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Question 2 (25 marks) Watson Limited is an unlisted company. It has recently become your new audit client. You are the audit manager of Chan & Co. Your firm is engaged to perform the audit of its financial statements for the year ended 31 December 2020. Based on the discussion with the CFO, your audit engagement team has prepared a draft engagement letter for your review: [Date] To the Board of Directors of Watson Limited Objective of services You have requested that we audit the financial statements of Watson Limited. We are pleased to confirm our acceptance and our understanding of this audit engagement by means of this letter. Our audit will be conducted with the objective of our expressing an opinion on the financial statements. Scope of audit The audit will be conducted in accordance with Hong Kong Standards on Auditing (HKSAs) issued by the Hong Kong Institute of Certified Public Accountants ("HKICPA"). Those standards require that the auditor complies with ethical requirements and plans and performs the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor's judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by the directors, as well as evaluating the overall presentation of the financial statements. Because of the inherent limitations of an audit, together with the inherent limitations of internal control, there is an unavoidable risk that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with HKSAS. in making risk assessments, we consider internal control relevant to your company's preparation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of your company's internal control. 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. Fees Our fees are computed based on the time spent on your affairs by the partners and our staff and on the levels of skill and responsibility involved plus out-of-pocket expenses. Unless otherwise agreed, our fees will be billed at appropriate intervals during the audit and will be due on presentation. We propose a fixed amount of audit fee of HK$150,000. Upon the issuance of our clean audit report, we are entitled to collect an additional fee of HK$80,000. Agreement of terms Once it has been agreed, this letter will remain effective, from one audit appointment to another, until it is replaced. Please sign and return the enclosed copy of this letter to indicate your acknowledgement of, and agreement with, the arrangements for our audit of the financial statements including our respective responsibilities. Yours faithfully, Chan & Co, Certified Public Accountants Date We agree to the terms of this letter. (Signed) Director, for and on behalf of the Board of Watson Limited Date REQUIRED: a) Comment on what essential sections are missing and should be added to this engagement letter. (18 marks) b) Comment on the appropriateness in the Fees section under this engagement letter. Describe any possible ethical threat and advise measures to eliminate the threats or reduce them to an acceptable level. (7 marks)