Answers

Part 3 Examination Paper 3.1(HKG) Audit and Assurance Services (Hong Kong) 1 ABC (a) Principal audit risks Construction industry

June 2003 Answers

The majority of building contracts undertaken may be individually material to the operating result, assets and liabilities reported in the financial statements. Audit risk will be increased if detection risk is not rendered sufficiently low. For example, sampling risk will be increased if audit evidence is drawn from only a few rather than all major contracts. Contracts of longer durations are inherently riskier than shorter ones because there is greater uncertainty about their ultimate outcomes. Fixed fee contracts can transform what initially appear to be profitable contracts into loss-making contracts (e.g. due to escalating costs). Expected losses should be recognised in full and immediately, even if construction work has not yet commenced (HKSSAP2.123 Construction contracts). The risk of bad and doubtful debts is particularly high where the product meets individual customers specifications. If a debt goes bad, the related building in the course of construction may have little value unless another purchaser can be found for it. Site accidents may result in costs (e.g. if construction is delayed and penalties are incurred). Actual liabilities may be understated and contingent liabilities not disclosed if there are breaches of health and safety or environmental regulations. Inherent risk is high because, for example, constructions may be defective (e.g. through structural design faults, subsidence, etc). This may result in material losses/unrecorded liabilities arising from penalties, legal action, restitution costs, etc.

Going concern risks Fewer local government contracts increase the risk that the going concern assumption may not be appropriate. If ABC does not have enough contract work: idle, owned assets (plant, equipment, etc) may need to be disposed of; and labour may need to be laid off. If the skilled labour force is curtailed it may be difficult for ABC to re-recruit it at a later date. The time it takes to complete significant building contracts (i.e. months, years) places a considerable strain on working capital requirements. ABCs accounting system should bill customers accurately and on a timely basis.

Percentage of completion method The percentage of completion method of recognising revenue and profit on contracts in progress is inherently risky because of the degree of subjectivity in its application and its susceptibility to manipulation and misstatement. Cost overruns increase the proportion of stage of completion and so increase the % profit taken. The reliability of the financial statements depends on the accuracy of the estimates of: contract revenue; costs; and stage of completion.

Financial reporting risks include the risks associated with each of these as follows: Unsuitable estimates of contract revenue e.g. overestimating performance incentives for early contract completion; Inaccurate estimates of contract cost e.g. reliance on inaccurate or incomplete cost data; Inappropriate measures of the stage of completion e.g. using the costs of materials purchased where they are held in inventory and not yet used in the contract (the stage of completion will be overestimated).

Costs incurred to the balance sheet date Contracts must be considered on a contract by contract basis (HKSSAP2.123). ABCs accounting and internal control system must be adequate to relate direct costs to specific contracts. Major construction sites may be individually material to the financial statements (in terms of the assets held and costs incurred at the balance sheet date). Therefore, material misstatement could arise if, for example, contracts which have been undertaken have not been recorded (i.e. omitted contracts).

Material costs attributed to each contract may be misstated if there are poor physical controls over the materials requisitioned to each site. For example, materials delivered to site before they are required for construction may be stolen and/or damaged. Direct costs assigned to each contract may be misstated if transfers between them are not accurately recorded. For example, if hired plant is used at different sites on different days (or materials are transferred between sites because of a delay in delivery of an order to a site). Misclassification between capital and revenue expenditure could result in material misstatement. For example if: hired assets are treated as owned (and capitalised and depreciated); or finance leases are treated as operating leases.

Indirect expenses (attributable overheads) may be misstated if 70% of direct costs is not an accurate approximation of the extent to which head office expenses relate to production (i.e. construction) rather than marketing, selling or administration. ABCs accounting/costing system should identify those relevant costs which relate to the preparation of tenders, material procurement, labour administration (including the quantity surveyors salary), etc. The 70% overhead absorption rate (of indirect costs) may be insufficient (i.e. results in under-absorption) as fewer contracts have been started in the year than budgeted. If costs to the balance sheet date are understated and estimated costs to completion are an extrapolation of costs to date, then any foreseeable loss may be underprovided (or attributable profit overstated). Costs may be misstated if an accurate cutoff is not established. For example, subcontracted labour will be invoiced in arrears and may include hours worked six weeks ago (say) if the subcontractors employees are late in submitting their time sheets. Any variations arising (e.g. due to change in customer specification) should be agreed between the customer and ABC in writing (e.g. in a Variation Order). (Similarly, any remeasures, where an estimated bill of quantities has been revised to reflect actual quantities, must be agreed between ABC and the customer.)

Estimated costs to completion Tutorial note: This is clearly a risk area as it was the cause of the prior year auditors report modification. Profit on any contract should only be recognised when a favourable outcome can be estimated reliably and with reasonable certainty (HKSSAP2.123). Contracts must be sufficiently complete in order to support estimates to completion and assess the likelihood of outcomes. Losses on contracts should be recognised immediately and in full (HKSSAP2.123) and cannot be offset against anticipated profits on other contracts (except where a group of contracts should be treated as a single construction in accordance with HKSSAP2.123). Lack of sufficient evidence and information to support the clients estimated costs to completion has previously given rise to a qualified audit opinion (i.e. except for). Unless the matter is resolved the risk of errors arising (inherent risk) remains very high. The audit team alone may not possess the skills and knowledge necessary to measure the work to date on all material contracts (which will contribute to the calculations of estimated costs to completion). Hence it is almost certain that some reliance will be sought to be placed on the work of the quantity surveyor. Costs may not be incurred in direct proportion to contract activity (e.g. foundation work may represent 20% of total costs but only 10% of contract activity). Estimated costs to completion may be misstated if they are extrapolated solely from costs to date. Specific (direct) costs to completion may be forecast by contract (e.g. by costing the work necessary to complete the contract). The risk of misstatement is high if: controls over the budgetary system are poor (e.g. management do not review variances); or the quantity surveyor has little experience of certain types of building work (e.g. bridges).

Costs to completion may be underestimated if the value of work completed at the balance sheet date (which measures stage of completion) is overstated. Management may be biased towards overstatement (of the stage of completion) as the value at the balance sheet date determines reported revenue, and ultimately profit. The extent to which penalty and retention clauses are used may affect the time (and costs) to completion. In particular, original timetables may be extended with costs (when ABC will be able to pass on costs to the customer) or without costs.

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(b)

Reliance on quantity surveyor Tutorial note: The need for an expert has already been determined and the clients expert is appropriately qualified and experienced. The question is therefore not whether to rely on the expert but how much? (i.e. extent). Nature The auditors responsibility (to obtain audit evidence sufficient to draw conclusions therefrom) is in no way diminished by any reliance being placed on the work of the quantity surveyor. Reliance may be sought to be placed on the quantity surveyor: in his rle as a management control within the clients system of internal controls (supervising monthly counts and budgetary control of costs); and as an expert providing one source of audit evidence on total cost to completion.

Extent The extent of audit reliance on the quantity surveyors rle as an internal control will depend on the results of evaluating its operation. For example, if as a result of the surveyors supervision the incidence of discrepancies between book and physical material inventories at sites is seen to decrease, substantive procedures on year-end quantities may be reduced. As the risk of contract costs being materially misstated is high (especially with regard to estimated costs of completion) it would be inappropriate to place too much reliance on the surveyor. However, the information for all the contracts in progress at the year end is likely to be sufficiently complex to warrant that some reliance be placed on the judgement of the surveyor (as an expert). Sufficient evidence should be available to form an opinion on the direct costs incurred to the balance sheet date and attributable overheads without the need for any reliance to be placed on the surveyor. However, as lack of evidence to support the estimated costs to completion was the reason for last years audit qualification, reliance will be sought on the experts findings in this area. The better the quality of the quantity surveyors documentation and evidence, the greater the reliance which may be placed on his work. ABCs customers (especially the local government departments) are likely to employ the services of their own quantity surveyor expert to agree the stage of completion (and progress payments falling due). More reliance should be placed on the work of ABCs expert if customers agree progress billings than if they dispute them (e.g. over the stage of completion reached). The surveyor is an employee of the client and therefore not independent. His status on the management team may: increase the perceived objectivity impairment (because he may be unduly influenced by management); or reduce it, in that he is afforded a sufficiently high organisational status to withstand any pressures from management which conflict with his professionalism.

(c)

Audit work Tutorial note: Total costs to completion are defined in the question (see point (3) of the quantity surveyors tasks). General Review board or other minutes for evidence of: management controls over contracts; significant problems (e.g. delays, claims, penalties).

Discuss the status of all major contracts (whether started or not) with the management team, including the chief finance officer and quantity surveyor. For loss-making contracts, compare the total costs to completion against the original budget and discuss with the quantity surveyor and contract site manager the reason for the overrun (the site manager may contradict or confirm the quantity surveyors assessment of the situation). For contracts completed after the year end, compare the actual costs to completion against the surveyors estimates to assess the reliability (or otherwise) of the experts schedules. Agree the direct costs incurred to the balance sheet date per the surveyors year-end schedules to the contract account balances in the general ledger. Confirm the validity and correct accounting treatment of any material reconciling items (e.g. for cutoff adjustments).

Direct costs Materials Select a sample of material and direct expense costs debited to the individual contract accounts and vouch to: suppliers invoices (for costs wholly attributable to a contract); or materials requisitions (for building supplies requisitioned from central stores); or transfer notes (for materials transferred from another site/contract).

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Visit and physically inspect all major contract sites at or around the year end: to ascertain whether the materials used/on site are at least consistent with book records (e.g. if glazing has commenced, a glass material cost should be included in the contract cost record); to estimate, in broad terms, their stage of completion (e.g. foundations only, how many floors, whether glazing or roofing commenced).

From the quantity surveyors schedules, by contract, select (a sample of) the most significant materials cost estimates, and compare with original cost estimate (e.g. bill of quantities). Substantiate managements explanations of any significant variances (e.g. inspect variation orders).

Direct costs Labour Agree a sample of labour costs debited to contract accounts to: a payroll analysis (for ABCs employees); and subcontractors invoices (for bought-in labour).

For a selected payroll agree a sample of labour costs analysed to projects by: reperforming the clients calculations; agreeing the allocation of individual employees hours to supporting time sheets/site foremens reports.

Assess the reasonableness of the quantity surveyors estimated labour costs (e.g. by comparison with average monthly payroll and subcontract costs). If labour costs appear very low, ask management whether there are plans to curtail the workforce, or if there are significant new contracts which have been tendered for. Evaluate the reasonableness of any manpower planning charts in the light of recent cut-backs in local government contract activity. Compare projected labour rates with current rates and confirm that any increases are in line with the industry averages, budgeted salary increases, trade union contracts, etc. For major contracts, compare the proportion of labour costs to material costs, to the year end and to completion and discuss any significant fluctuations with the quantity surveyor.

Direct costs Other Review costs charged to contracts for completeness (e.g. ensure all contracts have professional fees attributed to them). Agree significant professional fees (e.g. architects and legal fees) incurred to invoices. For a sample of on-going contracts agree costs to the balance sheet date, extrapolate to completion and compare predicted total with the quantity surveyors schedules. For example: agree portable building hire charges to invoices and project over expected contract duration; agree operating lease charges for plant and equipment to lease agreements and discuss with the quantity surveyor how assets leased for longer than contract durations will be used; recalculate depreciation charges; agree insurance premiums to policies and confirm that the type, amount and duration of cover is appropriate.

Attributable overheads Obtain a schedule of all head office expenses for the year, analysed between production and non-production. (The quantity surveyor should have requested this information as a basis of scheduling the attributable overheads.) Agree the classifications in the above analysis (e.g. a payroll clerks salary should be attributable to the costs of contracts but advertising costs should not). Compare the actual split of construction related overheads to total head office overheads with the 70% used in calculating attributable overheads. If materially different, year-end contract values should be recalculated to actual (and the standard changed for the forthcoming year). Compare the total of overheads attributed to contracts during the year with the construction overheads incurred during the year. Consider whether the quantity surveyors future estimates have taken into account the reduction in contract activity and the additional burden of under-absorbed overheads on existing contracts.

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FERRY (a) Top down approach In the emerging business risk methodologies, the top down approach to risk assessments is one whereby the general risks are assessed first and then the more specific risks are evaluated: The auditor gains a greater understanding of managements current and future business strategy, core business processes, key performance indicators and associated risks and controls in place. The top down approach involves the auditor comparing the expectations developed that are based on this assessment with the performance and position reflected in the financial report. (This can be contrasted with the financial risk approach, where the auditor assesses inherent, control and detection risk, and then undertakes testing within transaction or business cycles and from these samples infers back to the population a bottom up approach.)

The term top down is therefore used to describe the approach to an audit as a whole (i.e. as an audit methodology). However, it is also used to describe the approach to the stages that make up the audit process (e.g. planning, risk assessment, internal controls, etc). It means taking a big picture approach before tackling the details. For example: When planning an audit using a top down approach, knowledge of the business starts at the top with thorough discussions with management and preliminary analytical procedures on the financial statements (say). From an in-depth understanding of the clients business as a whole and then its key processes, the auditor then focuses on the details of risky transactions and balances. The overall audit plan summarises how the audit is to be conducted at a high level, whilst the detail is provided in the supporting (lower) audit work programs. Materiality assessment is described as top down when it is judged in relation to the financial statements as a whole and then allocated to particular account balances (when assigning tolerable error). A top down approach to internal controls considers first the highest level of controls (e.g. monitoring controls), then the general controls (also called pervasive controls) and lastly the specific procedures. Similarly the evaluation of the control environment is evaluated from top to bottom (i.e. firstly at a senior management level, then at the manager level, and finally at the operational level).

In a top down approach to a group audit, the primary focus will be on risks that are significant to the group as a whole and then the risks that are significant to each subsidiary. The term is also used to describe the involvement of the audit team, for example that a business risk audit is partner led (i.e. from the top). (b) Business risks (c) Processes for managing

Tutorial note: As part (c) is clearly related to the requirement of part (b), it is appropriate that a tabular approach be adopted. Rights to operate The rights to operate, which provide assurance that Ferry is a going concern for the time-being, are for a limited period (only 51/2 years of the 9 years remain). This casts doubts over the long-term future prospects of Ferry. Terms and conditions attached to the rights may threaten Ferrys operational existence if, for example, there are any circumstances under which the rights could be withdrawn. Competition Although at the moment there is none, any competition in the future (e.g. from a bridge crossing or if the right were to become non-exclusive) could reduce profitability. Monitor the progress of plans for bridge building or relevant road expansion projects. Reduce the risk by increasing the reliability and reputation of Ferrys service, improving comfort etc (e.g. in air-conditioned lounges). Accept at the present level (as one that has to be borne) but bear in mind (e.g. when making strategic decisions) the impact that managements actions could have on any renewal of the rights. Relevant terms and conditions should be communicated to all staff so they are clear about the importance of their areas of responsibility.

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Age of Ro-Ros The age of the Ro-Ros (20 years) will have a bearing on fuel consumption and other costs (e.g. repairs and maintenance). Although a major refurbishment has only relatively recently been undertaken, Ferry should manage its cash flows and borrowing capability (e.g. bank loan facility) to carry out repairs as and when needed.

Environmental Protection Regulations Ferry will have to comply with emissions standards from next year. Costs must necessarily be incurred to meet Environmental Protection Regulations. Quite apart from the emissions standards, fuel leaks or other waste spills (e.g. of sewage) may result in substantial fines. To reduce the risk of disruption to scheduled crossings and to ensure that the Ro-Ros are not withdrawn from use (for non-compliance), Ferry should: ensure funds are available for the investment in overhauling the engines (or whatever is required); plan the timing of the overhauls when business is at a relatively low volume taking only one Ro-Ro out of use at a time; notify customers in advance of any necessary changes in schedule (and apologise for any inconvenience); monitor and record the amount and frequency of spills, etc (e.g. arising on refuelling). Fuel prices Increases in fuel prices will reduce profitability. Incorporation of surcharges into the price structure so that significant increases can be passed on to the customers. Hedging against the effect of energy price (and exchange rate) risks through forward contracts. Weather Weather conditions may delay or cancel crossings. Actual and potential customers may prefer to drive if they face disruptions and uncertain journey times. Manage the impact of the risk/modify the business activity. For example, driving conditions may be hazardous if weather conditions are so bad as to disrupt the crossing so offer facilities in comfortable surroundings in which travellers can break their journey.

Economy Currently 70,000 vehicles a year is c. 40% capacity (W). Although capacity has almost doubled over two years, the demand for travel is likely to be reduced if there is an economic downturn (especially if journeying is for holiday/leisure). Keep tariffs (i.e. prices) under review and respond to changes in the economy and demand patterns. For example: charge premiums at peak and busy periods; offer discounts for advance bookings; introduce a loyalty scheme for frequent users. Service levels Ferrys service is described as efficient and timely. Deterioration in service levels is likely to result in loss of customers, revenue and goodwill. Ferrys reputation may suffer if there are complaints about the facilities provided through franchise arrangements. Ferry should benchmark how frequently it operates, and if crossings are on time, against a comparable Ro-Ro ferry service operating in similar weather conditions. Ferrys contractual arrangements with franchisees should ensure that: the franchisees bear the risks of non-performance (e.g. through penalty payments); and Ferry can terminate contracts expeditiously and seek alternative providers. WORKING 2 boats 40 vehicles 6 crossings per day 365 days = c. 175,000 vehicles. Therefore 70,000 represents 40% capacity.

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Loss of subsidy Ferry may be financially dependent on the subsidy which it receives. If information in the quarterly returns is not submitted on a timely basis, cash flows will deteriorate as the local transport authoritys payments of the subsidy will be delayed. Inaccuracies in the returns (e.g. through error) may result in payments being withheld altogether. Numbers returned could be fraudulently overstated to inflate the amount of subsidy received. Passenger safety Although passenger safety is of paramount importance, associated costs are likely to be onerous. Passengers may prosecute Ferry for personal injury or damage to or loss of property. A fatal accident could irreparably damage Ferrys image and result in a huge financial liability. Costs of providing a safe service should be reflected in the prices charged (e.g. including an insurance premium). Ferry should disclaim liability where appropriate (e.g. for valuables left in unattended vehicles). Staff training should be on-going with regular safety drill procedures (e.g. in manning the use of lifeboats). Ferrys information system must have internal controls necessary to provide accurate and timely information on the number of vehicles carried. An internal audit function could assist in providing assurance to management about the reliability of the information being submitted to the authority.

Crew safety Ferry will have difficulty recruiting and maintaining the services of appropriately qualified crew members if it does not have sufficient regard for their health and safety. Work rosters should ensure, for example, that: crew members take breaks between journeys; there is adequate cover when crew are sick or taking leave.

Disaster A serious accident (e.g. fire), collision or breakdown may threaten operations in both the short and longerterm. External consultants could be engaged to develop a model to simulate unwanted outcomes (e.g. collisions) and their potential impacts (e.g. loss of life). Recommendations for risk management could include the deployment of on-board equipment or rapid response from an external emergency unit. Safety management The application for a safety management certificate will be turned down if there is insufficient information to support Ferrys conformity to documented procedures. Ferry must have documented procedures. Adherence to them must be monitored (e.g. through captains logs) and their effectiveness reported to management. An internal audit function could monitor and review the safety management system and make recommendations for improvements.

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DEXY (a) Non-cancellable lease (i) Matters The principal issue is whether the lease payments should be: capitalised (as an asset) and amortised; or expensed as incurred.

HKSSAP2.114 Leases requires that a finance lease should be recognised as an asset and a liability. Operating lease payments should be expensed in the income statement on a straight line basis over the lease term (or other systematic basis representative of the pattern of benefits consumed). Whether the non-cancellable lease is a finance or an operating lease depends on its economic substance rather than its legal form. Indicators of a finance lease are less likely to apply to this lease than an item of equipment (say). For example, seven years of use of a floor of a new office block development will certainly not be for the major part of such an assets inherently long life. $770,000 represents 21% of total assets. This is likely to be considered material as the issue is whether this asset should be recognised in its entirety, or not at all. Whether $770,000 is the present value at inception of the lease (as required by HKSSAP2.114 in determining the amount recorded as an asset) or as calculated as at the balance sheet date (say). The basis of setting the discount rate used to calculate the present value if there is no rate implicit in the lease. $130,000 represents 4% of profit before tax. Not expensing the annual lease payment may, in isolation, be considered not material. Also, as the impact on the income statement is off-set by $110,000 amortisation plus finance charge, the net effect on profit before tax is insignificant. (There is no difference over the life of the asset.) The terms of the lease. For example: whether or not there is any option to renew the lease at any time which suggests that Dexy would occupy the premises for the duration of the suites economic life; whether title to the premises could under any circumstances be eventually transferred to Dexy.

The extent to which Dexy bears the risks and rewards of ownership. For example, whether Dexy is responsible for payments of business rates, office maintenance, repairs, insurance, etc. Also whether Dexy has the right to sub-let office space to an independent party or whether Dexy can, for example, partition the office space without the lessors consent. A finance lease gives rise to a depreciation expense. Dexys depreciation policy (i.e. straight line) should be consistent with equivalent owned assets. Unless there is reasonable certainty that Dexy will obtain ownership by the end of the lease term, seven years will be appropriate (being the shorter of the lease term and the assets useful life). The reason why Dexys management should wish to capitalise the lease if it is an operating lease. Tutorial note: The issue is usually the other way around i.e. that management want to keep lease liabilities off the balance sheet by treating finance leases as though they are operating leases.

(ii)

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

Audit evidence The suite of offices on the 13th floor that they exist and are used by Dexy. The contract setting out the lease terms to establish its legal form (more likely to be an operating lease than a finance lease) and interpret its economic substance. The nature and amount of office expenditure incurred by Dexy in respect of these premises, agreed to invoices, management charges, etc. (to gauge to what extent the risks and rewards of ownership are borne by Dexy rather than the lessor.) Recalculation of the present value of the minimum lease payments (should be as at inception of the lease). Recalculation of the pre-tax cost of capital of the discount rate used (if there is no rate implicit in the lease). Agree a $110,000 amortisation charge for the year to the income statement. Agree the completeness of disclosure of the minimum lease payments. For example: $130,000 not later than one year; $520,000 later than one year and not later than five years; and $130,000 later than five years.

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(b)

Advertising costs (i) Matters $350,000 budgeted expenditure represents 109% profit before tax and is therefore material. However, the amount which is being deferred ($125,000) is only 39% of profit before tax and 03% of total assets and therefore immaterial, when considered in isolation. Whether deferral of expenditures (as compared with immediate write off) constitutes a change in accounting policy. If so, whether it has been treated as such in accordance with HKSSAP2.102 Net profit or loss for the period, fundamental errors and changes in accounting policies (i.e. an estimate of the prior period prepayment adjusted against retained profit). If so, the impact on the current year income statement will be negligible. If $125,000 is time-apportioned from six months expenditure, the actual annual cost could amount to an (4 125k) 350k overspend of c. 40% = 429% 350k

Advertising is an expense incurred to provide future economic benefits, but no intangible asset is acquired or created that can be recognised (because it is indistinguishable from internally-generated goodwill). It is therefore expensed when it is incurred (HKSSAP2.129 Intangible assets). HKSSAP2.129 does not prohibit the recognition of prepaid advertising expenditure. For example, costs incurred in December for advertisements which will go out after 31 March 2003, are prepaid. To the extent that costs incurred represent product catalogues which have not been distributed at 31 March they should be included in inventory rather than prepaid expenses (although the amounts involved are immaterial). The extent to which any relationship can be established between advertising expense incurred and revenue arising. For example, if revenue in April June clearly corresponds to the New Year catalogues issued before 31 March 2003, this would support deferring the costs of those catalogues at the balance sheet date. (Similarly advertising costs.) If the prior period is not restated, the main impact of the change in policy will be a one-off reduction in the expense charged to the income statement, in the year in which the change takes place. Thereafter, assuming advertising costs do not fluctuate significantly from one year to the next, the annual expense will be comparable year on year. (There will be a rising trend if annual expenditure increases year on year.) The reason why Dexys management should want to make the change. For example, if there has been significant overspend on the advertising budget (see earlier calculation), carrying forward some of that cost will lessen the impact on the income statement.

(ii)

Audit evidence Current year annual budget, by month, compared with prior year(s) and actual monthly costs incurred during the year to 31 March 2003 compared with budget and prior year. To see if there is evidence of under-budgeting/overspending that might have prompted the change in accounting policy. Supporting invoices for major items of expense incurred in June and December (e.g. for the design of the advertisements and the printing of the product catalogue, etc) The make-up of $125,000 prepayment. If actual costs approximate to budget and similar amounts are spent in December as in June, the prepayment at 31 March 2003 for the three months to 30 June would be expected to be only c. $90,000 (i.e. 350,000 4). The number of product catalogues held and included in the inventory valuation at the balance sheet date. (The $125,000 includes the cost of catalogues in inventory so it would be double-counted.) Artwork for the advertisements designed before the year end but not placed until after the year end to confirm that the expense incurred should be deferred to the next accounting period.

(c)

Painting (i) Matters $135 million represents 37% of total assets per draft financial statements (i.e. including revalued amount) and is therefore material to the balance sheet. Tutorial note: The impact on PBT is not assessed because it has no impact on the income statement. The painting is an asset i.e. a resource held by Dexy arising from past events (a purchase) and from which future economic benefits are expected to flow (e.g. when the investment is realised through an eventual sale). The asset has been held for 50 years and unless it is now held with a view to sale should be classified as noncurrent (HKSSAP2.101 Presentation of financial statements). Managements future intention to hold or sell this asset, to determine its classification as current or non-current.

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Dexys going concern status and financial position. (Managements intention could be to hold the asset but as it is not used in day-to-day operations it would be the ideal asset to dispose of to raise finance.) The painting is clearly not held for use in the production or supply of goods or services. So unless it is held for rental to others or for administrative purposes, it is not an item of property, plant and equipment (as defined by HKSSAP2.117). It is therefore not subject to an annual depreciation charge. Whilst it was displayed in the reception office it may (arguably) have been a furnishing for administrative purposes. However, as it has now been removed outside of the business premises its accounting treatment appears not to be covered by HKSSAP2.117. There is no HKSSAP dealing specifically with such assets held for their investment potential. HKSSAP2.113 Accounting for investment properties though not applicable (as the investment is clearly not in property) may provide a suitable benchmark for Dexys accounting treatment. Whether management intends to adopt a fair value model (i.e. to maintain it at fair value in the financial statements and include gains or losses arising on change in fair value to net profit or loss for the period) or regards this as a one-off revaluation. To where in equity has the surplus been credited (e.g. a revaluation or other non-distributable reserve)? How the change in measurement policy could otherwise be treated (if not as a current year revaluation surplus). For example, applying HKSSAP2.113 transitional provisions, the credit should be to the opening balance of retained earnings. Comparative information should not (cannot!) be restated because fair value was not previously disclosed publicly (because it was not known). Tutorial note: Neither the benchmark or allowed alternative treatments for changes in accounting policies under HKSSAP2.102 Net profit or loss for the period, fundamental errors and changes in accounting policies apply.

(ii)

HKSSAPs (e.g. 2.113 and 2.117) do not permit selective revaluation of assets. Therefore, if Dexy holds any other paintings they too must be revalued. Whether the taxation authority might seek to tax the CEO now holding the asset.

Audit evidence Historic cost agreed to prior year working papers and financial statements. The revaluation report of the independent appraisal company, in particular, the assumptions made. For example, if the fair value is one which could realistically be achieved only through auction rather than a private sale. Insurance documents, stating the amount insured and any related conditions (e.g. security arrangements) and confirming that it is covered in its current location. Correspondence with the insurers including the evidence the insurers required to confirm to their satisfaction the value of the painting. For example, whether the insurer relied on the revaluation report prepared for Dexy, or whether the insurer commissioned a further independent valuation. Physical inspection of the painting at the chief executives residence and review of the security measures in place (as compared with those operating over the office environment). Confirm the adequacy of the disclosure made in the financial statements, in particular, the measurement basis described in the accounting policy note. Written representation from the CEO that the painting is in his safekeeping. Written representation from the management board confirming their intention to hold or sell the painting. If holding, then their intention to have the painting valued annually (or otherwise).

Tutorial note: Marks will be awarded for suitable points about placing reliance on an independent expert valuer (e.g. to confirm the painting as an original). However, candidates should be mindful of the cost of such evidence and the availability of alternative evidence, as suggested above. 4 ICEHOUSE (a) Perceived limitations in the standard unmodified auditors report It is difficult for a private shareholder to understand its meaning because it: assumes knowledge of the audit process; and is jargonised.

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

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Terms which might be regarded as jargon include: reasonable assurance; material; misstatement; test basis; accounting principles; and true and fair view.

Although some of these terms are defined in Auditing Standards (e.g. materiality), others are not (e.g. true and fair view). Even relatively informed shareholders do not appreciate that reasonable assurance is merely a high level of assurance and not an absolute guarantee. The financial statements to which the auditors report refers is often only a small part of a much larger document (an Annual Report). What is it all for? How much is required by statute? What are the auditors responsibilities for it? The auditors responsibility, as stated, to express an opinion ... based on our audit, perhaps does not sound like much. One of the perceived limitations of using standard wording (generally) is that it is something routine which does not reflect the exercise of professional judgement. Institutional shareholders may believe that the rigid format of a standard auditors report is a constraint on the auditor being able to say what they really mean. Tutorial note: Marks will be awarded for other legitimate criticisms. For example, that it is not very readable (the readability index is high). (b) Explanation of shortcomings Has there been a limitation on scope? The however ... in the middle of the explanation of the scope of the audit suggests that what follows is some sort of reservation about what has just been stated. In a scope paragraph this would be expected to be a description of a limitation on scope. However, a limitation on scope is normally introduced with the wording except as discussed (below), we conducted our audit in accordance with .... The matter described concerns additional evidence having been discovered during the current year audit (to 30 September 2001) which suggests a lack of evidence in respect of the prior year. It is unclear from the wording the evidence available to us whether: the evidence has been made available to the auditor for the first time (e.g. it was previously withheld); or the auditor is claiming credit for having discovered new evidence.

Splitting the description of what an audit includes (between the first and third paragraphs) adds further confusion. Emphasis of matter An emphasis of matter is suggested by: the inclusion of additional information into the scope paragraph; and the cross-reference to a note in the financial statements.

It is not clear whether Note 22 relates to transactions in the previous paragraph or something unrelated. The addition of an emphasis of matter paragraph does not affect the auditors opinion. When emphasising a matter it is preferable to: include such a paragraph after the opinion paragraph; and state that the auditors opinion is not qualified with respect to it.

The reference to Note 22 is before the opinion paragraph and, although it would be reasonably inferred, there is no positive confirmation that the auditors opinion is not qualified. Going concern The opinion paragraph introduces doubts about going concern by referring to the loss on its operations. The last paragraph, being after the opinion paragraph, appears to be of the nature of an emphasis of matter (as explained above) of a fundamental uncertainty except that: there is no cross-reference to a note; and there is no statement that the auditors opinion is not qualified with respect to it.

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

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Although the opinion paragraph is unqualified, the use of the word adverse in the last paragraph could potentially be confused with an adverse opinion. Given the apparent circumstances (i.e. adjustments in relation to prior year, operating losses, net liabilities, lack of disclosure), it is conceivable that an adverse opinion may be appropriate (i.e. the financial statements do not give a true and fair view). The opinion paragraph should be a statement of the auditors opinion (belief) but the last paragraph makes two references to managements beliefs. There is no affirmation that the auditor concurs with those beliefs nor expression of disagreement that they are unfounded. Timeliness/date of report The auditors report is dated 19 January 2003 on the financial statements for an accounting period ended 30 September 2001 i.e. nearly 15 months after the balance sheet. The report should be dated as at the completion date of the audit (SAS 600). The reader is therefore informed that the auditor has considered the effect in the financial statements and on the report of events and transactions of which the auditor became aware of that occurred up to that date. For example, the entity has not ceased to trade or been liquidated in 2002. The lateness should concern the reader because the reason for it is not explained (e.g. whether due to lack of evidence or serious doubts about going concern). Prior period implications The omission of transactions from the prior years records could: be due to a cutoff error (e.g. omission of purchase invoices); indicate fraudulent reporting (e.g. deliberate suppression of liabilities from being recorded); have resulted in the understatement of an accounting estimate.

Whatever the circumstance the matter is presumably material, otherwise the auditors report should not refer to it. If the evidence available this year was not available last year, but should have been reasonably expected to be available, the scope of the prior year audit would have been limited. This should have resulted in a modified opinion in the prior years auditors report. If the matter has properly been resolved the current report does not ordinarily refer to it but an emphasis of matter paragraph may deal with the situation if it is material to the current period. It is not stated whether the adjustments have been made to the prior years financial statements as reflected in the corresponding figures, or in the current periods financial statements. The absence of any except for opinion means that the auditor concurs with the adjustments having been made. The opening balance of retained earnings should only have been adjusted (and comparative information restated) if the matter amounted to a fundamental error (HKSSAP2.102 Net profit or loss for the period, fundamental errors and changes in accounting policies). Tutorial note: The only other circumstance in which opening balances are adjusted is when there is a change in accounting policy which is not relevant here. Conclusions Tutorial note: The Q is set in the context of a client asking for clarification of the meaning of the auditors report and appropriate marks will be awarded for drawing a conclusion on the preceding analysis. The auditors report draws attention to two apparently unrelated matters: the prior years financial statements and the going concern basis. Although the prior period matter may have been correctly dealt with as an emphasis of matter, a clearer description of the problem and a statement where the adjustments have been made would have assisted the reader. Also, it should have been after the opinion paragraph and a statement made that the opinion was not qualified in this respect. Whatever the going concern issue, it is inappropriately dealt with. 5 DURAN (a) Ethical and professional issues The review, on an ongoing basis, of existing clients is a safeguard. For example, Duran is a listed company which should not be retained if recurring fees from it exceed 10% of Depeches gross practice income. Annual review is a safeguard if Durans fees exceed 5% (but are less than 10%). In making a decision to retain a client, Depeche must consider: its independence and ability to serve Duran properly; and the integrity of Durans management.

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(1) Hospitality Depeches objectivity may be threatened, or appear to be threatened, by acceptance of goods, services or hospitality from Duran, unless the value of any benefit is modest. The audit staff have already accepted the hospitality. Their objectivity should not have been impaired provided that the meals were appropriate to the normal courtesies of social life. However, undue hospitality is likely to be regarded as a corrupt practice, which could be indicative of fraudulent activities having taken place. As the staff needed to work late to meet the deadlines, an alternative to Duran buying in the refreshments would have been for the audit team to make their own arrangement and for Duran to have been re-charged the expense.

(2) Financial reward Professional accountants in public practice should be and appear to be free of any interest which might be regarded, whatever its actual effect, as being incompatible with integrity, objectivity and independence. The bonus was not accepted in respect of the audit managers involvement. Therefore there is no obvious threat to his objectivity. The bonus may be perceived to be a reward (or bribe) for having not detected or reported on a matter and acceptance of it may cast aspersions on the audit teams integrity. The bonus represents an increase in the audit fee and the gross cost to Duran should be included in the amount disclosed in the note to the financial statements as auditors remuneration. The bonus should be excluded from the fee when considering the recurring element. Has this situation arisen in respect of previous Duran audits? Was the subject of such bonuses mentioned before the audit fieldwork was completed? If the audit team had any expectation that a bonus might be awarded to them it is likely that there will be a perception that their objectivity could have been impaired. Has the situation created an expectation that such bonuses could be a feature of this audit? Acceptance of the bonuses may have created problems for Depeches practice management as it may be more difficult to allocate audit staff to other assignments if they have a preference for the Duran audit. That the bonus was not accepted at the manager level suggests that this was considered to be a threat to objectivity. This consideration and the decision to accept the bonus for other staff should have been documented.

(3) Client/auditor integrity Frankie Sharkeys apparent disregard for environmental legislation should have been taken into account when making a risk assessment of Durans control environment. It may cast doubt on his integrity. The audit of Duran should have been carried out with due regard to: SAS 120 Consideration of laws and regulations in an audit of financial statements; and SAS 610 Communications of audit matters with those charged with governance.

For example, if the illegal dumping became apparent during the audit but was not known at the planning stage, consideration should have been given to: the frequency of the illegal act, how long it has been going on and what measures, if any, had been taken to conceal it from the auditors; the potential financial consequences (e.g. fines, penalties, enforced discontinuation of operations and litigation); whether the potential consequences require disclosure; whether risk assessments made at the planning stage need now to be revised; the validity of management representations.

Matters to be communicated to those charged with corporate governance (i.e. the audit committee) include: the potential effect on the financial statements of any significant risks and exposures, such as pending litigation, that are required to be disclosed in the financial statements (this could arise from the illegal dumping); and other matters warranting the attention of those charged with governance, such as questions regarding management integrity. Tutorial note: Although the fines are only small, the boycotting of Durans products or other adverse publicity could have a detrimental effect on the companys operations.

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It is of potential concern that the matters have not been included in the final report unless the engagement partner knows, for example, that the matter has already been brought to the audit committees attention (e.g. in an internal auditors report). Does the draft report constitute an audit working paper? If it is retained on file it should clearly explain why it was not incorporated into the final report (and whose decision it was to exclude the managers or partners). If there is no apparent justification for its exclusion, the integrity of the audit manager and/or engagement partner may be questioned.

(b)

Available safeguards Tutorial note: Available safeguards will be appropriate if they eliminate the threats or reduce them to an acceptable level. The firms guidance on receiving hospitality should be reviewed and amended as necessary. It may be that on-going hospitality is refused, if construable as excessive. Review of the engagement partners decision to accept the bonus on behalf of the staff. For example, whether the firms quality assurance policies and procedures required him to consult with other partners. Audit staff and the client should be advised that the bonus was a one-off and not to be repeated. Senior staff (the two qualified seniors and two supervisors) should not be assigned to the audit for the year to 31 December 2003. Involving a second partner to review the conduct of the audit and advise staff involved of any concerns they have about their independence from Duran and the integrity of Durans management. If the engagement partner has been involved in the audit for a number of years (say seven), it may be time to rotate the assignment. Discuss issues of independence with Durans audit committee and obtain written confirmation that they are aware of the potential threats posed by public interest, fees, hospitality, etc and that they are satisfied that the firms safeguards are adequate.

Advice whether or not the audit of Duran should continue The Duran audit should be retained only if a partner of Depeche unconnected with Duran independently reviews the safeguards available and considers them to be adequate. Alternatively: If the safeguards available are not adequate to maintain independence, Depeche should withdraw from the audit. 6 AUDIT FAILURES Introduction Possible audit failure, though not a new subject for discussion, has come under wider and closer scrutiny since the Enron Corporation filed for bankruptcy in December 2001. When well known companies fail, confidence in the stability of the capital markets falls. The collapse of Enron brought down share values across the world. Now regulators, the public and the profession are seeking solutions to the concerns raised. Audit failure There are many ways in which an audit may be said to have failed. For example, when auditors give a clean report on the published accounts of a company which then ceases to be a going concern. Thus, it is the publics perception that the audit (and auditor) will have failed if: shareholders are not warned about going concern issues and so lose the value of their equity investments; a fraud is not detected (even though the auditor has not been negligent in complying with auditing standards) but subsequently emerges.

Misconceptions about the auditors responsibilities for going concern and fraud are a major component of the expectation gap which exists between what users of financial statements expect (often unreasonably) and what auditors can reasonably be expected to deliver. There will be an audit failure when an auditor does not adhere to a basic principle or carry out an essential procedure in accordance with Statements of Auditing Standards (SASs). For example, if an auditor issues an unmodified opinion knowing that it is inappropriate, that is negligent. Auditor failure can also arise through incompetence. For example, where the auditor does not have sufficient understanding of the risks involved in the reporting of earnings of dot.coms or measuring fair values. In general, the audit can be said to have failed when, for whatever reason, it fails to provide that assurance which gives credibility to the financial information needed by the capital markets and other legitimate users.

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Issues raised Significant concerns have been raised about many issues including: responsibilities for the detection of fraud; the rigor of financial reporting and auditing standards; auditor independence; monitoring, enforcement and regulatory mechanisms in the profession; and the quality of corporate governance.

Professional developments before Enron (e.g. the issue of SAS 110 The auditors responsibility to consider fraud and error in an audit of financial statements and SAS 610 Communications of audit matters with those charged with governance) are unlikely to console shareholders or unpaid creditors. The capital market and its regulators have become more sceptical about the value of the auditors role and the credibility of the financial statements in the wake of scandals which reveal too cosy relationships between companies and their auditors. In particular: the provision of other non-audit services for fees which far outweigh audit fees; and senior finance executives being former auditors.

Frameworks of principles (e.g. IFACs Professional Code of Ethics) are just theory to many who now call for an end to selfregulation of the profession and demand much stricter legal regimes of monitoring and enforcement (however unworkable). Auditors are likely to be perceived to be at fault when legalistic, rules-based standards facilitate creative accounting practices which devalue and even undermine their judgement. Footnotes to accounts may be in very small print, not because they are less relevant than the larger print, but intentionally because it is harder to read. So, for example, telecom companies have included swaps of capacity (hollow swaps) as sales, even though no cash changes hands. This may be acceptable within national financial reporting standards and disclosed in the notes and therefore satisfy the true and fair requirement on which the auditor forms an opinion. However, real earnings are clearly inflated to a normal person. Although stock exchange listing provisions may require a minimum number of independent directors to sit on audit committees (e.g. in the US, UK, Netherlands, etc) this does not mean that they will have sufficient expertise to be effective in providing corporate governance. Possible responses There is already wide support for the application of International Accounting Standards in financial reporting. By embracing one set of such principles-based standards on a global basis, the auditing profession can dismiss the rules-based approaches which can currently undermine an auditors judgement. ACCA, for example, supports a think global: act local view. That is, that solutions need to be agreed and co-ordinated at a global level but introduced and controlled at a national level. National regulators need to be persuaded to rise above issues of their sovereignty and give up some element of control over domestic issues in return for participation in, and influence over, global developments. Some commentators believe that an International Accounting Standard on the principal of substance over form is much needed and long overdue. (However, others might argue that the IASBs regard for it as a qualitative characteristic of financial statements, as set out in The Framework, lends to it more fundamental importance than a standard.) Support for International Standards on Auditing issued by the International Federation of Accountants (IFAC) is also increasing. In January 2002, IFAC issued a revised Code of Ethics for Professional Accountants which takes a framework (i.e. principles-based rather than rulebook-based) approach. Although this is not effective for auditors reports dated before 31 December 2004, support for early application and national adoption could be agreed and co-ordinated at a global level. The profession should undertake a review of the regimes for monitoring compliance with professional guidance (e.g. the Joint Monitoring Unit for UK statutory work and mandatory peer reviews in the US) and the enforcement mechanisms which support them. On the issue of auditor independence it has been suggested that: a limit could be placed on the time which auditors may hold appointments; and auditors be prohibited from undertaking consulting work.

Although these measures have been debated for many years and already operate at a national level in some countries, they have been discounted as a global solution. An alternative approach is to make relationships between reporting entities and their auditors more transparent. For example, by: making audit appointments less dependent on executive directors through the greater involvement of non-executive directors, the audit committee and institutional shareholders; limiting the nature and extent of other services which can be offered to listed and other public interest clients; requiring fuller disclosure of audit fees, including expenses, and other fees in the financial statements; a mandatory review by audit committees of the independence of the external auditors and the publication of a statement that they are satisfied with their findings.

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It has also been suggested that audit firms should be prohibited from providing audit services to clients where senior audit staff have left the audit firm to take up executive positions within the client company. This might be implemented by prohibiting staff from leaving to join client companies within a minimum specified period from having been personally involved with the audit. However, this may not be practicable as employment contracts which prevent auditors from leaving their firms for 18 months (say) may not be enforceable. It is often argued that one way in which the profession could respond to issues which contribute to the expectation gap is to educate users to overcome misconceptions about the audit process. So for example, the standard wording of auditors reports has been revised to refer to the applicable financial reporting framework. However, although the auditors report tells the user what an audit is it does not explain what it is not. Perhaps it is time for the auditors report: to state, explicitly, that it does not guarantee going concern; and to include a disclaimer of responsibility for the detection of fraud.

Perhaps one of the reasons for genuine audit failure (e.g. where the auditor lacks competence) is because too much is expected from the average auditor in terms of knowledge and experience of business risks, IT, systems, etc. Although the syllabuses of professional qualifications are periodically revised, to be made more relevant, and qualifications can be made harder, the competence of those who are already qualified must also be assured (e.g. through compulsory continuing professional development and statutory licence renewal procedures). Conclusion Audit failure is perceived to be linked, directly or indirectly, with corporate failures. So, if company failures are unavoidable, audit failures will happen however effective the auditing professions response.

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Part 3 Examination Paper 3.1(HKG) Audit and Assurance Services (Hong Kong)

June 2003 Marking Scheme

Marks must only be awarded for points to answering the question set. Unless otherwise indicated, marks should not be awarded for restating the facts of the question. For most questions you should award 1/2 a mark for a point of knowledge, increased to 1 mark for the application of knowledge and 11/2 marks for a point demonstrating the higher skill expected in Part 3. The model answers are indicative of the breadth and depth of possible answer points, but are not exhaustive. Most questions require candidates to include a range of points in their answer, so an answer which concentrates on one (or a few) points should normally be expected to result in a lower mark than one which considers a range of points. In awarding the mark to each part of the question you should consider whether the standard of the candidates answer is above or below the pass grade. If it is of pass standard it should be awarded a mark of 50% or more, and it should be awarded less than 50% if it does not achieve a pass standard. When you have completed marking a question you should consider whether the total mark is fair. Finally, in awarding the mark to each question you should consider the pass/fail assessment criteria: Adequacy of answer plan Structured answer Inclusion of significant facts Information given not repeated Relevant content Inferences made Commercial awareness Higher skills demonstrated Professional commentary

In general, the more of these you can assess in the affirmative, the higher the mark awarded should be. If you decide the total mark is not a proper reflection of the standard of the candidates answer, you should review the candidates answer and adjust marks, where appropriate, so that the total mark awarded if fair.

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Marks 1 (a) Principal audit risks Generally 1/2 mark for identification + 1 mark each point of explanation Ideas Industry impact on financial statements inherently uncertain outcomes fixed fee contracts B&DD implications for WIP Going concern less work working capital requirements Percentage of completion method subjectivity impacts on revenue, profits/losses, etc judgement in projecting costs to date to completion % how determined? HKSSAP2.123 Costs to BS date materials exist? direct costs correctly allocated? overheads appropriate apportionment? consequence for foreseeable loss provision cutoff e.g. on subcontract labour Estimated costs to completion PY qualification high inherent risk need for an expert cost v contract activity management bias/level of judgement (b) Nature and extent of reliance on quantity surveyor Generally 1 mark each point contributing to an explanation Ideas (SAS 520) Nature reliance v audit opinions/responsibility as an internal control as a source of audit evidence (expert) Extent results of evaluating ICs materiality/risk of misstatement complexity of information/level of judgement sufficiency of complementary evidence/alternative sources expert skills (c) Audit work on total costs to completion Generally 1 mark each point Ideas Actual (to date) v estimated (to completion) Direct materials Direct labour Other direct Indirect costs 25 max 8 max 5 max 12

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Marks 2 (a) Top down approach Generally 1 mark each point Ideas Business risk methodology Business focus v financial statements/audit focus Top = overview v bottom = detail In planning In risk assessment In materiality assessment In evaluating internal controls In group audits (b) Principal audit risks Generally 1/2 mark for identification + 1 mark each point of explanation Ideas Environment risks competition weather economy accident, collision, breakdown Financial risks Ro-Ro costs fuel prices loss of subsidy Compliance risks rights to operate non-compliance with environmental regulations waste spills safety management Operations risks poor service levels (e.g. catering, booking, timely operation) passenger safety employee-related issues (e.g. crew safety) Tutorial note: Although in practice an analysis of the risks would be structured around suitable classifications of risk (e.g. those suggested above) many candidates will identify the risks as they come to them in reading through the scenario. To show that this is acceptable, the model answer has been left in such an order. However, candidates struggling to identify sufficient risks in the scenario could have drawn on a classification to give them ideas on what to look for. (c) Risk management processes Generally 1 mark each point Ideas Accept the risk low impact risks benchmark (or could reduce risk) Reduce the risk by implementing improved internal controls staff training hedge against it (e.g. fuel prices) Avoid unacceptable risks non-compliance Transfer the risk by insurance (amount/type) contractual risk sharing (with franchisees) Recovery plan disaster scenarios 25 max 10 max 10 max 5

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Marks 3 (i) Matters Generally 1 mark each comment maximum 6 marks issue (a) 4 marks (b) and (c) Ideas materiality (assessed) relevant HKSSAPs (e.g. 2.102, 2.113, 2.114, 2.117, 2.129) and The Framework risks (e.g. FS assertions capital v revenue, ownership, existence) responsibilities (e.g. directors to safeguard assets) implications for auditors report (ii) Audit evidence Generally 1 mark each item of audit evidence (source) maximum 6 marks issue (a) 4 marks (b) and (c) Ideas (SAS 400) oral vs written internal vs external auditor generated procedures (AEIOU)1 max 20 (a) (b) (c) max 8 max 6 max 6 20

max 12

max 12

1SAS

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

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Marks 4 (a) Comment on perceived limitations Generally 1 mark each comment max 5

Ideas What are Standards (on Auditing)? Standards referred to before an audit is explained Jargon (reasonable assurance, material, misstatement test basis, accounting principles true and fair view) Annual report v financial statements Readability Auditors responsibility (not much?) Standard wording = no judgement (b) Matters to be considered (before expressing an opinion) Generally 1 mark each comment Ideas Limitation on scope? v Inherent uncertainty/Emphasis of matter? Lack of evidence intentionally suppressed? Split description of an audit Reference to note No statement that opinion not qualified Going concern Fundamental uncertainty? v Disagreement? Adverse Timing/date Prior period Cause of omission Prior year auditors report modified? How adjusted? Emphasis of matter HKSSAP 2.102 15 max 10

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Marks 5 (a) Ethical and professional issues Generally 1 mark each comment Ideas General 5 10% fees for listed co review review = a safeguard (independence & integrity) (1) Hospitality threat to objectivity corrupt practice(?) when acceptable (social courtesy) (2) Financial reward (= bonus) manager v other staff participation bribe (?) audit fee (not recurring element) practice management implications (3) Client/auditor integrity SAS 120 SAS 610 reason for exclusion from final report (b) Appropriateness of available safeguards Generally 1 mark each safeguard and 1 mark each comment thereon Ideas Review (policies, procedures) Second partner involvement Rotation (partner/senior staff) Audit committee involvement For advice clearly based on adequacy of available safeguards 1 15 max 5 max 10

Discussion of audit failure Generally 1 mark a point up to Ideas (illustrative) Introduction (why it is topical) Enron Audit failure (possible) Going concern Fraud Expectation gap Creative accounting practices Competence Credibility Issues raised Adequacy of accounting/auditing standards Role in corporate governance Framework (principles) v rulebook approaches Enforcement mechanisms (e.g. peer reviews) Possible responses Global acceptance of standards (e.g. IAS) Code of Ethics Independent monitoring Transparency Training/CPD requirements 15 max 15

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