Audit and Assurance Services

(Hong Kong)
PART 3 TUESDAY 11 JUNE 2002

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

Section B

Paper 3.1(HKG)

Section A ALL THREE questions are compulsory and MUST be attempted 1 You are an audit manager in Riebeck & Co, a firm of Certified Public Accountants. One of your audit clients, Amber Pan Europe (Amber), a listed company with a 30 June accounting year end, provides wirefree communications services in a rapidly growing market. In August 2001 Amber purchased Talc, a competitor group of companies. Significant revenue, cost and capital expenditure synergies are expected as the operations of Amber and Talc are being combined into one group of companies. The following financial and operating information consolidates the results of the enlarged Amber group: Year end 30 June 2002 (Estimated) 2001 (Actual) $m $m 7,585 4,893 (3,454) (2,212) (3,184) (1,889) (28) (24) (1,030) (735) (296) (224) ______ ______ (407) ______ ______ 8,861 6,084 655 241 (191) ______ ______ 5,914 1,688 714 283

Revenue Cost of sales Distribution and administrative costs Research and development costs Depreciation and amortisation Finance cost Loss before taxation Customers (in thousands) Contract (Note 1) Prepaid (Note 2) Average revenue per user (ARPU) Contract Prepaid Notes:

(1) Contract customers have specified minimum terms and monthly subscription charges. (2) Prepaid customers have no monthly subscription charges and pay for airtime through refill cards/vouchers. In May 2002 Amber purchased Socolla, a large mobile phone network operator in East Africa, where your firm has no representation. The financial statements of Socolla for the year ended 30 June 2002 will continue to be audited by a local firm of Certified Public Accountants. Socollas activities have not been reflected in the above estimated results of the group. Amber is committed to introducing its corporate image into Africa. In order to sustain growth, significant costs are expected to be incurred as operations are expanded, networks upgraded and new products and services introduced. Required: (a) Identify and describe the principal business risks for the Amber group. (8 marks)

(b) Explain what effect the acquisitions will have on the planning of Riebecks audit of the consolidated financial statements of Amber for the year ending 30 June 2002. (10 marks) (c) Describe how analytical procedures may be used in the audit of Amber for the year ending 30 June 2002. (7 marks) (25 marks)

Azure sells inclusive tours (i.e. international flights, hotel accommodation and meals) to two million customers. All hotels are independently owned and operated. The company employs 5,000 people and uses 11 leased aircraft. Azure has a representative office at each of 13 holiday locations. Your firm has been invited to tender for the audit of Azure for the year ending 31 December 2002. As the prospective audit engagement manager, you have been asked to identify the principal audit risks and other planning issues, including audit strategy, to be presented as part of your firms written submission. The invitation to tender indicates that written submissions will be used as a means of shortlisting for the presentation stage. You have obtained the following information from Azures Annual Report 2000: (1) Holidays are sold through Azures retail travel agency, IsoTours, which has 29 outlets (1999: 31). Direct sales through call centres is the fastest growing distribution method and Internet bookings are now offered. (2) The internal financial control system includes: divisional planning and budgeting systems and regular Board reviews of actual results compared to budget and prior year comparatives; an internal audit function and a review of internal audit reports by the Audit Committee.

(3) Financial extracts ($m): Turnover (Note i) Operating profit before tax Tangible non-current assets Trade receivables Cash and cash equivalents Current liabilities (Note ii) 5% Convertible debt due 2005 (Note iii) Notes: (i) Turnover represents gross revenue receivable from inclusive tours and travel agency commissions. Revenues and expenses relating to inclusive tours are taken to the Income Statement on holiday departure. 2000 9428 273 1091 297 1386 (2372) (730) 1999 7637 257 803 182 910 (2005)

(ii) Revenue received in advance included in current liabilities amounts to $699 million (1999: $614 million). (iii) Debt will be redeemed at its principal amount on 7 January 2005 unless it is converted at the option of the debt holder any time before 31 December 2004. (iv) Annual commitments under non-cancellable operating leases are as follows ($m): Less than one year Between one and five years Five years or more 2000 43 167 174 384 1999 25 179 127 331

Required: (a) Explain the audit planning issues which should be included in the written submission as requested by Azure. (15 marks) (b) Suggest and comment on appropriate selection criteria which should be used by Azure in its evaluation of submissions received. (10 marks) (25 marks)

[P.T.O.

You are the manager responsible for the audit of Visean, a limited liability company, which manufactures health and beauty products and distributes them through a chain of 72 retail pharmacies. The draft accounts for the year ended 31 December 2001 show profit before taxation of $183 million (2000 $124 million) and total assets $184 million (2000 $127 million). The following issues are outstanding and have been left for your attention: (1) Visean owns nine brand names of fragrances used for ranges of products (e.g. perfumes, bath oils, soaps, etc), four of which were purchased and five self-created. Purchased brands are recognised as an intangible asset at cost amounting to $589,000 and amortised on a straight-line basis over 10 years. The costs of generating self-created brands and maintaining existing ones are recognised as an expense when incurred. Demand for products of one of the purchased fragrances, Ulexite, fell significantly in January 2002 after a marketing campaign in December caused offence to customers. (8 marks) (2) In December 2001 the directors announced plans to discontinue the range of medical consumables supplied to hospital pharmacies. The factory manufacturing these products closed in January 2002. A provision of $800,000 has been made as at 31 December 2001 for the compensation of redundant employees and a further $450,000 for the three years unexpired lease term on the factory premises. (7 marks) (3) Historically the companys cash flow statement has reported net cash flows from operating activities under the indirect method. However, the cash flow statement for the year ended 31 December 2001 reports net cash flows under the direct method and the corresponding figures have been restated. (5 marks) Required: For each of the above issues: (i) comment on the matters that you should consider; and

(ii) state the audit evidence that you should expect to find, in undertaking your review of the audit working papers and financial statements of Visean. (20 marks) NOTE: The mark allocation is shown against each of the three issues.

Section B TWO questions ONLY to be attempted 4 (a) Explain the auditors responsibilities for the appropriateness of the going concern assumption as a basis for the preparation of financial statements. (5 marks) (b) You are a manager in the quality control review department of Scheel, a firm of Certified Public Accountants. You are currently responsible for reviewing the appropriateness of your firms proposed auditors reports on financial statements. The draft financial statements of Cinnabar group for the year to 31 December 2001 disclose the following: Note 1 Significant event During the year, Cinnabar sold a significant amount of its business and certain assets (plant and equipment and inventory) and commenced a systematic winding down of its operations. The groups remaining assets (including property, trade receivables and cash) were sufficient to meet the groups liabilities, as at 31 December 2001. Note 2 Accounting policies The consolidated financial statements have been prepared in accordance with Hong Kong Accounting Standards (HK SSAP) under the historical cost convention. As described in Note 1, the group has commenced the winding down of its operations and remaining assets have been restated to their net realisable values. There are no other disclosures relating to the going concern assumption although the significant event is referred to in the directors report under the heading principal activities and trading review. Cinnabar ceased to trade in April 2002. The auditors report on Cinnabars financial statements for the year ended 31 December 2000 was unmodified. Required: Comment on the suitability or otherwise of an unmodified auditors report for Cinnabar for the year ended 31 December 2001. Your answer should discuss the appropriateness of alternative audit opinions. (10 marks) (15 marks)

The audit of the financial statements of Corundum, a limited liability company, for the year ended 31 December 2001 is nearing completion and the companys annual general meeting is to be held next week. The current audit firm, Skarn, has not sought to be reappointed as it is Corundums policy to change auditors periodically. Nuee Ardente, a firm of Certified Public Accountants, has accepted nomination as auditor for the year ending 31 December 2002. It has just come to light that a provision which should have been made in the financial statements for the year ended 31 December 2001 has been omitted in error. This is of such significance that the financial statements which are soon to be issued cannot be considered to be reliable. However, the financial statements have been approved through the companys internal processes and the directors do not propose to amend them at this late stage but will not agree to a modified auditors report. Skarn has discussed the matter with Nuee and obtained verbal assurances that if Skarn were to sign an unmodified report, the comparative information in the financial statements for the year ending 31 December 2002 would not be restated. The company outsourced all legal and company secretarial work to Adam Flysch, a qualified legal practitioner, who worked from home using his own computer. Adam died suddenly. Corundum does not routinely keep copies of minutes and legal documentation. Required: Identify and discuss the ethical and other professional issues relating to the above matters. (15 marks) 5 [P.T.O.

Knowledge of the business is crucial to determining the most effective and efficient audit strategy for an entity using the Internet for electronic commerce. Any auditor needs to have an in-depth understanding of the related risks and the security measures to minimise them. Required: Discuss the impact of e-commerce on the audit process. (15 marks)

End of Question Paper