Audit and Assurance Services

(Hong Kong)
PART 3 TUESDAY 3 DECEMBER 2002

QUESTION PAPER Time allowed 3 hours This paper is divided into two sections Section A ALL THREE questions are compulsory and MUST be answered TWO questions ONLY to be answered

Section B

Paper 3.1(HKG)

Section A ALL THREE questions are compulsory and MUST be attempted 1 You are an audit manager in Robert Bracco, a firm of Certified Public Accountants. One of your audit clients, Meadow, is a company listed on a stock exchange with a 30 September accounting year end. The principal activity of Meadow is retailing under the Vazandt brand name. The retail industry has recently suffered from a reduction in consumer spending. Meadow has two operating divisions: Domestic and International. Each retail division is sub-divided into four business units: Ladieswear, Menswear, Home furnishings and Foods. The International retail business consists of three broad geographic areas: Africa, South America and the Far East. Robert Bracco is represented by affiliated offices in all relevant countries. You have obtained the following information from Meadows draft financial statements: (1) Financial extracts Income Statement Turnover Total operating profit Provision for loss on operations to be discontinued (Note i) Finance cost (net) Profit before tax For the year ended 30 September 2002 2001 $m $m 2,5850 2,6388 _______ _______ 1291 1200 (838) (47) _______ 406 _______ (48) _______ 1152 _______

Balance sheet Tangible non-current assets Land and buildings Store fit out, fixtures and equipment Inventory (Note ii) Trade and other receivables Cash and cash equivalents

As at 30 September 2002 2001 $m $m 9505 4489 1642 225 537 9640 4818 1659 369 1046

Notes: (i) The company has announced its intention to close loss-making businesses in Africa, subject to the full consultation that the Board recognises will need to take place. The decision to close would be taken only after consultation with employee representative bodies and if no other solution is found during the consultation. Net closure costs of $838m have been provided, covering future trading losses, losses on disposal of assets and redundancy costs. (ii) Inventory is valued at the lower of cost and net realisable value using the retail method (i.e. by reducing sales value by the appropriate percentage gross profit margin).

(2) Segment information Turnover 2002 $m International Africa South America Far East Total International Domestic Total operating activities 990 2640 383 _______ 4013 2,1837 _______ 2,5850 _______ 2001 $m 967 2505 389 _______ 3861 2,2527 _______ 2,6388 _______ Operating profit 2002 2001 $m $m (118) 111 28 _______ 21 1270 _______ 1291 _______ (90) 53 (12) _______ (49) 1249 _______ 1200 _______

Number of stores 2002 2001 International Africa South America Far East Total International Domestic Total (3) International restructure On 29 September 2002, the company announced the intention to: Required: (a) Using the information provided, identify and explain the principal audit risks and other matters to be considered when planning the approach to the final audit of Meadow for the year ended 30 September 2002. (17 marks) (b) Describe the audit work that you would undertake to determine whether the accounting treatment and disclosure for the: (i) segment information; and close all African operations (representing 14 stores); and sell the South American businesses. 14 86 4 _______ 104 107 _______ 211 _______ 13 87 4 _______ 104 106 _______ 210 _______

(ii) international restructuring; are appropriate. (8 marks) (25 marks)

[P.T.O.

Imperiol, a limited liability company, manufactures and distributes electrical and telecommunications accessories, household durables (e.g. sink and shower units) and building systems (e.g. air-conditioning, solar heating, security systems). The company has undergone several business restructurings in recent years. Finance is to be sought from both a bank and a venture capitalist in order to implement the boards latest restructuring proposals. You are a manager in Hal Falcon, a firm of Certified Public Accountants. You have been approached by Paulo Gandalf, the chief finance officer of Imperiol, to provide a report on the companys business plan for the year to 31 December 2003. From a brief telephone conversation with Paulo Gandalf you have ascertained that the proposed restructuring will involve discontinuing all operations except for building systems, where the greatest opportunity for increasing product innovation is believed to lie. Imperiols strategy is to become the market leader in providing total building system solutions using new fibre optic technology to link building systems. A major benefit of the restructuring is expected to be a lower on-going cost base. As part of the restructuring it is likely that certain of the accounting functions, including internal audit, will be outsourced. You have obtained a copy of Imperiols Interim Report for the six months to 30 June 2002 on which the companys auditors, Discorpio, provide a conclusion giving negative assurance. The following information has been extracted from the Interim Financial Report: (1) Chairmans statement The economic climate is less certain than it was a few months ago and performance has been affected by a severe decline in the electrical accessories market. Managements response will be to gain market share and reduce the cost base. (2) Balance sheet 30 June 2002 (unaudited) $m 835 696 252 599 83 ______ 2465 ______ 304 60 891 ______ 1255 654 556 ______ 2465 ______ 31 December 2001 $m 726 638 208 502 238 ______ 2312 ______ 304 91 890 ______ 1285 457 570 ______ 2312 ______

Intangible assets Tangible non-current assets Inventory Receivables Cash Total assets Issued capital Reserves Accumulated profits Interest bearing borrowings Current liabilities Total equity and liabilities

(3) Continuing and discontinuing operations Six months to 30 June 2002 (unaudited) $m Turnover Continuing operations Electrical and telecommunication accessories Household durables Building systems Total continuing Discontinued Total turnover Operating profit before interest and taxation continuing operations Required: (a) Explain the matters Hal Falcon should consider before accepting the engagement to report on Imperiols prospective financial information. (15 marks) (b) Describe the procedures that a professional accountant should undertake in order to provide a report on a profit forecast and forecast balance sheet for Imperiol for the year to 31 December 2003. (10 marks) (25 marks) 3 You are the manager responsible for the audit of Siegler, a limited liability company. Siegler develops products and technologies for the life sciences industry. The draft accounts for the year ended 30 June 2002 show profit before taxation of $46 million (2001 $42 million) and total assets of $463 million (2001 $417 million). The following issues are outstanding and have been left for your attention: (1) A government grant of $800,000 was received in May 2002 to assist in operating a new pilot plant that will use Sieglers patented bio-technology. The amount of the grant has been deducted from bio-technology development costs that are included in intangible assets with a carrying value of $45 million. In October 2002, Sieglers order for specialist equipment, which was to have been used in the pilot plant, was cancelled. A recent board minute shows that the companys research activities are to be focused on a new smart-drug technology. (8 marks) (2) Siegler closed and demolished one of its laboratories four years ago. The land on which it stood has not been used since and is carried at a cost of $72,000. Results of tests by the local water authority published in July 2002 show that the site is contaminated with hexavalent chromium, which is known to be toxic. Although there is currently no legislation requiring Siegler to clean up the site, a provision for $1 million has been made in the financial statements for the year ended 30 June 2002. (6 marks) (3) Siegler owns two properties as well as its laboratories, production facilities and head office. One property is a residential apartment block and the other an office block. The apartments are leased out on an annual basis and are currently fully let. However, many of the offices are vacant and available for let on monthly as well as annual terms. On 30 June 2002, the apartment block was valued at an open market value that was $33m in excess of its carrying amount under the benchmark treatment of HKSSAP 2.117 Property, Plant and Equipment (i.e. at cost less accumulated depreciation). This excess has been credited to a revaluation reserve. (6 marks) Required: For each of the above issues: (a) comment on the matters that you should consider; and (b) state the audit evidence that you should expect to find, in undertaking your review of the audit working papers and financial statements of Siegler. (20 marks) NOTE: The mark allocation is shown against each of the three issues. 5 [P.T.O. Year to 31 December 2001 $m

553 379 537 ______ 1469 ______ 1469 ______ 134 ______

1189 770 949 ______ 2908 653 ______ 3561 ______ 322 ______

Section B TWO questions ONLY to be attempted 4 (a) Explain the role of support letters (also called comfort letters) as evidence in the audit of financial statements. (5 marks) (b) You are an audit manager in Moltisant, a firm of Certified Public Accountants, and currently assigned to the audit of Capri Group. The consolidated financial statements of Capri Group are prepared in accordance with the accounting standards and interpretations issued by the Council of the Hong Kong Society of Accountants. The draft financial statements for the year ended 30 June 2002 show profit before taxation of $62 million (2001 $55 million) and total assets $325 million (2001 $298 million). One of the Groups principal subsidiaries, Capri (Overseas), is audited by another firm, Marcel. You have just received Marcels draft auditors report as follows: Basis of audit opinion (extract) As set out in notes 4 and 5, expenditure on finance leases has not been reflected in the balance sheet but included in operating expenses and no provision has been made for deferred taxation. This is in accordance with local taxation regulations. Opinion In our opinion the financial statements give a true and fair view of the financial position of the company as of 30 June 2002 and of the results of its operations and its cash flows for the year then ended in accordance with The draft financial statements of Capri (Overseas) for the year ended 30 June 2002 show profit before taxation of $19 million (2001 $17 million) and total assets of $65 million (2001 $66 million). The relevant notes (in full) are as follows: (4) Leased assets During the year the company has incurred expenditure on leasing agreements that give rights approximating to ownership of fixed assets with a fair value of $790,000. All lease payments are charged to the income statement as incurred. (5) Taxation This includes current taxes on profit and other taxes such as taxes on capital. No provision is required to be made for deferred taxation and it is impracticable to quantify the financial effect of unrecognised deferred tax liabilities. Required: Comment on the matters you should consider before expressing an opinion on the consolidated financial statements of the Capri Group. (10 marks) (15 marks)

You are an audit manager of Kloser, a firm of Certified Public Accountants. You are assigning staff to the final audit of Isthmus, a company listed on a stock exchange, for the year to 31 December 2002. You are aware of the following matters: (1) Isthmus has recently issued a profits warning. The company has announced that the significant synergies expected from the acquisition of Vanaka, a former competitor company, have not materialised. Moreover, it has emerged that certain of Vanakas assets are significantly impaired. Your firms corporate finance department, assisted by two audit trainees, carried out due diligence work on behalf of Isthmus before the purchase of Vanaka was completed in December 2001. (2) Mercedes, the assistant manager assigned to the interim audit of Isthmus, has since inherited 5,000 $1 shares in Isthmus. Mercedes has told you that she has no intention of selling the shares until the share price recovers from the fall to $195 which followed the profit warning. (3) Anthony, an audit senior, has been assigned to the audits of Isthmus since joining the firm nearly three years ago. He has confided to you that his father owned 1,001 shares in Isthmus but sold them only days before the profits warning at a share price of $795. You are assured that Anthony did not previously know that his father had the shares. Required: Comment on the ethical and other professional issues raised by the above matters and their implications, if any, for staffing the final audit of Isthmus for the year to 31 December 2002. (15 marks)

If there is a need for a uniform set of international accounting standards and international auditing standards, there is also a need for global corporate governance standards. Required: Discuss and reach a conclusion. (15 marks)

End of Question Paper