Reporting and Communications

Chapter 13 Reporting and Communications

1.Communications with Those Charged with Governance

Section Summary

Corporate

Governance

What

is?

Purposes

Structure

Functions

Audit

Committee

Communications

with Those

Charged with

Governance

(A)Introduction

1.1Under HKSA 260, it is necessary for an auditor to communicate audit matters of governance interest arising from the audit of financial statements with those charged with governance of an entity.

1.2The auditors communication with those charged with governance may be made orally or in writing.

(B)Corporate Governance ()

1.3Corporate governance is the means by which a company is operated and controlled. It concerns such matters as:

(a)the responsibilities of directors

(b)the appropriate composition of the board of directors

(c)the necessity for good internal control the necessity for an audit committee

(d)relationships with the external auditors

1.4HKICPA, through the establishment of the Working Group of Corporate Governance, plays an important role in developing the good corporate governance in HK. After the formation of the Group, HKICPA published various reports:

(a)First report of the Working Group of Corporate Governance of HKSA (1995)

(b)Second report of the Working Group of Corporate Governance of HKSA (1997)

(c)A Guide for the Formation of an Audit Committee (December, 1997)

(d)A Guide for Directors Business Review in the Annual Report (November, 1998)

(e)Directors Remuneration Recommendations for Enhancing Transparency and Accountability (November, 1999)

(f)Corporate Governance Disclosure in Annual Report A Guide to Current Requirements and Recommendations for Enhancement (March,2001)

(g)A Guide for Effective Audit Committee (February, 2002)

1.5Benefits of having good corporate governance

(a)The transparency and disclosure of information are essential to the shareholders in terms of protection of their interest and control of the directors performance.

(b)Assist the improvement of the Boards effectiveness in making investment, financial and operating decisions that is beneficial to the company as a whole.

(c)Ensure the compliance of the requirements of relevant rules and regulations, such as Companies Ordinance, Listing Rules, etc.

(d)Reduce the management inefficiencies and minimize the misuse of companys resources through the establishment of audit committee and independent non-executive directors.

(e)Minimise agency cost by tightening the requirements of transparency and information disclosure of directors interests and performance.

(C)Audit Committee

(a)What is?

1.6Audit committee is a committee consisting primarily of non-executive directors, which is able to view a companys affairs in a detached () and independent way and to liaise () effectively between the main board of directors and the external auditors.

(b)Purposes and objectives of establishing audit committee

1.7The purposes and objectives are:

(a)provide an independent review, on behalf of the Board, of the effectiveness of the financial reporting process and internal control system of the company.

(b)provide advices and recommendations to the Board regarding the effectiveness of financial reporting and internal control system.

(c)increase public confidence in the credibility and objectivity of published financial information.

(d)assist directors, in particular the non-executive directors, in meeting their responsibilities in respect of financial reporting.

(e)serve as a means to increase the effectiveness, accountability, objectivity and transparency of the Board.

(f)strengthen the external auditors independent position.

(c)Structure of audit committee

1.8Constitution should be established as a Committee of the Board with terms of reference (). The terms of reference should be normally approved by the full board.

1.9Membership

(a)Size:

(i)minimum three members with a quorum () of two.

(ii)comprises 3 to 5 members, depending on the size of the company.

(iii)under listing rules, each listed company should have at least two independent non-executive directors.

(b)Non-executive directors

(i)Duties and responsibilities same as executive directors

(ii)Independence

1.10Chairman and secretary

(a)The chairman should have the confidence and ability to direct discussion and follow-up actions and recommendations with the full board.

(b)The company secretary facilitates communications between the Board and the Committee.

1.11Commitment members of the audit committee should:

(a)be commit sufficient time and effort to the job.

(b)act in the best interest as committee members.

(c)insist on adequate information being supplied to them by management.

1.12Remuneration should be remunerated to reflect the time, commitment and responsibility involved in serving the committee.

(d)Functions of audit committee

1.13The functions of an audit committee could include the following:

(a)Review of a companys internal control procedures.

(b)Review of the internal audit function the audit committee providing an independent reporting channel.

(c)Review of the companys current accounting policies and possible changes resulting from the introduction of new accounting standards.

(d)Review of regular management information, such as monthly management accounts.

(e)Review of the annual financial statements presented to shareholders.

(f)Review of the results of the external auditors examination to ensure that the auditors have performed an effective, efficient and independent audit.

(g)Procedures for reviewing published interim statements, draft prospectus, profit forecast etc.

(h)Dealing with external auditors criticisms of management, and ensuring those recommendations of internal and external auditors have been implemented.

(i)Recommending nomination and remuneration of the auditors.

(e)Benefits derived from audit committee

1.14It may have the following potential benefits:

(a)Improve the quality of financial reporting.

(b)Increase public confidence in the credibility and objectivity of financial statements and of the Board.

(c)Assist the finance director by raising the issues of his concern.

(d)Strengthen the position of external auditors by providing them a communication channel and forum for issues of their concern.

(e)Provide a framework to assist the external auditors in maintaining independence where there are disputes with management.

(f)Strengthen the position of internal audit function by providing a greater degree of independent from management.

(g)Create a climate of discipline and control that will reduce fraud.

(h)Enable the non-executive directors to contribute an independent judgement and play a positive role.

1.15Test your understanding 1

The Stock Exchange of Hong Kong required every listed company to have an audit committee.

Actually in the United States, audit committees were first recommended in 1940. At the present time, nearly all large companies in the United States have audit committees and the Securities and Exchange Commission have made them compulsory for all companies listed on the New York Stock Exchange.

In order to improve the knowledge of individual investors, the Stock Exchange plans to invite audit practitioners to conduct seminars on how to read an audit report.

Required:

(a)What is audit committee?(2 marks)

(b)State three main objectives for the establishment of an audit committee.

(3 marks)

(c)State four functions of an audit committee.(4 marks)

(Adapted HKAAT Paper 8 Auditing December 1998)

2.Reports to Management and Shareholders

Section Summary

Auditor's

Responsibilities

Purposes

Content

Presentation

Confidentiality

Management

Letter

Content

Unqualified

Unmodified

Unqualified

Qualified

Adverse

Disclaimer

Modified

Categories

Audit

Report

Reports to

Management

and

Shareholders

(A)Responsibilities of the external auditor

2.1The audit opinion the auditors main responsibility is to form an opinion on whether the companys financial statements give a true and fair view.

2.2HKSA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement states that an auditor should make management or those charged with governance aware of material weaknesses in the design or implementation of internal control which have come to the auditors attention.

2.3When material weaknesses in the accounting and internal control systems are identified during the audit, the auditor would provide a written report to the directors, management of appropriate levels or the audit committee on a timely basis. To be effective, the report to directors or management should be issued as soon as possible after the completion of the audit procedures giving rise to comment. Such report is also called letter of weaknesses, management letter.

2.4What the auditors are not responsible for (they are the responsibilities of management):

(a)preparing the financial statements.

(b)choosing accounting policies.

(c)implementing systems and controls.

(d)establishing the mechanisms for ensuring that good standards of corporate governance are maintained.

(B)Purposes and content of a management letter ()

2.5Reasons for issuing management letter

(a)give his comments on the design and operations of accounting records and system and internal controls that he has examined during the course of his audit;

(b)provide management with other constructive advice on the design and operation of the control system; and

(c)communicate matters that have come to the auditors attention during the audit that might have an impact on future audits.

2.6Content of a management letter

(a)Weaknesses in the structure of accounting system and internal controls.

(b)Deficiencies in the operation of accounting systems and internal controls.

(c)Unsuitable accounting policies and practices and non-compliance with accounting standards and legislation.

(d)Recommendations for rectifying the deficiencies and for improvements.

(e)Managements response, if any.

2.7Presentation of the report

(a)Address to the board of directors or those charged with governance.

(b)Contain matters of varying levels of significance that can be presented in tiered structure.

(c)Include replies from directors or management to the points raised in the report, indicating the actions that the directors or management intended to take.

2.8An example of a typical letter is shown below; there is no prescribed format. There are other acceptable layouts which you may have seen in practice; columnar formats with the headings weakness, implication and recommendation are common.

PRIVATE AND CONFIDENTIAL

The Directors

Upper Crust Limited

Lower Court

Mongkok, Kowloon

15 May 2009

Dear sirs,

Upper Crust Limited

Audit for the year ended 31 December 2009

In accordance with our normal practice, we are writing to you with regard to matters arising out of our audit for the year ended 31 December 2009 which we consider should be brought to your attention.

Our responsibilities as auditors are governed by company law and principally require us to report on the accounts laid before the company in general meeting.

This report has been prepared for the sole use of the directors of Upper Crust Limited. None of its contents may be disclosed to third parties without our written consent. Bloggs & Co assumes no liability to any other persons.

The matter detailed in this report reflect matters coming to out attention during the course of audit. They are not intended to be a comprehensive statement of all weaknesses that may exist or of all improvements that could be made. We set out below those matters which we consider to be of fundamental importance. Other matters of lesser significance, but which nevertheless require your attention, are dealt with in note form in the attached Appendix.

(a)Management reporting

A fundamental requirement to allow proper control over your business is the regular and timely preparation of accurate management accounts. Preferably these should be prepared monthly, compared with budgets and submitted for formal consideration and adoption by the full board of directors. At the moment no such system exists.

(b)Internal control accounting system

(i)The company exercises no control over the input, processing or output of information processed by the computer bureau. Reliance is placed on the computer bureau to ensure complete and accurate processing of accounting information. In our opinion the directors should ensure that the company effects proper control over the completeness and accuracy of information processed.

(ii)There are other areas covering aspects of inventory, non-current assets and receivables where control is lacking or inadequate which are dealt with in the Appendix attached.

(iii)Our audit work was made considerably more difficult by the absence of care in filing supporting documentation which was therefore difficult to trace. The proper maintenance of records is not only a requirement of company law but is also necessary for the efficient running of your business.

(c)Preparation of accounts

The quality of the draft statutory accounts submitted to us for audit was poor.

(i)The accounts were produced late without proper support. When support was provided in some cases it failed to agree with the amounts stated in the draft accounts.

(ii)A number of items required to be disclosed were omitted. Extensive discussions were necessary with you to ascertain the information to be disclosed in respect of directors interests and capital expenditure.

To reduce the time spent on the audit, and thus the cost to you, all supporting documentation should agree with the accounts and statutory disclosure information should be assembled prior to out examination.

We would be pleased to discuss these points with you at your convenience.

Yours faithfully,

Bloggs & Co.

Appendix

Upper Crust Limited year ended 31 December 2009

(a)Computer processing

Weakness:

Lack of control exercised over computer processing.

Implications:

The completeness, accuracy and validity of the accounting records may be undermined.

Recommendations:

(i)Authorisation of input especially journals not arising from books of prime entry.

(ii)Batch controls using registers over all input in terms of value and number of documents/transactions processed.

(iii)Use of hash totals.

(iv)Management control over master file amendments.

(v)Reconciliation to control accounts.

(vi)Clear audit trail for the correction and resubmission of any rejected transactions.

(vii)All financial information processed at one location.

(viii)A back-up system should be available if the bureau is unable to process the input.

(b)Payroll

Weakness:

No evidence of approval.

Implications:

Unauthorised changes may occur.

Recommendations:

Management should evidence their approval of the payroll, changes in rates of pay and the employment of new staff.

(c)Inventory

Weakness:

Lack of physical and financial control over inventory.

Cut-off errors were discovered for widgets despactched prior to the year end but uninvoiced.

Overhead allocation in valuation of widgets lacked support.

Implications:

Inventory could be misappropriated.

The year end inventory figure could be misstated.

Recommendations:

(i)A simple system of perpetual inventory should be implemented at each location. This should be used to check for the dispatch and receipt of inventory and would provide good overall control to enable a comparison of:

Expected use to actual by comparison with orders, and

Book inventory to actual after regular inventory checks.

(ii)Improvements should be made to the system of control to facilitate a review of the despactches at the year end to ensure that a proper cut-off is achieved.

(iii)The valuation of widgets depends on the estimated throughout during the year. It is important that the number of widgets produced is properly recorded and that consideration is given to normal production levels to allow compliance with HKAS 2.

(d)Non-current assets

Weakness:

Lack of physical control.

Lack of clear capitalization policy.

Assets with nil net book value were subject to a depreciation charge.

Implications:

Portable assets could be misappropriated.

Items could be incorrectly capitalized.

The depreciation figures in the accounts could be overstated.

Recommendations:

(i)A register should be introduced to record all assets at cost together with associated depreciation.

(ii)In previous years capital additions, notably the improvements to the leasehold premises, have been written off. Also, assets scrapped have not been written off. The effect of these cancel out and therefore we have not proposed an adjustment to opening figures. A capitalization policy should be laid down and adhered to.

(iii)A register would enable the identification of fully depreciated assets and allow them to be excluded from the depreciation calculations.

(C)Confidentiality of the report to management

2.9When the directors or management of the holding company of a group of companies may wish to be informed of significant points arising from the report, permission is needed from the directors or management of the subsidiary to disclose the contents of any reports to directors or management to the holding company or the principal auditors.

2.10The auditor should not normally reveal the content of the report to any third party without prior written consent of the management of the company.

(C)Auditors report

(a)Content of auditors report (HKSA 700)

2.11Major items in the auditors report is listed below:

Date of report, auditors

address and signature

Other reporting responsibilities

The basis of opinion

Scope paragraph

Respective responsibilities

of directors and auditors

Introductory paragraph

Title and addressee

2.12The sample of audit report taken from the Appendix of HKSA 700.

INDEPENDENT AUDITORS REPORT

TO THE SHAREHOLDERS OF ABC LIMITED

(incorporated in Hong Kong with limited liability)

We have audited the financial statements of ABC Limited set out on pages ........ to........ , which comprise the balance sheet as at 31 December 200X, and the income statement, [statement of changes in equity or statement of recognised income and expense] and cash flow statement for the year then ended, and a summary of significant accounting policies and other explanatory notes.

Directors responsibility for the financial statements

The directors are responsible for the preparation and the true and fair presentation of these financial statements in accordance with Hong Kong Financial Reporting Standards issued by the Hong Kong Institute of Certified Public Accountants and the Hong Kong Companies Ordinance. This responsibility includes designing, implementing and maintaining internal control relevant to the preparation and the true and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error; selecting and applying appropriate accounting policies; and making accounting estimates that are reasonable in the circumstances.

Auditors responsibility

Our responsibility is to express an opinion on these financial statements based on our audit2. We conducted our audit in accordance with Hong Kong Standards on Auditing issued by the Hong Kong Institute of Certified Public Accountants. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance as to 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 auditors judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entitys preparation and true and fair presentation 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 the entitys internal control. 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.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, the financial statements give a true and fair view of the state of the companys affairs as at 31 December 200X and of its profit and cash flows for the year then ended in accordance with Hong Kong Financial Reporting Standards and have been properly prepared in accordance with the Hong Kong Companies Ordinance.

XYZ & Co.

Certified Public Accountants (Practising) [or Certified Public Accountants]

[Address]

Date

(b)Categories of audit reports

2.13An audit report may be either:

(a)unmodified often referred to as a clean audit report, or

(b)modified reports

2.14The unmodified report means that in the auditors opinion the financial statements:

(a)do give a true and fair view;

(b)do comply with the applicable reporting framework;

(c)do not give the auditor any need to report other matters under the exception reporting rules

2.15If the auditor is unable to decide whether the financial statements give a true and fair view, or disagrees with some aspect of them, the unmodified report may not be appropriate. When this is the case, the audit report will require modification. Modification may or may not result in a qualified audit report.

Unmodified

Opinion

(HKSA 700)

Qualified

Opinion

(HKSA 705)

Adverse

Opinion

(HKSA 705)

Disclaimer

of Opinion

(HKSA 705)

Emphasis

of Matter

Paragraph

(HKSA 706)

Other Matter

Paragraph

(HKSA 706)

Modified

Opinion

Audit

Opinion

(c)Matters not affecting the audit opinion

2.16Not all modifications result in qualification.

2.17Where there are particular circumstances surrounding the financial statements, e.g.

(a)significant uncertainties whose outcome depends on future events;

(b)going concern problems;

(c)material misstatements in prior period figures.

and they are fully disclosed, the auditors may wish to draw the readers attention to them in the audit report.

(d)The emphasis of matter paragraph

2.18The way these kinds of issues are included in the audit report is by the use of an emphasis of matter paragraph. An example is shown below where an emphasis of matter paragraph has been deemed necessary due to a significant uncertainty, the resolution of which is dependent on future events outside the direct control of the entity.

Without qualifying our opinion we draw attention to Note X to the financial statements. The company is the defendant in a lawsuit alleging () infringement () of certain patent rights and claiming royalties and punitive () damages. The Company has filed a counter section, and preliminary hearings and discovery proceedings on both actions are in progress. The ultimate outcome of the matter cannot presently be determined, and no provision for any liability that may result has been made in the financial statements.

2.19There are some further things to note:

(a)The emphasis of matter paragraph is placed after the opinion paragraph.

(b)The auditor makes it clear in the paragraph that the opinion is not qualified.

(c)The sections of the report prior to the paragraph are unchanged.

(d)Where possible, the potential financial effect on the financial statements should be quantified.

(e)The paragraph is given a separate heading.

(e)The types of modified opinion

2.20HKSA 705 Modifications to the Opinion in the Independent Auditors Report states that all qualifications arise from either material misstatements or inability to obtain sufficient appropriate audit evidence, which can be material or pervasive.

2.21The qualification grid below is a useful summary of the decisions the auditor has to make in drafting a modified audit report.

Nature of matter giving rise to the modification

Auditors judgment about the pervasiveness of the effects or possible effects on the financial statements

Material but not pervasive

Material and pervasive

Financial statement are materially misstated

Qualified opinion

()

Adverse opinion

()

Inability to obtain sufficient appropriate audit evidence

Qualified opinion

Disclaimer opinion

()

2.22In the new HKSA 705, a pre-condition in determining which type of modification is required to the auditors opinion is whether the auditor is able to obtain sufficient appropriate audit evidence.

2.23In the audit report context, the materiality column above will come into play when the auditor encounters a material problem with one or more specific items in the financial statements, but the remaining items and the financial statements as a whole comply with the true and fair view criterion.

2.24Other than the word material, pervasive is used to describe the effects on the financial statements of misstatements. Pervasive effects on the financial statements are those that, in the auditors judgment:

(i)are not confined to specific elements, accounts or items in the financial statements;

(ii)if so confined, represent or could represent a substantial proportion of the financial statements; or

(iii)in relation to disclosures, are fundamental to users understanding of the financial statements.

2.25The following table distinguishes which type of modification to the auditors opinion should be applied:

2.26There is a disagreement with management regarding:

(i)the acceptability of the accounting policies selected

(ii)the method of their application

(iii)the accounting treatment adopted for particular transactions or

(iv)the adequacy of financial statement disclosures.

(e)Effect on audit report

2.27The result of these matters on the audit report is shown below. Note the circumstances given at the top of the example reports that will give you an indication of when each type will be appropriate.

2.28An example of an except for opinion relating to material misstatements

Previous paragraphs as per standard report

Basis for Qualified Opinion

The Companys inventories are carried in the [balance sheet][statement of financial position] at xxx. The directors have not stated the inventories at the lower of cost and net realizable value but have stated them solely at cost, which constitutes a departure from Hong Kong Financial Reporting Standards. The Companys records indicate that had the directors stated the inventories at the lower of cost and net realizable value, an amount of xxx would have been required to write the inventories down to their net realizable value. Accordingly, cost of sales would have been increased by xxx, and income tax, net income and shareholders equity would have been reduced by xxx, xxx and xxx, respectively.

Qualified Opinion

In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements give a true and fair view of the state of the Companys affairs as at 31 December 20X1, and of its [profit][loss] and cash flows for the year then ended in accordance with Hong Kong Financial Reporting Standards and have been properly prepared in accordance with the Hong Kong Companies Ordinance.

2.29Adverse opinion relating to a pervasive material misstatements

Basis for Adverse Opinion

As explained in Note X, the Company has not consolidated the financial statements of subsidiary DEF Limited it acquired during 20X1 because it has not yet been able to ascertain the fair values of certain of the subsidiarys material assets and liabilities at the acquisition date. This investment is therefore accounted for on a cost basis. Under Hong Kong Financial Reporting Standards, the subsidiary should have been consolidated because it is controlled by the Company. Had DEF been consolidated, many elements in the financial statements would have been materially affected. The effects on the consolidated financial statements of the failure to consolidate have not been determined.

Adverse Opinion

In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, the consolidated financial statements do not give a true and fair view of the state of affairs of the Company and of the Group as at 31 December 20X1, and of the Groups [profit][loss] and cash flows for the year then ended in accordance with Hong Kong Financial Reporting Standards. In all other respects, in our opinion the consolidated financial statements have been properly prepared in accordance with the Hong Kong Companies Ordinance.

2.30An example of an except for opinion relating to a material inability

Previous paragraphs as per standard report

Basis for Qualified Opinion

ABC Limiteds investment in DEF Limited, a foreign associate acquired during the year and accounted for by the equity method, is carried at xxx on the [balance sheet][statement of financial position] as at 31 December 20X1, and ABCs share of DEFs net income of xxx is included in ABCs income for the year then ended. We were unable to obtain sufficient appropriate audit evidence about the carrying amount of ABCs investment in DEF as at 31 December 20X1 and ABCs share of DEFs net income for the year because we were denied access to the financial information, management, and the auditors of DEF. Consequently, we were unable to determine whether any adjustments to these amounts were necessary.

Qualified Opinion

In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements give a true and fair view of the state of the Companys affairs as at 31 December 20X1, and of its [profit][loss] and cash flows for the year then ended in accordance with Hong Kong Financial Reporting Standards and have been properly prepared in accordance with the Hong Kong Companies Ordinance.

2.31An example of a disclaimer of opinion relating to a pervasive inability to obtain sufficient appropriate audit evidence.

Basis for Disclaimer of Opinion

The Companys investment in its joint venture DEF (Country X) Limited is carried at xxx on the Companys [balance sheet][statement of financial position], which represents over 90% of the Companys net assets as at 31 December 20X1. We were not allowed access to the management and the auditors of DEF, including DEFs auditors audit documentation. As a result, we were unable to determine whether any adjustments were necessary in respect of the Companys proportional share of DEFs assets that it controls jointly, its proportional share of DEFs liabilities for which it is jointly responsible, its proportional share of DEFs income and expenses for the year, and the elements making up the statement of changes in equity and [cash flow statement][statement of cash flows].

Disclaimer of Opinion

Because of the significance of the matter described in the Basis for Disclaimer of Opinion paragraph, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on the financial statements. In all other respects, in our opinion the financial statements have been properly prepared in accordance with the Hong Kong Companies Ordinance.

Report on matters under sections 141(4) and 141(6) of the Hong Kong Companies Ordinance

In respect alone of the inability to obtain sufficient appropriate audit evidence regarding an investment in a joint venture:

we have not obtained all the information and explanations that we considered necessary for the purpose of our audit; and

we were unable to determine whether proper books of account had been kept.

N13-16

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