SECTION A – CASE QUESTIONS
(Total: 50 marks)
Answer 1(a) Control activities that are relevant to an audit are: -
Control activities that relate to significant risks or relate to risks for which substantive procedures alone do not provide sufficient appropriate audit evidence; or
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Those that are considered to be relevant in the judgment of the auditor.
Answer 1(b) Control activities that are relevant to the audit of the revenue of CCT include the following: Information processing control activities -
CCT has two significant financial systems including “Checkout” (i.e. POS system) and “Flex account” (i.e. general ledger system). The general IT controls of these two systems such as program change controls are relevant to the audit.
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At every day end, the cashier reconciles the money receipts of the day with the sales records in Checkout.
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Checkout has an interface with CCT’s general ledger system (i.e. Flex account). The sales data is synchronised between Checkout and Flex account every two hours.
Physical controls -
Each restaurant is required to bank-in the surplus cash at 9 a.m. every day.
Answer 1(c) Control activities around revenue that are relevant to an audit and commonly found in a restaurant with a relatively good control environment include the following: Authorisation
The revenue transactions should be approved by an appropriate person. For example, the daily revenue should be approved by the restaurant manager after counting the cash receipt.
Performance review
Actual performance versus budgets and forecasts of each of the restaurants should be analysed and reviewed.
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Different sales analysis (such as sales by restaurants, or by month, by hour, etc.) analysing their relationship and investigation if there is any difference should be performed.
Restaurant’s performance should be compared to market / industry data.
Segregation of duties
Segregation of duties implies a number of people being involved in the accounting process.
For example, the cashier is responsible for reconciling the daily cash receipt with the daily sales record. The daily cash receipt is approved by the restaurant manager. The POS system is used to record the daily sales transactions. The accounting team reviews and approves monthly sales based on the POS sales record.
Answer 2(a) Though the increase in revenue of CCT in 2016 seems in proportion to the increase in the number of restaurants opened during the year, the increase in revenue in 2016 compared to 2015 seems overly optimistic. Based on the financial extracts, the increase in average spending per customer is of a lesser magnitude than the decrease in the number of mainland China visitors, and so there may be a risk of material misstatement that the revenue is overstated. In addition, there is manual control reconciling the daily cash receipt with the “Checkout” daily sales report and the automated control that the daily sales ledger in Flex account automatically updated every two hours. The last year’s audit results also indicated that the relevant controls in place on revenue were operated effectively throughout the year. However, according to the Forecast, the restaurants in mainland China contribute approximately 32% of revenue to CCT and they only implemented “Checkout” in 2016. Though this POS system has proven to be effective based on the prior years’ audit results, there is a risk that “Checkout” is not properly implemented, therefore, revenue may not be completely and accurately recorded. Considering all of the above, the risks of material misstatements in revenue on occurrence and completeness assertions are assessed to be high.
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Answer 2(b) In response to the risks of material misstatements identified in Question 2(a), the proposed audit procedures for revenue should include the following: (i)
Test of controls
Inquire of the management and understand the implementation plan for “Checkout” in the China restaurants.
Inquire of the management and understand the processes and controls in the revenue cycle upon the implementation of “Checkout” in the China restaurants.
Perform a walkthrough test to understand and validate the processes and controls of the China restaurants.
Identify the relevant controls implemented by the China restaurants and perform validation tests to validate the effectiveness of the relevant controls.
Test the effectiveness of the IT general control of “Checkout” and “Flex account”.
Test the effectiveness of the interface between “Checkout” and “Flex account”.
Test the effectiveness of the automated control of synchronising the sales data between “Checkout” and “Flex account” every two hours.
Validate if the manual control of reconciling the daily sales receipts with the daily sales report from “Checkout” has been operating effectively throughout the year in the restaurants in both Hong Kong and mainland China.
Identify other relevant controls and validate the operating effectiveness of the relevant controls implemented in the restaurants in both Hong Kong and mainland China.
(ii) Substantive procedures
Perform analytical procedures by comparing the current year’s revenue data with last year’s revenue data (e.g. revenue per restaurant, revenue per square metre of restaurant, and revenue per customer per restaurant, etc).
Consider the effect on sales due to changes in quantities sold or products or prices.
Perform industry / competitor comparisons on key financial data such as revenue per square metre of restaurant, and revenue per customer per restaurant, etc.
Analyse the cost structure and calculate the net profit margin and record the reasons for any changes.
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Agree the daily sales report generated from “Checkout” with the daily cash receipts, Octopus records and credit card receipts.
Agree the daily cash receipts, Octopus records and credit card receipts with the monthly bank statements.
Answer 2(c) HKSA 315 (Revised) Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment requires that if the auditor has determined that a significant risk exists, the auditor shall obtain an understanding of the entity’s controls relevant to these significant risks, including the evaluation of the design of the control activities. The audit engagement team should consider whether the management has specifically responded to these significant risks by implementing control activities. If the audit engagement team has planned to place reliance on the management’s control, the audit engagement team should perform validation tests of the relevant controls in addressing these significant risks. HKSA 330 (Clarified) The Auditor’s Responses to Assessed Risks further states that if the auditor has determined that an assessed risk of material misstatement at the assertion level is a significant risk, the auditor shall perform substantive procedures that are specifically responsive to that risk. When the approach to a significant risk consists only of substantive procedures, those procedures shall include tests of details. The SIC’s suggestion on the audit plan is not completely in compliance with the requirements of the auditing standards. Since both the risks of material misstatements of revenue with respect to occurrence and completeness assertions are considered high and the fraud risks in revenue recognition are designated as significant risks, the audit engagement team, apart from performing the control validation, must plan and perform substantive procedures that are specifically responsive to the risks in addition to the tests of controls.
Answer 3(a) The two bank borrowings are 5-year term loans bearing interest at market rates which seem to be a normal market arrangement. There are also no other facts presented in the case that CCT may hide any borrowing arrangements intentionally. The risks of material misstatements pertaining to the bank borrowings in terms of completeness and classification are assessed to be low.
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With reference to the financial extracts stated in the case, CCT’s bank borrowings have significantly increased by HK$300 million since July 2015 and with an expected gearing ratio exceeding 40% as at 30 June 2016. However, the finance costs for the year seem to be unreasonably low (i.e. 0.7% of total bank borrowings) which cannot be reconciled to the annual interest rates of 5% to 6%. The interest expenses payable to the respective banks may be understated for the year ending 30 June 2016. Therefore, the risks of material misstatements of the completeness and accuracy assertions of finance costs are considered to be high.
Answer 3(b) The substantive audit procedures on ascertaining the completeness and classification of the bank borrowings should include the following:
Examine the loan agreements entered between CCT and the two reputable banks in Hong Kong.
Understand and summarise the terms of the bank borrowings, e.g. loan periods, interest rates, pledge and security, and callable features, etc.
Circulate loan confirmations to the banks to confirm the balances of the bank borrowings as at year end and the terms of the bank borrowings.
Review the loan repayment schedules and terms of the bank borrowings and consider if CCT has classified the bank borrowings appropriately between the long-term and short-term in accordance with the loan terms (e.g. callable features) and the repayment reschedules.
Identify any loan covenant and consider whether CCT complies with the covenant.
If CCT breaches the loan covenant, assess the appropriateness of the loan classification.
Review the company’s board of directors’ meeting minutes to understand whether CCT has other bank borrowing arrangements.
Answer 4 The following factors will be considered:
The number of restaurants that are counted each time and whether all restaurants are counted at least once a year.
Whether the management maintains adequate inventory records that are kept up-to-date for each of the restaurants and consider the data reliability test results.
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Management’s control over the accuracy of CCT’s perpetual inventory record.
Effectiveness of management’s control over CCT’s perpetual inventory record and consider the control test results.
Whether the management has satisfactory procedures for cycle inventory counts and test-counting.
Whether the cycle inventory count arrangement and instructions are as rigorous as those for the year end inventory count by reviewing instructions and observation counts.
Whether there is one centralised designated inventory count team monitoring the inventory count procedures and results.
Composition and objectivity of the centralised designated inventory count team. If the centralised designated inventory count team is under the control of the financial controller, objectivity may be affected.
Whether there are no inventory movements while the count is taking place, and inventory records are updated up to the time of the inventory count.
Whether the management investigates and corrects all material differences identified during the continuous inventory count.
Whether the reasons for differences are recorded and reviewed, and necessary corrective actions are taken.
Since a continuous inventory count focuses on test of controls rather than substantive audit work, whether the audit engagement team also need to do some further substantive audit work in addressing the risks of material misstatements of completeness and existence assertions of the inventories at year end (e.g. roll-forward testing or roll-backward testing).
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SECTION B – ESSAY / SHORT QUESTIONS
(Total: 50 marks)
Answer 5 The substantive audit procedures to test the completeness of trade payables include the following:
From the listing of trade payables, reconcile the total amount of HK$128,000 with the general ledger by casting and cross-casting.
Select samples of suppliers’ statements and trace these back to the suppliers’ accounts.
Consider whether there could be significant unrecorded liabilities by making inquiries of the management.
Ask the management about balances with significant fluctuations, such as the balance with Supplier C which had decreased from the previous year from HK$50,000 to zero at the current year end.
Ask the management about unusual items, such as the balance due to Supplier E, which is construction in nature and is not related to Super’s business.
Examine files of unmatched purchase orders and supplier invoices for any unrecorded liabilities.
Examine post year-end transactions and subsequent payments and compare the actual dates with the dates they were recorded in the ledger to check whether the cut-off has been applied correctly.
Confirm the balances with Suppliers A, B, D and E, and the balance with Supplier C (zero balance) and a few suppliers with balances less than HK$1,000.
Perform confirmations of trade payables. Perform follow-up procedures for those confirmations which disagree with the information in the request and confirmations without a reply.
As the risk on completeness of trade payables is “high”, there may be a risk of unrecorded liabilities. Regular suppliers who have small or zero balances on their accounts and a sample of other accounts will be confirmed in addition to any large balances.
Perform comparisons on the following data to check for reasonableness:
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Current year balances for trade payables and accruals with the previous year.
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The amounts owed to a sample of individual suppliers in the trade payables listing to amounts owed to these suppliers in the previous year.
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The payables’ turnover and payables’ days with the previous year and industry data.
Complete the disclosure checklist to ensure that all the disclosures relevant to liabilities have been made.
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Answer 6(a) Under HKSA 210 (Clarified) Agreeing the Terms of Audit Engagements, before the start of any professional work, the auditor and its entity should agree, in writing, the scope and nature of the work to be undertaken. Accordingly, the engagement letter prepared by the audit engagement manager does not contain enough information to satisfy the requirements under HKSA 210 (Clarified). The following content should be added to the engagement letter: Directors’ responsibilities (a)
keeping proper accounting records, and making them available to the auditor;
(b)
preparing the financial statements which give a true and fair view in accordance with the applicable financial reporting framework and any regulatory requirements, such as the Hong Kong Companies Ordinance;
(c)
enabling the preparation of financial statements that are free from material misstatement, for such internal control as the directors determine is necessary, whether due to fraud or error; and
(d)
provide auditor with access to all information of which the directors are aware that is relevant to the preparation of the financial statements such as company’s books of account and all other relevant records and documentation, including minutes of all management and shareholders’ meetings and other matters.
Auditor’s responsibilities (a)
forming an opinion on the entity’s financial statements as to whether they show a true and fair view and comply with the Hong Kong Companies Ordinance; and
(b)
other reporting when there are certain other matters which, according to the circumstances, may need to be dealt with in the auditor’s report. For example, where the financial statements do not give details of directors’ remuneration or of loans to officers, the Hong Kong Companies Ordinance requires the auditor to disclose such matters in the auditor’s report.
Scope of audit (a)
The auditor has a professional responsibility to report if the financial statements do not comply in any material respect with Hong Kong Financial Reporting Standards issued by the HKICPA, unless in the audit opinion the noncompliance is justified in the circumstances. In determining whether or not the departure is justified, the auditor considers (a) whether the departure is required in order for the financial statements to give a true and fair view: and (b) whether adequate disclosure has been made concerning the departure.
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(b)
The auditor will communicate to directors in writing concerning any significant deficiencies in internal control relevant to the audit of the financial statements that the auditor has identified during the audit.
(c)
Any such other report which does form part of our audit opinion may not be provided to third parties without the auditor’s prior written consent. Such consent will be granted only on the basis that such reports are not prepared with the interests of anyone other than the company in mind and that the auditor accepts no duty or responsibility to any other party as concerns the reports.
(d)
As part of the auditor’s audit procedures, the auditor will request the management to provide written confirmation concerning representations which the auditor has received from the management during the course of the audit on matters having a material effect on the financial statements.
(e)
The auditor is also entitled to attend all general meetings of the company and to receive notice of all such meetings.
(f)
The responsibility for safeguarding the assets of the company and for the prevention and detection of fraud, error and non-compliance with law or regulations rests with the directors.
(g)
Once the auditor has issued the auditor’s report, the auditor has no further direct responsibility in relation to the financial statements for that period.
Form of reports for the engagement The form and content of auditor’s report may need to be amended in the light of the audit findings.
Answer 6(b) The additional audit fee of HK$50,000 is considered as a contingent fee arrangement which is prohibited under Section 290 of the Code of Ethics for Professional Accountants. Contingent fees are fees which are calculated on a predetermined basis relating to the outcome of a transaction or the result of the services performed by the firm. Payment arrangements based on outcomes would create self-interest and advocacy threats. The threats created would be so significant that they cannot be reduced to acceptable levels through the application of suitable safeguards. All contingent fee arrangements shall be prohibited.
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Answer 7(a) HKSA 450 (Clarified) Evaluation of Misstatements Identified during the Audit deals with the auditor’s responsibility to evaluate the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements. The auditor shall determine whether these uncorrected misstatements are material, individually or in aggregate. In making this determination, the auditor shall consider: (a)
the size and nature of the misstatements, both in relation to particular classes of transactions, account balances or disclosures and the financial statements as a whole, and the particular circumstances of their occurrence; and
(b)
the effect of uncorrected misstatements related to prior periods on the relevant classes of transactions, account balances or disclosures, and the financial statements as a whole.
The identified misstatements for Nos. 1 to 5 are regarded as factual misstatements misstatements without doubt. No. 1 represents overstatement of accrued expenses. As the impact is less than the materiality, this individual uncorrected misstatement is considered as not material. Nos. 2 and 3 represent the cut-off errors on sales and cost of sales which should be considered together. The net impact of these two items resulted in overstatement of profit before tax of HK$60,000 and net profit of HK$50,100 which exceeds/ approaches materiality, accordingly, these uncorrected misstatements are considered material. Since the sales cut-off error (Nos. 2 and 3) is considered to be material, it is unlikely that it can be offset by other misstatements (i.e. No.1). Therefore, the auditor should not offset No. 1 with Nos. 2 and 3 when evaluating the cumulative impact of the identified misstatements. No. 4 is related to the misstatement in classification. Although no profit or loss impact arose, the auditor shall evaluate other factors when determining whether a classification misstatement is material. As referred to in the statement of financial position of Star Limited as at 31 December 2015, the uncorrected reclassification misstatement would distort the current assets and current liabilities, this uncorrected misstatement is considered as material. No. 5 is related to the misstatement regarding disclosure. The auditor shall evaluate qualitative factors when determining whether such an omission is material. As the financial statements of Star Limited will be used by a potential investor for his investment decision, capital commitment is regarded as key financial information by the potential investor, the misstatement of omitting this financial disclosure is material.
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The auditor would also need to evaluate the aggregate impact of these uncorrected misstatements. Considering the fact that the use of these financial statements is for a potential investor to make his investment decision, the uncorrected misstatements which would present a more favorable financial position (such as higher profit, less liability level, and lack of capital commitment) are considered as material misstatements to the financial statements as a whole.
Answer 7(b) The auditor shall communicate on a timely basis all misstatements accumulated during the audit with the appropriate level of management. The auditor shall request the management to correct those misstatements accumulated during the audit. If the management refuses to correct some or all of the misstatements communicated by the auditor, the auditor shall obtain an understanding of the management’s reasons for not making the corrections and shall take that understanding into account when evaluating whether the financial statements as a whole are free from material misstatement. The auditor shall communicate with those charged with governance uncorrected misstatements and the effect that they, individually or in aggregate, may have on the opinion in the auditor’s report. The auditor shall request a written representation from the management and, where appropriate, those charged with governance whether they believe the effects of the uncorrected misstatements are immaterial, individually and in aggregate, to the financial statements as a whole.
Answer 8(a) The report should comprise an assessment of internal controls and should confirm that the board has considered all significant aspects of internal control based on its identification of business risks. In particular, the report should include the following: (a)
Any changes since the last assessment in the nature and extent of the significant risks faced by the company, and the company’s ability to respond to changes in its business environment.
(b)
The scope and quality of the monitoring by management of risk and internal control, and the scope and quality of the work of the internal audit function, if such a function exists in the company.
(c)
The extent and frequency of reporting to the board (or board committee) on the results of this ongoing monitoring activity. This regular reporting enables the board or committee to build up a cumulative assessment of the state of the controls and the effectiveness of risk management.
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(d)
The incidence of any significant control failings or weaknesses that have been identified which have a material impact on the company’s financial performance or condition, or might have a material impact in the future.
(e)
The effectiveness of the company’s processes for compliance with financial reporting rules and Listing Rules.
In addition, a narrative statement about how they have complied with the Code provisions on internal controls during the reporting period. In particular, they should disclose: (a) the process used to identify, evaluate and manage significant risks; (b) the main features of the risk management and internal control systems; (c)
an acknowledgement by the board that it is responsible for the risk management and internal control systems and reviewing their effectiveness;
(d) the process used to review the effectiveness of the risk management and internal control systems; and (e) the procedures and internal controls for the handling and dissemination of inside information. Where an issuer includes the board’s statement that it has conducted a review of its risk management and internal control systems in the annual report, the report should also disclose: (a) Whether the issuer has an internal audit function; (b) How often the risk management an internal control systems are reviewed, the period covered, and where an issuer has not conducted a review during the year, an explanation why not; and (c)
A statement that a review of the effectiveness of the internal control systems has been conducted and whether the issuer considers them effective and adequate.
Answer 8(b) During the year under review, Green Limited had experienced significant control failings with regard to its IT system. The IT system has a material impact on the company’s sales and inventory processes and its financial reporting. The discrepancies found in the company’s sales and inventory ledgers may cause material misstatements in its financial statements. The lack of the IT support may also cause a failure to safeguard Green Limited’s assets if sales and inventories are not properly recorded. Module C (June 2016 Session)
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The board of Green Limited should consider in particular: -
the resources in the accounting and financial reporting function may not be adequate because reconciliation of these discrepancies is required;
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the qualifications and experience of the staff of the IT-related financial reporting function do not meet requirements because only part-time and non-IT staff are employed;
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increasing the budget to recruit more qualified staff to remediate the existing control failure; and
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implementing the remediation plan to ensure the internal control of the IT system is effective.
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