Q4

Part A

Star Beauty Ltd. is a small private limited company. The company has a retail shop selling cosmetics at Tsuen Wan. The Ho family owns 100% of the equity shares of the company and manages the company by themselves. The Ho family intends to expand the business; as a result. more capital is needed for this purpose. After careful discussion, the Ho family decided to raise additional capital through issuing new shares and debentures. The equity interest of the Ho family will be reduced to 50%. In order to cope with the quick expansion of the business, a managing director from outside the family will be appointed to oversee the financial reporting and daily operations of the company. The Ho family together with other members will concentrate on issues at the strategic level.

Required:

(a) Discuss the reasons why there is a demand for auditing services in a free-market economy. (5 marks)

(b) Discuss the necessity for Star Beauty Ltd. to have an independent audit of the financial statements. (7 marks)

(c) Discuss whether there will be agency risk when the Ho family delegates certain authority to the manager. If there could be agency risk, explain the nature of the agency costs that could arise. (8 marks)

Part B

Your CPA firm. LU KWOk and Co.. has just been appointed auditors of E-Toys Asia Ltd., a distributor of toys sold through the Internet in South East Asia. The companys shares have just been recently listed on the GEM Board in Hong Kong. As the partner in charge of the audit. you. Ann Lu, and your team have been busy studying the nature of the companys business and the industry.

While performing analytical procedures, you noted that E-Toyss debt to equity ratio

increased substantially from 1:2 to 2:1 during the year. The company has been making losses since it started 5 years ago.

A preliminary review of internal controls showed that the documents and records were adequate, and there was a system of authorization and approval for major purchases, sales, cash receipts and cash disbursements. However, because of the small size of the company. the number of personnel involved in processing transactions was very limited. Besides, senior management was largely not involved or interested in the internal control system, but concentrated on marketing and other expansion efforts.

Required:

(a) What are the three components of audit risk? Briefly explain the nature of each of the components of audit risk. (6 marks)

(b) Explain how (if at all) each component is affected in the audit of E-Toys Asia Ltd. (that is, would increase or decrease relative to a normal or typical audit). (9 marks)

(c) Given your analyses of the various components of audit risks in part (b), state which audit strategy you would choose in this case, i.e. either a substantive strategy or a compliance/reliance strategy. Justify your choice. (5 marks)

Part C

ln each of the four following situations. the auditors face two sources of evidence resulting from their audit procedures.

	Source A	Source B
Situation 1	Observation of the clients physical counting of inventories at the year-end.	Confirmation of the clients inventories held at an independent warehouse by requesting a confirmation from the warehouse management.
Situation 2	Observation of the clients inventories composed primarily of sophisticated mobile phones.	Observation of the clients inventories composed primarily of metal sheets.
Situation 3	Review of all payments made to suppliers after the year-end to determine if they were properly recorded as trade creditors at the year-end.	Request for suppliers confirmations at the year-end for all significant suppliers from which the client made purchases during the year.
Situation 4	Confirmation of the clients bank balance at the year-end directly with the bank.	Checking the balance of the clients bank accounts with bank statements kept by the client.

Required:

(a) For each of the four situations, state the two most important management assertions (in order of importance) which are being tested by the described audit procedures. (6 marks)

(b) For each of the four situations, identify which of the two sources gives more persuasive evidence. and briefly explain your reasoning. (8 marks)

(c) The major purpose of audit working papers is to document the evidence gathered by the auditor. Discuss four other purposes or uses of audit working papers. (6 marks)