstatement as the valuation is likely to be complicated and involve significant Judgement and estimates.

c) ~ the loss from the derivative financial instruments have been recorded in the proper accounts. This has a significant risk of material misstatement as management may be inclined to apply hedge accounting for the foreign currency contracts, whilst the rules for hedge accounting are complicated and rigid under HKAS 39.

Substantive audit procedures include:

Completeness

Clrcularlse confirmations with banks and/or brokers and agree any derivative financial instruments identified from the confirmations to the accounting records.

Inspect settlements of derivative financial instruments subsequent to the year end and agree any derivative financial instruments identified to the accounting record.

Inspect a record/list of all treasury transactions and agree any derivative financial instruments identified to the accounting record.

o

Valuation and allocation

• Inspect the valuations of the derivative financial instruments and agree to the accounting records.

Review I test the key assumptions, data and methods underlying the valuations to ensure they are appropriate and reasonable. Depending on the auditor's assessment of his/her competency and experience in such valuations as well as the risk, engage an expert in the valuation of derivative financial instruments to conduct such a review I test.

Classification j ~ CCI- .

Agree the chang] d? # fair value of the instrument to P&L or eqUitr ~ovements, as appropriate

under HKAS 39./ rj rc-FRS~ . .

For derivative financial instruments that are considered by management to have satisfied the criteria for hedge accounting under HKAS 39:



FTMS Hong Kong


Inspect and review the terms in the underlying contracts to ensure the instruments satisfy the criteria for being a qualifying hedging instrument under HKAS 39.

Inspect and review the relevant hedge documentations (including the effectiveness test) to ensure that they satisfy the requirement of the accounting standards for hedge accounting to apply under HKAS 39.

Recalculate the effectiveness test included in the hedge documentations [Note: the effectiveness test forms the basis of whether and how hedge accounting should apply for the instruments].



FTMS Hong Kong

H.KICPA Final Examination Module C ~ Course Notes

Q11) Auditing revenue. risk offraud (Dec 2006 FE Paper II)

A-Group operates in three major business segments, namely publishing and multimedia, electronic information and solutions, and recruitment advertising and training. A-Holdings Limited, through its subsidiaries, is a diversified media company. The core business of the A-Group is the publication of the Hong Kong A-Journal ("A-Journal"), the leading business and finance newspaper in Hong Kong. Apart from newspaper publishing, A-Group has successfully developed other business ventures such as recruitment advertising ("A-Careers"). In addition, A-Group is a leading real-time information provider providing financial information, equities and derivatives quotations, news, commentaries and information on Hong Kong listed companies to professional market and retail investors ("A-Online"). A-Group has attained the following honours for its various business operations:

1. A-Journal is the leading business and finance newspaper in Hong Kong, according to a report generated by The Hong Kong Audit Bureau of Circulations Ltd. (HKABC). It ranked first in gross display advertisement revenue among all business and finance newspapers in Hong Kong. While AJournal has a reputation for business and finance news reporting and is one of the recognised newspapers for official information announcements, it also has all the features of a typical newspaper, such as sports and entertainment.

2. A-Careers has been ranked first in the recruitment classified advertising market in Hong Kong. Customers of A-Journal and A-Careers are required to sign a contract when advertisement orders are placed. A price matrix is set each year by the company with effect from 1 January. Advertising revenue charged is based on advertising space (six sizes available) and length of display period (daily, weekly, bi-weekly and monthly). Full payment of advertising revenue is required upon signing of contract. Advertisers' main considerations in the selection of a newspaper to place advertisements are circulation volume and readers' profiles, including their income level, educational background and demographic profile. Over the years, A-Group has developed a diversified advertiser base including banking, finance, property, travel, leisure, consumer goods and health products.

3. A-Online is one of the market leaders in providing real-time business and financial information to the professional market and retail investors. Subscription to A-Online's services is made on-line by customers through A-Online's website. The period of subscription can be monthly, quarterly, semiannually or annually. Payments are made in full by credit card upon on-line subscription.

Peter Cheung, A-Group's general manager, has prepared the following business plan and information for the next board of directors meeting:

Business Plan

A-Group's mission is to become a leading branded financial and business information and services

provider in Greater China. In order to pursue this mission, A-Group plans to ride on. its branded r--"

( i

platform and expand its product line as well as its business geographically, and to enhance its \_/

operational efficiency, including:

A. Geographic and product expansion

A-Group is planning to develop a new magazine, A-Digital, which specialises in disseminating industry and market information on consumer digital products such as digital cameras. A-Digital's principal income would derive from advertisements placed by dealers of these digital products and from circulation of the magazine.

A-Group has entered into a conditional sale and purchase agreement with Shenzhen Holding to acquire the entire registered capital of Shenzhen Advertising, a subsidiary of Shenzhen Holding. The acquisition of Shenzhen Advertising will increase A-Group's exposure in Mainland China and provide opportunities for A-Group to explore business cooperation with other media companies with strong growth potential in Mainland China.

HK$30 million has been budgeted for the planned expansion, though not yet approved by the board of directors, in the next three financial years.



FTMS Hong Kong


A-Group also plans to pursue the development and customisation of its A-Online quotation products so as to cater for the specific needs of the Mainland China market. Two projects are involved for the purpose of business expansion in Mainland China, namely:

. 1. A web site, China-A-Online, is under development. Feasibility studies have been undertaken and HK$6 million has been paid to purchase the hardware while HK$4 minion has been paid for the graphic design. With the launch of the customized products and the increased hardware set up coupled with A-Group's knowledgeable and committed sales team, it is believed that A-Group is able to not only increase its market coverage in this segment but also, through the provision of customised products, build a sustainable relationship with its customers. An additional HK$20 million is budgeted, though not yet approved by the board of directors, for content development in the coming year.

2. A simplified Chinese version of A-Group's web site has been developed to promote and advertise the services of China-A-Online. The development has been completed at a cost of HK$2 million. Realtime business and financial information is not expected to be provided through this web site since a dedicated electronic connection is expected through China-A-Online for security purposes.

B. Advertising services in exchange for receiving advertising services

A-Group entered into an arrangement to provide advertising services in exchange for receiving advertising services from .its customers. Advertisements are displayed in A-Journal in exchange for A Group's advertisements being displayed on customers' web sites. The web sites of these customers are not used primarily for generating revenue.

c. Upgrade production technology by adoption of "computer-to-plate"

A-Group is looking for an appropriate time in the next three financial years for the adoption of "computer-to-plate" equipment so as to reduce material costs, manpower resources and production lead time. Financing of the plan requires an input of HK$25 million. A-Group is considering whether the equipment should be purchased or leased. If it is to be leased, Agroup needs to pay annual instalment of HK$4,068,635 in arrears for 10 years. The equipment will have a useful economic life of 10 years and there shall be no residual value after 10 years. The present value of the minimum lease payment is substantially the same as the fair value of the equipment and A-Group is going to use the assets for an extended period, covering the useful life of the assets. CTP software is required to operate the "computer-to-plate" equipment. This software was developed by CTP Inc., a US company which does not carry on business in Hong Kong. Agroup has tentatively negotiated with CTP Inc. to pay an annual fee of HK$1 million to CTP Inc. for the use of CTP software.

You are the audit manager responsible for the A-Group audit.

Required:

a) Every year, A-Journal is required to report its annual gross display advertisement revenue to HKABC. This year, HKABC has asked A-Journal to obtain a report from its auditors on the amount of gross display advertisement revenue reported to HKABC. Your engagement. partner proposes to issue a report on agreed-upon procedures and asks you to prepare a memo describing the factors to be .considered in this engagement. (5 marks)

b) Describe the auditor's responsibility to consider fraud in an audit of financial

statements. Assess the risk of fraud of A-Group's revenue recognition. (5 marks)

c) In planning for the year-end audit of A-Group, document your assessment of the risks of material misstatement of advertising revenue by assertion and document your audit

approach in response to the assessed risks. (10 marks)

d) Peter Cheung has asked you to assist him in identifying the business risks associated with A-Online's online subscription process. Prepare a memo to Peter Cheung.

(5 marks)



FTMS Hong Kong



a)

To: Audit Partner From: Audit Manager

Re: Aqreed-upon procedures on the amount of gross display advertisement revenue

This year, HKABC asked A-Journal to obtain and submit a report from its auditors on the amount of gross display revenue reported to HKABC. This memo summarises the factors we will need to consider in issuing a report on agreed-upon procedures on the amount of A-Journal's gross display advertisement revenue.

We will need to refer to the Hong Kong Standards on Related Services 4400, Engagements to perform aqreed-upon procedures regarding financial information, issued by the Hong Kong Institute of Certified Public Accountants.

First of all, the procedures to be performed on the amount of A-Journal gross display advertising revenue will need to be agreed by A-Journal. A signed engagement letter must be obtained from A

Group to record the agreed terms of this engagement. .

Our report, will include the following: - C'

A list of the specific procedures we have agreed to perform;

Descriptions of factual findings including sufficient details of errors and exceptions found;

A statement that the procedures performed do not constitute an assurance engagement and, as such, no assurance was expressed; and

A statement that the report is restricted to those parties that have agreed to the procedures to be performed.

b} Responsibilities of the auditor for detecting material misstatement due to fraud

HKSA 240 set out the responsibilities of the auditor to consider fraud in an audit of financial statements. An auditor conducting an audit in accordance with HKSAs needs to obtain reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error.

Therefore, an auditor needs to assess the risks of fraud in an audit and design procedures to detect material misstatements due to fraud by performing the following:

Discussing the susceptibility of A-Group's financial statements to material misstatement due to fraud with the engagement team;

Inquiring about and obtaining an understanding of oversight exercises by those charged with /">. governance; U Considering fraud risk factors;

Considering unusual or unexpected relationships.

When obtaining reasonable assurance, an auditor needs to maintain an attitude of professional scepticism throughout the audit and consider the potential for management override of controls.

An auditor cannot obtain absolute assurance that material misstatements in the financial statements will be detected because of such factors as the use of judgement, the use of testing, and the inherent limitation of internal controls and the fact that much of the audit evidence available to the auditors is persuasive rather than conclusive in nature.

Material misstatement due to fraudulent financial reporting often results from a misstatement of revenue. Therefore, the auditor ordinarily presumes that there are risks of fraud in revenue recognition.

The following fraud risk factors exist in A-Group's revenue recognition:

Management may be under pressure or has an incentive to overstate revenue as:



FTMS Hong Kong


* The Group is a leader in the Hong Kong market and its mission is to become a leading branded financial and business information and services provider in Greater China.

* The gross display advertisement revenue of A-Journal is reported and published by HKABC. Opportunities exist as the recognition of advertising services revenue in exchange for receiving services is subject to estimates that are difficult to corroborate.

Management may be able to use different reasons to rationalise the committing of frauds, although the rationale would not stand.

c) Advertising revenue - Risks of material misstatement by assertions and audit approach Occurrence refers to the assertion that advertising revenue that has been 'recorded has occurred and pertains to A-Group. As discussed above, it is a presumption that revenue recognition has a higher risk of misstatement due to fraud and the management of A-Group has incentives I pressures to overstate revenue.

Therefore, the inherent risk would be that advertising revenue may not be supported by the existence of advertising contracts and the placement of advertisements by customers.

r=> Completeness refers to the assertion that all advertising revenue that should have been recorded have been recorded. As discussed above, the risk of advertising revenue is overstatement and therefore, the risk of material misstatement of the completeness assertion is assessed as low.

Accuracy refers to the assertion that advertising revenue has been recorded appropriately.

The inherent risks of material misstatement of the accuracy assertion are considered high as A-Group entered into arrangements to provide advertising services in exchange for advertisements being displayed on the web sites of its customers. These web sites are not primarily used for generating revenue. As a result, revenue recognition of these barter transactions is subject to significant estimates which will be difficult to corroborate.

Also, as the pricing of advertisement services varies and is based on advertising space and length of display period, there is also an inherent risk that the advertising revenue recognised may not be in accordance with A-Group's pricing matrix.

Cutoff refers to the assertion that advertising revenue has been recorded in the correct accounting period.

There is an inherent risk of material misstatement of the cutoff assertion as both A-Journal and A /"> Careers require up-front payment of advertising revenue upon signing of contracts and that each contract covers a period of time. Therefore, advertising revenue may not be recorded in the proper accounting period (i.e. over the advertisement display period).

Audit procedures can be classified as test of controls and substantive procedures. Risks of material misstatement can be reduced if A-Group has implemented effective internal control. Therefore, it is important to obtain an understanding of the entity and its environment, including its internal controls in preventing or detecting and correcting material misstatements at the assertion level. If an internal control is considered to be effective, reliance can be placed on A-Group's internal control to support our reasonableness conclusion after we have tested and are satisfied with the operating effectiven ess. '

Since advertising revenue is a material class of A-Group's transactions, substantive procedures are always required to obtain sufficient appropriate audit evidence.

Substantive procedures include substantive analytical procedures and test of details.

For assertions with low risks of material misstatement, a combined approach of test of controls and substantive analytical procedures is likely to be the most efficient way to obtain audit evidence.


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For assertions with higher risks of material misstatement, the following tests of details should be performed in order to obtain sufficient audit evidence

On a test basis, check that the advertising revenue agrees with the signed contract, the advertisements displayed in A-Journal and A-Career (occurrence assertion) and the payments received;

On a test basis, check that the advertising revenue agrees with the terms of contract and price matrix (accuracy);

Understand the client's process in the recording of barter transactions (i.e. exchanges of advertisement services). Review and test the client's estimates / judgement in the amount of revenue recognised in a barter transaction (accuracy);

Select a sample of contracts. For the contracts covering the period subsequent to year end, re perform the client's cutoff procedures to ensure that revenue has been properly recognised over the display period (cutoff).

d)

To: Peter Cheung

From: Jess Lee, Audit Manager

Re: Business risks associated with on-line subscription process

This memo summarises the various business risks associated with A-Group's on-line subscription process:

loss of transaction integrity, the effects of which may be compounded by the lack of an adequate audit trail in either paper or electronic form;

pervasive e-commerce security risks, including virus attacks and the potential for the entity to suffer fraud by customers, em ployees and others through unauthorized access;

improper accounting policies related to, for example, capitalisation of expenditures such as website development costs and revenue recognition if other entities are given advertising space on A-group's web site;

non-compliance with taxation and other legal and regulatory requirements, particularly if on line subscriptions are conducted across international boundaries;

failure to ensure that contracts evidenced only by electronic means are binding;

over reliance on e-commerce when placing significant business systems or other business transactions on the Internet;

systems and infrastructure failures or "crashes".



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Q12) Audit of Related Party Transactions & PPE (extracted from FE June 2008 Paper II Q3) Mr. Chan is the Chief Financial Officer (CFO) of C-Group, a company listed on the Stock Exchange of Hong Kong. Mr. Chan works closely with Mr. Lee, the Chief Executive Officer (CEO) of C-Group. Mr. Lee plans to expand C-Group as quickly as ~ossible. to demonstrate his ability to his father; the

founder of C-Group. 4atJ1rQUI\JQ,~ V '

JJ .. '-1 Rlt7li lIlMf~

Operations ofC-Group

C-Group, together with its subsidiaries as a group, is principally engaged in the design, manufacture and sale of electronic consumer products and plastic products.

Despite a tough environment in the year ended 31 March 2008, C-Group was able to achieve steady growth, overcoming the various troughs through prudent planning and execution. The measures taken included minimising costs and reducing lowerend products, the costs of which are more susceptible to fluctuations in the prices of raw materials such as plastic and metal. Moreover, the company has maintained efforts to strengthen automation in order to combat escalating labour costs in China. The greater use of Automatic Optical Inspection (AOI) equipment has helped to reduce the reliance on workers while at the same time raising the quality of its PCB (printed circuit board) assemblies and

---. products.

C-Group also substantially expanded its automatic spraying facilities by 80% which has helped to save cost and further eased the demand for skilled labour. As a result of these and other measures, C-Group has been able to reduce the staff count by roughly 10% to 15% annually and duly deployed. the present workforce most effectively, running double shifts during peak seasons to ensure customers' orders are always punctually met.

As the best means of combating cost is raising profitability, C-Group was committed to high valueadded products. Due to the decrease in LCD panel prices during the year which led to higher affordability and greater demand, C-Group was able to penetrate the LCD TV market quite successfully. As an indication of the success of this strategy, C-Group was able to maintain its gross profit margin despite an increasingly difficult business environment.

(a) Reportable segments

C-Group has four reportable segments: electronic consumer products, plastic products, software and finance. The electronic consumer product segment produces electronic products for sale to retailers. The plastic product segment produces plastic and packaging products for sale to retailers. The software segment produces application software for sale to computer and electronic product

r> manufacturers and retailers. The finance segment is responsible for portions of the com pany's financial operations including financing customer purchases of products from other segments.

The accounting policies of the four operating segments are the same as those described in the summary of significant accounting policies except that the pension expense for each operating segmenfis recognised and measured on the basis of cash payments to the pension plan. C-Group evaluates performance on the basis of profit or loss from operations before tax expenses not including non-recurring gains and losses and foreign exchange gains and losses.

C-Group accounts for intersegment sales and transfers as if the sales or transfers were to third parties, i.e. at current market prices.

C-Group's reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different technology and marketing strategies. Most of the businesses were acquired as individual units, and the management at the time of the acquisition was retained. Since C-Group's reportable segments are based on differences in products and services, no additional disclosures of revenue information about products and services are required.

You are the audit manager of Smart CPA firm responsible for the up-coming year end audit of C-Group. Your engagement partner has asked you to prepare a memo on the following:



a)

the proposed audit procedures on related party transactions; and

(10 marks)

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b)

your assessment of risks of material misstatement of property, plant and equipment by assertions and your proposed audit procedures in response to the risks identified.

~ (10 marks)

Suggested Answers fbMl1t-

Q12)

a)

To: Audit Partner From: Audit Manager

Re: Year end audit of C Group

The proposed audit procedures on related party transactions:

As C Group engaged in a number of related party transactions, we need to have a sufficient understanding of the entity and its environment to enable identification of the events, transactions and practices that may result in a risk of material misstatement regarding related parties and transactions with such parties.

HKSA 550 sets out the guidance on the auditor's responsibilities and audit procedures regarding related parties and transactions with such parties.

Because of the degree of uncertainty associated with the assertions regarding the completeness of related parties, we should review information provided by C Group identifying the names of all known related parties and should perform the following audit procedures in respect of the completeness of this information:

(a) Review prior years' working papers for names of known related parties;

(b) Review the entity's procedures for identification of related parties;

(c) Inquire as to the affiliation of those charged with governance and officers with other entities;

(d) Review shareholder records to determine the names of principal shareholders or, if appropriate, obtain a listing of principal shareholders from the share register;

(e) Review minutes of the meetings of shareholders and those charged with governance and other relevant statutory records such as the register of directors' interests; and

(f) Review the entity's income tax returns and other information supplied to regulatory agencies.

With respect to related party transactions, we should obtain an understanding of the entity's internal

control and consider the adequacy of control activities over the authorisation and recording of related I~'

party transactions. U

To ensure completeness of related party transactions, we should be alert for transactions which appear unusual in the circumstances. The following audit procedures should be performed:

Performing detailed tests of transactions and balances.

Reviewing accounting records for large or unusual transactions or balances, p·aying particular attention to transactions recognised at or near the end of the reporting period.

Reviewing confirmations of loans receivable and payable and confirmations from banks. Such a review may indicate guarantor relationship and other related party transactions.

Reviewing investment transactions, for example, purchase or sale of an equity interest in a joint venture or other entity.



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HKICPA Final Examination Module C - Course Notes.

Given the nature of related party relationships, audit evidence of a related party transaction may be limited. Therefore, the following procedures will be performed to examine identified related party transactions:

Confirming the terms and amount of the transaction with the related party.

• Inspecting information in possession of the related party.

Confirming or discussing information with persons associated with the transaction, such as banks, lawyers, guarantors and agents.

As HKAS 24 requires the disclosure of related party relationships, we should review the disclosure made by management in the financial statements to ensure that we are satisfied that the disclosure is adequate.

Management representation should be obtained concerning the completeness of information provided regarding the identification of related parties and the adequacy of related party disclosure in the financial statements.

b)

r Assessment of risks of material misstatement of property, plant and equipment by assertions and proposed audit procedures in response to risks identified:

Property, plant and equipment is considered a key audit area as there have been significant additions due to the following:

• The greater use of Automatic Optical Inspection (AOI) equipment The expansion of the automatic spraying facilities by 80%

The potential addition of a $10 million facility through bank borrowing or finance lease

Therefore, risk of material misstatement is considered medium to high, especially relating to the following assertions:

Completeness - since lease classification may not be straight forward, it is possible that property, plant and equipment additions that meet finance lease classification requirements have not been

recorded. .

Valuation and allocation - since depreciation rates and impairment assessment are subject to management estimates which are more difficult to substantiate, property plant and equipment may not be included in the financial statements at appropriate amounts and any resulting valuation

r> adjustments may not be appropriately recorded.

As C Group has been prudent in its business planning and execution, it is likely that controls are in place to monitor capital expenditure and additions of property, plant and equipment.

Therefore, a combined approach will be adopted. To rely on C Group's internal controls, we will need to test the controls to assess their design and operating effectiveness.

Substantive procedures by assertions will be performed and are listed below:

Completeness:

• Compare total additions of property, plant and equipment to the annual budget.

Review minutes, significant contracts and agreements to identify additions of property, plant and equipment

• Review the repair and maintenance account to ensure additions meeting the capitalisation policy are not expensed

Review lease agreements to ensure proper classification



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Valuation and allocation:

Review the appropriateness of C Group's estimates in establishing its depreciation policy such as useful life, residual value, etc.

• Recalculate the depreciation expense on a test basis.

Review impairment testing and assess the reasonableness of the calculation of a recoverable amount.

Existence, and Rights and obligations:

Physical inspection

Agree to invoices or purchase agreements

o



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HKICPA Final Examination Module C· Course Notes

Q13) Risk of MM & Controls (June 2009 FE Paper I)

(Extract of questions only)

Assume that you are Sporty Group's finance manager, Mr. Chan. You are helping the finance director to prepare for the audit committee meeting next week. The finance director asks you to write him a memo on the following issues that may be raised by the independent directors during the meeting:

Management's assessment of the risk of material misstatement of the financial statements (including fraud risk), along with the possible internal controls that could mitigate the risks identified, associated with:

(i) the high concentration of sales; and (6 marks)

(ii) retail business if the company goes ahead with its plan to operate its own retail

outlets; and (9 marks)


i)

The performance and hence the viability of the Sporty Group is highly correlated with the performance of its 5 major customers, especially the largest customer who accounted for more than half (51 %) of the Group's sales in the Financial Year 2008. Given sales are highly concentrated, risk of material misstatement of financial statements may arise in the following areas:

Going concern: Sales of the Sporty Group are made to Europe and the US markets. The sub-prime mortgage issue and the financial crisis are leading to the economic downturn I contraction in borrowing in the US and Europe. Our major customer which operates within these regions may be negatively impacted. Default risks also increase during the economic downturn. These will not only have adverse impact on our group performance but also put pressure on the Group's liquidity position.

Recoverability of Accounts Receivable: Recoverability of debts from our counterparts operating in the US and Europe may become doubtful. This again, will put pressure on the Group's cashflow.

Realisability of inventories: Since the Group's products are exported to Europe and the US, any decrease in demand from these markets will increase the risk of inventory obsolescence. The net realisable value of the inventory could be lower than the cost.

The following controls could be implemented by management to mitigate the risks:

1) Performing an assessment of going concern by analysing future cash flows.

2) Preparing and monitoring a cashflow budget. The actual cashflow position would be monitored against the budget to identify liquidity issues and to formulate action plans to manage such issues if any.

3) Producing a business risk map. All threats (including but not limited to high concentration of sales) would be included in the map. Mitigating factors identified to mitigate the risks include the exploration of new markets, discovering opportunities in Asia or the Middle East or the development of our own brands targeting customers in non US I Europe markets. The business risk map would be reviewed and approved by management regularly.

4) Holding monthly management meetings to discuss the threats and the mitigating controls I strategies.

5) Reviewing of AR aging report. Management would perform AR aging reviews on a regular basis.



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6) Following up closely on overdue debts and strict adherence to the Group's collection procedures. Collection letters would be sent to all overdue accounts.

7) Provision for bad debts: Based on the feedback received during the collection process and aging reports, management would review the adequacy of doubtful debt provisions.

8) Reviewing the inventory aging report: the aging report would be reviewed by management ensuring adequate provision is made against the aged inventory items.

9) Reviewing the order book f Meeting periodically with the distributors f collecting feedback from distributors. These would be done in order to identify slow moving items.

10) Reviewing the sales trend to ensure the pricing strategy responds to market demand and com petition.

ii)

The Group is considering the operation of its own retail outlets. The following are generally the key risks for a retail business:

1) Completeness of sales - unreported sales. Goods may be sold but are not recorded.

2) The risk of misappropriation of cash is high due to a high turnover of cash.

3) Risk of burglary. Cash could be lost.

4) Stock loss resulting from theft of merchandise and misappropriation of stock.

5) Inaccurate inventory balance: inventory movement may not be accurately recorded if the till (electronic sales register) is not integrated with the inventory recording system.

6) Manipulation of prices by the salesman f cashier. Pricing and discounts offered to customers may not follow the Group's approved price list f discount policy.

7) Improper implementation or inadequate monitoring of the stock replenishment system.

Inventory with a high turnover rate could be piled up in the storeroom. Cash could be tied up and this could adversely affect the liquidity of the business.

8)

Business risks I inherent risks of retail business. The retail business is an integral part of the economy. During an economic downturn, retail sales are one of the most badly hit sectors. When the economy picks up, rental charges may increase tremendously and the majority of profits will be "handed over" to the landlord.

9) Risks of receiving counterfeit money.

10) Other valid risks.

Controls to be implemented include:

1) Regular stock take: A "blind count" should be performed periodically to ensure the individual stock balance agrees with the inventory record. The count result (count sheet) should be submitted to the Accounts Department for reconciliation. An independent person, e.g. from the Accounts Department should attend and observe the count at least once a year. Unfavourable variances should be investigated and written off from the books.

2) Reconciliation of sales and the inventory balance: Sales reconciliation should be performed to ensure sales are in line with the inventory movement (stock out).



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3) Daily cash count: This should be performed by the Shop Manager on a daily basis ensuring the amount received agrees with the till record. Cash should also be deposited into the bank in a timely manner.

4) Regular bank reconciliation I Reconciliation of money received against receipts recorded at the till: Reconciliation should be performed on a daily basis to ensure "money" (either in the form of cash, EPS I credit card transaction slips) agrees with the amount of receipts per the till records. Bank reconciliation is also required to ensure cash and non-cash receipts are banked in and there are no fictitious non-cash receipts.

5) Physical control over assets: Security devices such as a eeTV surveillance system should be installed at retail stores. Inventories and cash should be securely stored I safely kept. The shop should be locked during non-operating hours.

6) Implementation of an integrated system: This links up cash drawers and inventory records, i.e. a Point of Sale (POS) and bar-coding system. Goods are checked out by scanning the barcode. The bar-coding system enables transactions I receipts to be recorded at the till by an electronic cash register. The system at the same time allows the inventory record to be updated to reflect the stock out.

7) Implementation of the bar-coding system also helps to ensure prices cannot be manipulated.

A price list should be generated from the system and it should be reviewed by management to ensure prices are correctly set. Access to price setting I applying sales discounts should be limited to authorised personnel. The cash registry I exception price report should be generated from the electronic register and reviewed by management to ensure no unauthorized discounts are given to customers.

8) Periodic review of sales trends in conjunction with the inventory activity report: This ensures the inventory movement is in line with the sales trend. Surprise visits to the store may be done to observe the stock replenishment system.

9) Avoidance of high concentrations of sales in one geographical location: Diversify the risk by expanding the business into other markets that are less dependent on the economy of home country {where the retail stores are located). During economic downturns, purchase the premises where the retail outlets operate (Normally property prices are lower during a

recession).· .

10) Staff training: including the ability to detect counterfeit money.

11)

Segregation of duties whereby incompatible responsibilities are handled by different persons.



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Q14) Internal control environment & procedures (extracted from Dec 2009 Paper I Q1e & 19)

(Students are required to review the case study of this Q1 of Paper I before appreciating the answers)

List out the specific policies or practices that you expect RED should have in place in order to have a strong control environment (being the first component of internal control). (12 marks)

Advise the internal controls necessary over the subcontracting process for property

construction projects. (6 marks)


Control environment is about setting the tone of an organisation which influences the control consciousness of its people. It is the foundation for all other components of control. The controls in respect of RED's control environment that could be implemented include the following:

Communication and enforcement of integrity and ethical values

A comprehensive code of conduct which includes a conflict of interest policy, expected standard of ethical and moral behaviour and acceptable business practices. The code should be communicated prominently throughout the organisation (e.g. posters, em ails) and/or distributed to all employees.

A process in place for employees to follow should they encounter inappropriate behaviour and for providing remedial action against violations of the code. Departures from policies and procedures are noted in performance appraisals, communicated to key management and board where necessary and, depending upon the severity, result in additional training or termination.

A whistleblower policy in place for reporting of inappropriate behaviour on an anonymous basis to an independent party. All whistleblower reports are investigated to determine if any inappropriate behaviour has occurred. Appropriate remedial action is taken and findings/implications communicated within the entity.

There are means for third parties to communicate financial reporting issues anonymously if so required. Complaints of improper financial matters by third parties such as suppliers or regulators are fully investigated, documented, and reported to those charged with governance.

Commitment to competence

Documented job descriptions are provided. Management ensures requisite skills are reflected in job openings when posted, and participates in the review and interviewing process to ensure adequately skilled personnel are hired. Management periodically reviews and evaluates employees relative to their assigned roles.

Ongoing training and opportunities for advancement are provided to ensure employees have adequate knowledge and skills to perform their jobs.

Participation by those charged with governance

The roles and responsibilities of the Board are appropriately defined in the charter. Self review is performed at least annually to determine whether the Board's performance is in accordance with the charter.

The Board is provided with information to review and approve, where appropriate, on a periodic basis (e.g. quarterly), the long term strategic plan along with the annual objectives, the periodic risk assessment, updates on progress toward achieving the yearly objectives and information on significant transactions anticipated in the near future. .


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The Board of Directors has a set schedule of regular (e.g. monthly/quarterly) meetings and meets on an as-needed basis when significant issues arise.

Annually the Board or a Remuneration Committee reviews the compensation of senior management. Compensation tied to performance of these personnel must be approved by the board.

There is an Audit Committee comprising independent non-executive members with its roles and responsibilities appropriately defined, which should include, among others: review of the complaints received and the treatment by the company regarding accounting, internal controls or auditing matters, including those anonymously reported through the whistleblower programme or other channels; responsibility to appoint, evaluate and terminate the external auditor; review with the external and internal auditor of any audit problems or difficulties and management's response.

The Audit Committee is provided with appropriate information on a timely basis. This includes the quarterly financial package, which contains a budget to actual review, periodic updates of internal audits results and significant findings.

The Audit Committee periodically meets with management, with the internal auditors (or those responsible for that function) and with the external auditors for regularly scheduled executive sessions to allow discussion of issues and concerns.

The internal audit department reports directly to the Audit Committee. The Audit Committee periodically reviews, discusses and approves internal audit's charter, staffing and resources, annual plan, modifications to annual plan and organisational reporting lines. The Audit Committee receives quarterly reports from the Internal Audit on results of recent reviews/audits.

Management philosophy and operating style

There is a formal communication channel to report violations of policies and procedures and to communicate findings/implications that ensures appropriate remedial action is taken to deter violations of policies.

Before entering into any significant transaction, management conducts a comprehensive risk assessment process and makes major business decisions only after analysing the risks and benefits.

r>.

r

Organisational structure

Organisation structure and roles and responsibilities are clearly defined and communicated to all concerned parties. An organisation chart should be updated from time to time depicting the reporting responsibilities across the organisation. It should be made available to all employees. The organisational structure is periodically evaluated to ensure it adequately supports the achievement of the company's objective.

Assignment of authority and responsibility

Authority and responsibilities are set out clearly with a written authorisation matrix established. This should show the level of authority by nature and approval limit and delegation of authority and defined authority levels based on individual job responsibilities. These authorities should be communicated to all staff and a regular review and update of the level of authority should be performed.

Human Resources policies & practices

Documented Human Resource policies and procedures are in place for hiring, training, promoting, retaining and compensating employees.



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Performance appraisals are completed at least annually on all personnel. HR oversees the overall review process of each department and reviews employee retention decisions (or other remedial action necessary), along with readiness for additional responsibility or promotion decisions.

References are required as part of the hiring process and referees are contacted for all candidates prior to hiring. This process is evidenced through documentation in each personnel file.

Performance of background checks is required on all personnel, particularly those with access to sensitive data and information systems.

Suggested Answer (second part)

Internal controls in respect of the subcontracting process:

The selection criteria for subcontractors must be clearly defined and the assessment must be based on at least 3 comparative bids.

The selection process should be transparent and RED should have an authorisation matrix which sets out the authority for approval of a subcontractor.

The following should be considered during the selection process and form part of the selection criteria:

Financial stability Work quality

Experience and qualification of their staff Available resources

Insurance coverage of the subcontractor (public liabilities for third parties and for its staff) Declaration of related party transaction - the candidate who bids for the construction project should declare the person (name and position) they know who is working in RED.

Once contract is awarded to the subcontractor, RED must have routine processes to monitor the work progress ensuring it is on schedule as well as the quality of work. E.g. a checklist should be designed and RED's project management team should perform site visits periodically and complete the checklist accordingly.

THere must be a monitoring system to ensure the above is done. The checklist should be signed off

by the head of the project management and it should be reviewed and signed off by the project (~.'

director. '<::

Separate evaluation should be done by the internal audit function to ensure the company policies have been complied with.

Best regards, Finance Manager


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Q15) Fraud, Control and Internal Audit (adapted from June 2006 FE Paper II)

a) By referring to the characteristics of fraud, identify the potential risks of fraud for a hotel who sells rooms in bulk sales transactions with travel agencies and airlines (these sales contributed to 75% of the hotel revenue). Suggest internal controls to reduce any such risks. .. (6 marks)

b) Identify the potential risks regarding the extensive use of an on-line computer systems and

suggest internal controls to reduce any such risks; (8 marks)

c) Determine whether a company, who had just invested in a hotel and is new to hotel operation, should set up an internal audit unit to look at its operation; and suggest the scope of work specific to the hotel operation; (6 marks)

d) Comment on the internal auditor's ethical duties by comparison with those of the external auditors (For the purpose of this part, you should assume that the internal auditor is a certified public accountant). (5 marks) Total: 25 marks

.~ Q15} Suggested Answers

a)

Risks of fraud are higher when (1) there is incentive or pressure to commit fraud; (2) a perceived opportunity to do so; and (3) some rationalisation of the act.

In the case of bulk sales to travel agencies and airlines, the hotel general sales manager may have significant power to determine the terms of any agreements with travel agencies or airlines.

A perceived opportunity for fraudulent acts may still exist when the general sales manager believes internal controls can be overridden, for example, because he/she is in a position of trust or has knowledge of specific weaknesses in the internal control.

While this may be a fact in hotel industry practice, it poses a risk of fraud in the sense that the general sales manager is perceived to have the opportunity to take advantages of the practice, for example, by receiving kickbacks from travel agencies or airlines, or nonmonetary benefits, such a luxury holiday packages.

Given that revenue from these sales accounts for 75% of the hotel's revenue, the general sales manager may rationalise such fraudulent acts by considering them as proper rewards for the ~ manager's contribution to the hotel.

Possible internal controls to reduce the risks may include (1) establishing an ethical code for staff of all levels to follow, (2) establishing a standard policy on travel agency or airline selection, with authorisation limits within which the general sales .manager may negotiate the terms of agreements, reviews of exceptions by senior management, e.g. the managing director or the board, (3) setting up an internal auditing function to review compliance with these standards and guidelines, etc.

b)

An on-line computer system has the following characteristics (1) on-line data entry and validation, on line access to the system by users, (2) possible lack of visible transaction trails; and (3) potential access to the system by non-users, including programmers and other third parties (for example, through e-mail and the internet).

In particular, on-line data entry and access to the system by users provides a user with the potential ability to make unauthorised changes to the data and programs.

Applications in an on-line environment may have greater exposure to unauthorised access and updates.



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The company's security infrastructure will play an important part in ensuring the integrity of the information produced. The hotel needs to establish suitable general controls to mitigate the risks of viruses, unauthorised access and the potential destruction of audit trails. Hence access controls are particularly important to on-line processing.

These controls may include the use of passwords and specialised access control software, such as on-line monitors, that maintains control over the menus, authorisation tables, passwords, files and programs that users are permitted to access.

They may also include physical controls such as the use of key locks on terminal devices, locked computer rooms and inactivity timeouts.

Other relevant controls include, for example, programming controls; transaction logs; and firewa II s. Certain application controls are particularly important to on-line processing. These include pre processing authorisation; terminal device edit, reasonableness and other validation tests; input error. reporting and handling; cut-off procedures etc.

c}

An internal audit is an independent appraisal function established by the management of an /~\

organisation for the review of the internal control system as a service to the orqanisatlon. '0

It objectively examines, evaluates and reports on the adequacy of internal controls as a contribution to

the proper, economic, efficient and effective use of resources.

Routine checking of transactions by officers of the company should be regarded as part of internal controls and not an internal audit function.

Since running a hotel is new to the company, it is worthwhile for the company to exercise tighter control over the hotel's operations.

The internal auditing department is an integral part of the organisation and functions of a hotel under the policies established by management and the board of directors. The scope and objectives of the internal audit function are set by the management and directors of the hotel.

The scope and objectives of the internal auditor function of the hotel may include:

review of the accounting and internal control systems in relation to the hotel operations; (measures to reduce risk of fraud, misappropriation of assets etc.)

examination of the reliability and integrity of the financial and operating information used by

hotel managers (for example, sales forecasts and room utilisation rate estimation);Fj review of the economy, efficiency and effectiveness of operations including nonfinancial 0 controls of the hotel (for example, employee job satisfaction and quality of customer service);

and

review of compliance with laws, regulations and other external requirements and with management policies and directives and other internal requirements (for example, compliance with fire regulations, hygiene regulations and labour law regulations applicable to the hotel business etc).

d)

In principle, the ethical duties of the internal" auditor and the external auditor are the same since they are subject to the same set of fundamental principles of professional ethics. In accordance with the fundamental principles of professional ethics:

the internal auditor should be straightforward and honest in all professional and business relationships;

the internal auditor should not allow bias, conflict of interest or undue influence of others to override professional or business judgments;

the internal auditor has a continuing duty to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service



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based on current developments in practice, legislation and techniques. A professional accountant should act diligently and in accordance with applicable technical and professional standards when providing professional services;

the internal auditor should respect the confidentiality of information acquired as a result of professional and business relationships and should not disclose any such information. to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose. Confidential information acquired as a result of professional and business relationships should not be used for the personal advantage of the professional accountant or third parties; and

the internal auditor should comply with relevant laws and regulations and should avoid any action that discredits the profession. (courtesy)

However, it is also recognised that the independence of internal auditors is different from that of external (or statutory) auditors on financial statements. Internal auditors' independence comes from their organisational status, essentially their function and to whom they report, and from their objectivity.

For external auditors, independence derives from the absence of any obligation to or financial interest in the entity they audit. Internal auditors should follow the detailed guidance in the code of Ethics for

Professional Accountants. .



FTMS Hong Kong


Q16) Sales process and control weaknesses (Source: ACCA Paper FB June 2007)

Rhapsody Co supplies a wide range of garden and agricultural products to trade and domestic customers. The company has 11 divisions, with each division specialising in the sale of specific products, for example, seeds, garden furniture, agricultural fertilizers. The company has an internal audit department which provides audit reports to the audit committee on each division on a rotational basis.

Products in the seed division are offered for sale to domestic customers via an Internet site. Customers review the product list on the Internet and place orders for packets of seeds using specific product codes, along with their credit card details, onto Rhapsody Co's secure server. Order quantities are normally between one and three packets for each type of seed.

Order details are transferred manually onto the company's internal inventory control and sales system, and a two part packing list is printed in the seed warehouse. Each order and packing list is given a random alphabetical code based on the name of the employee inputting the order, the date, and the products being ordered.

In the seed warehouse, the packets of seeds for each orger are taken from specific bins and

despatched to the customer with one copy of the packing lisVThe second copy of the packing list is (~';

sent to the accounts department where the inventory and sales computer is updated to show that the \.J order has been ~espatched. The customer's credit card is then charged by the inventory control and

sales computerl Bad debts in Rhapsody are currently 3% of total sales.

Finally, the computer system checks that for each charge made to a customer's credit card account, the order details are on file to prove that the charge was made correctly. The order file is marked as completed confirming that the order has been despatched and payment obtained.

Required:

In respect of sales in the seeds division of Rhapsody Co, prepare a report to be sent to the audit committee of Rhapsody Co which:

(i) identifies and explains FOUR weaknesses in that sales system;

(ii) explains the possible effect of each weakness; and

(iii) provides a recommendation to alleviate each weakness.

Note: Up to 2 marks will be awarded for presentation.

(14 marks)


c'

Report to audit committee Inventory control and Sales System Seed division

12 June 20xx

The internal audit of the inventory and sales system identified the following weaknesses:

Weakness 1 - Recording of orders

Orders placed on the Internet site are transferred manually into the inventory and sales system. Manual transfer of order details may result in information being transferred incompletely or incorrectly, for example, order quantities may be incorrect or the wrong product code recorded.

Potential effect of weakness

Customers will be sent incorrect goods resulting in increased customer complaints.

These notes are prepared by FTMS lecturing team, They are for the sole use of FTMS students attending HKICPA FE 72


FTMS Hong Kong


Recommendation

The computer systems are amended so that order details are transferred directly between the two computer systems. This will remove manual transfer of details limiting the possibility of human error.

Weakness 2 ~ Control over orders and packing lists

Each order/packing list is given a random alphabetical code. While this is useful, using this type of code makes it difficult to check completeness of orders at any stage in the despatch and invoicing

process. .


Packing lists can be lost resulting either in goods not being despatched to the customer (if the list is lost prior to goods being despatched) or the customer's credit card not being charged (if lost after goods despatched but prior to the list being received in the accounts department).

Recommendation

Orders/packing lists are controlled with a numeric sequence. At the end of each day, gaps in the sequence of packing lists returned to accounts are investigated.

Weakness 3 ~ Obtaining payment

The customer's credit card is charged after despatch of goods to the customer, meaning that goods are already sent to the customer before payment is authorised.


Rhapsody Co will not be paid for the goods despatched where the credit company rejects the payment request. Given that customers are unlikely to return seeds, Rhapsody will automatically incur a bad debt.

Recommendation

Authorisation to charge the customer's credit card is obtained prior to despatch of goods to ensure Rhapsody Co is paid for all goods despatched.

Weakness 4 - Completeness of orders

The computer system correctly ensures that order details are available for all charges to customer credit cards. However, there is no overall check that all orders recorded on the inventory@ales system have actually been invoiced.


Entire orders may be overlooked and consequently sales and profit understated.

Recommendation

The computer is programmed to review the order file and orders where there is no corresponding invoice for an order, these should be flagged for subsequent investigation.

Summary

We look forward to arranging a meeting to discuss these weaknesses with you in more detail.



FTMS Hong Kong


Q17) Payroll process and control weaknesses (Source: ACCA Paper F8 Dec 2008)

South Lea Co is a construction company (building houses, offices and hotels) employing a large number of workers on various construction sites. The internal audit department of South Lea Co is currently reviewing cash wages systems within the company.

The following information is available concerning the wages systems:

(i) Hours worked are recorded using a clocking in/out system. On arriving for work and at the end of each days work, each worker enters their unique employee number on a keypad.

(ii) Workers on each site are controlled by a foreman. The foreman has a record of all employee numbers and can issue temporary numbers for new employees.

(iii) Any overtime is calculated by the computerised wages system and added to the standard pay.

(iv) The two staff in the wages department make amendments to the computerised wages system in respect of employee holidays, illness, as well as setting up and maintaining all employee records.

(v) The computerised wages system calculates deductions from gross pay, such as employee taxes, and net pay. Finally a list of net cash payments for each employee is produced.

(vi) Cash is delivered to the wages office by secure courier.

(vii) The two staff place cash into wages packets for each employee along with a handwritten note of gross pay, deductions and net pay. The packets are given to the foreman for distribution to the individual employees.

Required:

ail Identify and explain weaknesses in SouthLea Co's system of internal control over the wages system that could lead to mis-statements in the financial statements.

aii) For each weakness, suggest an internal control to overcome that weakness.


(8 marks)

Control weakness

Employees can be paid for work not done.

There appears to be no check to ensure that hours recorded in the computer system actually relate to hours worked.

There is no check to ensure that each employee inputs his/her employee number. One employee could input two numbers hiding the fact that one employee is absent.

Fake or dummy employees can be put onto the payroll.

The foreman can set up employee records for who do not exist as payment is made automatically from the records of hours worked.

The staff in the wages office could collude by setting up fake employee records in a similar way to the site foreman.

Internal control recommendations

A record of hours worked by each employee should be printed from the computerised wages system and signed by the site foreman to confirm that the hours are accurate.

The computerised wages system should print a list of employees present per the computer system during the day and the foreman should then sign this list to confirm it is accurate.

The wages office should check the list of employees against workers personnel records of authorised employees. Any new employees particularly should be verified in this way before payment is made.

The Jist of employees on the payroll should be checked for accuracy by a person outside of the wages department, for example the personnel department or the chief accountant. The list of net payments should be signed by this person to show it is correct.



FTMS Hong Kong


Gross pay inflated by wages department staff. The staff in the wages department could add extra hours to the records of some employees, and remove the net pay from the payment received from the courier prior to making up the pay packets.

The computerised. payroll system should be programmed to produce a list of ali amendments made to the payroll. This list should be reviewed by a responsible official outside of the wages department prior to wages being paid.

Alternatively, the computerised payroll system should produce payslip for each employee showing the hours worked, gross and net pay etc. Employees should then check that the cash paid agrees to the net payment recorded on the payslip.



FTMS Hong Kong

CLP yr.'t


Q18) Other Services (FPE Dec 2003 Paper I)

In order to give the board of directors of Sporty more comfort regarding their investment in PT Sincere, the Finance Director has requested your firm, the auditors of Sporty, to prepare a letter of comfort addressed to the board in respect of the balance of Property, Plant and Equipment as of 30 September 2003 since this is the most material item in PT Sincere's balance sheet at that date. As the carrying amount of the newly installed equipment accounts for more than half of the carrying amount of all Property, Plant and Equipment at 30 September 2003, the Finance Director expects the scope of comfort will be limited to those newly acquired assets.

During your meeting with the Finance Director, you propose an agreed-upon procedur~s e!Jga~EZlt,. . 0 'Vi~

o obJ€(ffvQ..)JU~PVl .J.v.~(Y_~!>L1t j

a) Explain to the Finance Director of Sporty the nature of an ag~eed,.upon of f; IW4

procedures engagement; . --==-, (3 marks) J

b} Give four sample procedures you may agree to perform in this situation; and a. 1«1.1 OPfl'fbrJ

( 4 marks) kr\..t~~ & (]V

c) Introduce to the Finance Director other services that your firm may provide, fl..&\-i{[Ivlrt{n.Ce

assuming that the Finance Director expects your firm to give an opinion on the f~' t

carrying amount of the newly installed equipment accounts. (3 marks) ( __ )

Because of time and other constraints, Sporty has only engaged your firm to perform an agreed-upon procedures engagement regarding the newly acquired Property, Plant and Equipment of PT Sincere.

Your team has completed the work on schedule and one of your assistants has drafted the following report:

Report on the balance of PT Sincere's Property, Plant and Equipment as at 30 September 2003

To: The Directors of Sporty Company Limited

We have performed the procedures agreed with you with respect to the balance of newly acquired Property, Plant and Equipment of Rp. 22,305,000 of PT Sincere Company Limited ("PT Sincere") as at 30 September 2003. Our engagement was conducted in accordance with Statement of Auditing Standards 710 "Engagements to perform agreed-upon procedures regarding financial information" issued by the Hong Kong Society of Accountants (HKSA).

We have reviewed the schedule of PT Sincere's newly acquired Property, Plant and Equipment as at 30 September 2003 and the calculations which arrived at the total carrying amount of Rp. 22,305,000. We are not aware of any material adjustments that need to be made to these schedules and calculations.

Had we performed additional procedures or had we performed an audit or review of the financial statements in accordance with Statements of Auditing Standards issued by the HKSA, other matters might have come to our attention that would have been reported to you.

ABC & Co.

Certified Public Accountants

d) Identify the principal deficiencies of the draft report with reference to the framework set out in SAS 710 and elaborate on the reasons why it is so important to correct these deficiencies. (10 marks)



FTMS Hong Kong


In addition to an agreed-upon procedures engagement on the balance of Property, Plant and Equipment, the Finance Director has discussed with you the possibility for your firm reviewing the budgeted results of PI Sincere for the five years ending 30 September 2008. The Finance Director wants to see a reduced level in the budgeted results for the five years. He considers that this will place Sporty in a better position to negotiate. The Finance Director suggests to you that your report should give some support to his move to manipulate the budgeted results.

e)

Explain how the Finance Director's expressed intention affects your position from the perspective of professional ethics ~ow you would handle the situation. (5 marks)

Q18) a)

Suggested Answers

Nature of an agreed-upon procedures engagement

The objective of an apreed-upon procedures engagement is for the firm, auditors of Sporty, to carry out procedures of an audit nature to which the firm, Sporty and PT Sincere have agreed and to report . -r>; ·on factual findings.

Agreed-upon procedures may include enquiry and analysis, recomputation, comparison and other clerical accuracy checks, observation, inspection and obtaining confirmation.

No assurance will be expressed in an agreed-upon procedures engagement and only factual findings are reported. Sporty should assess and draw its own conclusions from the factual findings reported.

b)

Examples of agreed-upon procedures applicable in this case

Obtain the list of equipment included in the carrying amount of Property, Plarit and Equipment of PT Sincere at 30 September 2003 which was acquired on or after a specific date ("the newly acquired equipment") and re-compute the total carrying 'amount of newly acquired equipment.

Obtain the suppliers' invoice for each item of newly acquired equipment and compare the invoiced

amounts to the recorded cost of the item. .

/"> Observe physical existence of each of the items and compare the serial number in the invoice and on the equipment.

Request confirmation from suppliers for each item of newly acquired equipment to confirm the cost and delivery to PT Sincere.

(Other examples are acceptable provided that they are fact finding procedures that do not involve auditors' judgment.)

c)

Possible services that may be offered

An assurance engagement may serve the interests of Sporty. The objective of such an assurance engagement is for auditors to evaluate the carrying amount of newly acquired equipment that is the responsibility of PT Sincere against identified suitable criteria, (e.g. HK GAAP) and to express a conclusion that provides Sporty with a level of assurance about the carrying amount.

The level of assurance provided by such a conclusion in an assurance engagement would convey the degree of confidence that one may place on the credibility of the subject matter. Ordinarily such engagements provide one of only 2 distinct levels of assurance: a high level and a moderate level.

These notes are prepared by FTMS lecturIng team. They are for the sole use of FTMS students attending HKICPA FE 77


FTMS Hong Kong


For a "high level of assurance", it is necessary to obtain sufficient appropriate evidence to conclude that the carrying amount of the newly acquired equipment conforms in all material respects with HK GAAP. The procedures performed would be similar to those that would be performed in auditing the account balance of PT Sincere's financial statements for the year ended 30 September 2003.

For a "moderate level of assurance" it would be necessary to obtain sufficient appropriate evidence to be satisfied that the carrying amount of the newly acquired equipment is plausible in the circumstances.

Procedures would be limited to expressing a negative assurance, stating a lack of awareness of any material modifications that need to be made to the carrying amount of the newly acquired equipment at 30 September 2003.

d)

The title of the report does not explicitly state that the report includes only factual findings. Users may be misled to believe that this is a report of an assurance engagement in which the auditors convey an opinion.

The report does not specify the "newly acquired equipment". The scope of the auditors' procedure is not clear.

It is not appropriate to state that "we have reviewed the schedule and the

calculations ". Such wording is not specific enough to

inform the user of the procedures that have been performed.

A list of specific procedures performed should be included.

It is not appropriate to state that "we are not aware of any material adjustments ... " as such wording gives a negative assurance. The report should list the fact found, for example, whether .or not the costs recorded by PT Sincere match with the suppliers' invoices and confirmations.

It does not contain a statement that the procedures performed do not constitute either an audit nor a review and, as such, no assurance is expressed. This statement is required by SAS 710 to make it clear to the user that no assurance is expressed in an agreed-upon procedures engagement.

It does not contain a statement that the report is restricted to those parties that have agreed to 0 the procedures to be performed. This statement is required by SAS 710.

It does not contain a statement that the report relates only to the carrying amount of newly acquired equipment specified in the report and does not extend to any financial statements of PT Sincere, taken as a whole. This statement is required by SAS 710.

The report should include a paragraph stating the purpose of the report.

The report should be properly dated.

The amount of Rp.22,305,OOO is not correct. It should be Rp.22,305 million.



FTMS Hong Kong

HKICPA Final Examination Module C M Course Notes

e)

It is in our personal self-interest to maintain good relations with our clients by providing the type of report that they are expecting so as to put them in a more favourable position when they negotiate with other parties.

This may, however, be in conflict with our role as independent professional accountants. Professional accountants have a duty to the public, to those who retain or employ them, to the profession itself and

to other members of the profession. .

Whenever we encounter such a situation, we should refer to the professional ethics principles and guidelines issued by the HKSA.

The fundamental principles of professional ethics issued by the HKSA require, amongst others, that a professional accountant should always have regard to any factors that might reflect adversely upon the member's integrity and objectivity in relation to the members' professional assignment or occupation.

The first question is whether the firm should accept the engagement in the first place if the Finance r Director has such an expressed intention. It also casts some doubts about the Finance Director's integrity.

If the firm were to accept the engagement, it would be essential that it maintained its integrity. All members of the team working on the engagement would need to perform professionally to draw up a report objectively, not affected by the Finance Director's expressed intentions.

If the Finance Directors were to continue to exercise improper influence on our objectivity in performing our work and our report, we should consider resigning from the engagement.



FTMS Hong Kong


Q19) Review & Ethics (FPE June 2004 Paper I)

One of the financing options being considered by the management of Perfect Industry is to introduce strategic investors into the company. Some of the potential investors insist to have a certain.level of comfort on the latest· financial information provided to them by Perfect Industry before they will commit to invest in the company. In the interest of time and cost, you, the Finance Manager of Perfect Industry, believe that a review of the company's financial statements for the four months ended 30 April 2004 by the company's auditors, ABC & Co, should meet the potential investors' requirements.

Write a memorandum to the potential investors, addressing the following matters as a minimum:

a) the nature of a review of interim financial statements under the Hong Kong

Auditing Standards; and (6 marks)

b} how a review differs from an audit of financial statements under the Hong Kong

Auditing Standards. (6 marks)

To better reflect the company's value to the potential investors, the management of Perfect Industry C believes that a valuation of the company's brand "Perfection" should be performed. The management

expects that any valuation surplus will be recognized or disclosed in the company's interim financial statements for the four months ended 30 April 2004.

Perfect Industry has requested ABC & Co, the company's auditors, to perform this valuation exercise. ABC & Co has already been engaged in the review of Perfect Industry's interim financial statements for the four months ended 30 April 2004.

c) You are one of ABC & CO's audit managers. Explain to Perfect Industry the independence issues that your firm would encounter with regard to the review of the interim financial statements of Perfect Industry if your firm were to take up the valuation engagement and the safeguards your firm would need to adopt in response to these independence issues.


To From Re

Potential investors

xxx, Finance Manager of Perfect Industry

Review of financial statements of Perfect Industry for the four months ended 30 April 2004

In response to your request for information on our company's latest financial situation, our company has requested our auditors, ABC & Co, to review our company's interim financial statements for the four months ended 30 April 2004. We believe that this is the most feasible solution in the interest of time and cost.

a) Nature of the review

Our auditors, ABC & Co will perform the review in accordance with SAS 700 Engagements to review interim financial reports.

The objective of the review is to enable our auditors to state whether anything has come to their attention that causes them to believe that material modifications should be made to our company's financial statements for the four months ended 30 April 2004.

Typical review procedures to be followed by our auditors will comprise mainly of enquiries and analytical procedures.



FTMS Hong Kong


Based on the work they perform, our auditors will assess whether any information obtained during their review indicates that material modifications should be made to our financial statements for the four months ended 30 April 2004.

If nothing comes to our auditors' attention that causes them to believe that material modifications should be made, our auditors will issue an unmodified review report on our financial statements for the

four months ended 30 April 2004. .

Our auditor's unmodified report would state that, based on their review, nothing has come to their attention that causes them to believe that material modifications should be made to our financial statements for the four months ended 30 April 2004.

Similar to any audit of our company's financial statements, the review report will be addressed only to the shareholders of the company (or the directors of the company). The review report is provided by our company to you for reference only. Our auditors do not have a contractual relationship with you.

b} Differences between a review and an audit of financial statements

r:

The following are the principal differences between the review of our financial statements for the

four months ended 30 April 2004 and the audit of our financial statements for the year ended 31 December 2003.

In a review of financial statements, our auditors do not ordinarily study and evaluate our internal accounting controls or perform tests of our accounting records. Our auditors also do not ordinarily perform tests to obtain corroborating evidence through inspection, observation or confirmation.

Since typical review procedures performed by our auditors compose mainly of enquiries and analytical procedures, these procedures do not provide all the evidence that would be required in an audit.

The review of our interim financial statements provides a moderate level of assurance in the form of negative assurance. Our auditors will design the engagement to reduce to a moderate level the risk

of an inappropriate conclusion. .

The expression "moderate level of assurance" refers to the auditors having obtained sufficient appropriate evidence to be satisfied that the financial statements are plausible in the circumstances.

An audit of financial statements provides a high level of assurance. In an audit of financial /"> statements, the auditors design the engagement to reduce to a low level the risk of an inappropriate conclusion.

The expression "high level of assurance" refers to the auditors having obtained sufficient appropriate evidence to conclude that the financial statements conform in all material respects with identified suitable criteria, e.g. HK GAAP.Note2

We hope a review of financial statements of our company for the four months ended 30 April 2004 will satisfy your requirements.

Best Regards

xxx, Finance Manager

c) General requirement for ABC & Co to be independent

The review of Perfect Industry's interim financial statements in accordance with SAS 700 is an example of an assurance engagement which is intended to enhance the credibility of financial information. It is in the public interest that members of the engagement teams and ABC & Co be independent.



FTMS Hong Kong


Professional Ethics Statement 1.203A of the HKSA requires both independence of mind and independence in appearance.

Independence of mind is the state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional scepticism.

Independence in appearance is the avoidance of facts and circumstances that are so significant that a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, would reasonably conclude a firm's, or a member of the assurance team's, integrity, objectivity or professional skepticism had been compromised.

Independence issues

If we accept the valuation engagement, the principal threats to our independence regarding the interim financial statement review are self-review and intimidation.

Self-review threats occur because our judgement in the valuation engagement needs to be reevaluated in reaching conclusions on the review engagement.

That is, we need to evaluate whether material modifications should be made to Perfect Industry's \_)

interim financial statements for the four months ended 30 April 2004 if the valuation is recognised or disclosed in the interim financial statements.

Similarly, a self-review threat will also occur in the coming audit of Perfect Industry's financial statements for the year ending 31 December 2004 if the valuation is recognised or disclosed in the financial statements for the year.

There would also be threat of intimidation, which occurs when a member of the engagement team may be deterred from acting objectively and exercising professional skepticism by threats, actual or perceived, from Perfect Industry.

The management of Perfect Industry expects that the brand valuation will be recognized or disclosed in the company's interim financial statements for the four months ended 30 April 2004.

It is clear that recognition of the brand as an intangible asset is not appropriate since it is internally generated. Whether the valuation should be disclosed in the interim financial statements is subject to argument. (Bonus marks should be given if candidates are able to give a sound discussion on the issue of disclosing the valuation of the brand name in the interim report.)

The potential disagreement over the accounting treatment of the brand valuation creates an c; intimidation threat of replacement of auditors.

Safeguards

Since the threats to our independence are not clearly insignificant, we need to adopt the following safeguards to eliminate the threats or to reduce them to an acceptable level:

We will discuss the independence issues relating to the provision of valuation services with those

. charged with governance of Perfect Industry, such as the audit committee. .

We will disclose to those charged with governance, such as the audit committee, the nature and extent of fees charged by our firm for the reviewing, auditing and valuation services.

We will involve additional professional accountants to advise on the potential impact of the valuation engagement on the independence of the members of the review/audit team and on the firm.

We will make arrangements so that personnel providing valuation services do not participate in the audit engagement.



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