5 (a) Matters to consider
The total cost of the new processing area of $5 million represents 2·9% of total assets and is material to the statement of
financial position. The borrowing costs are not material to the statement of financial position, representing less than 1% of
total assets; however, the costs are material to profit representing 10% of profit before tax.
The directly attributable costs, including borrowing costs, relating to the new processing area should be capitalised as
property, plant and equipment. According to HKAS 23 Borrowing Costs, borrowing costs that are directly attributable to the23
acquisition, construction or production of a qualifying asset should be capitalised as part of the cost of that asset. The
borrowing costs should be capitalised only during the period of construction, with capitalisation ceasing when substantially
all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.
In this case, the new processing area was ready for use on 1 September, so capitalisation of borrowing costs should have
ceased at that point. It seems that the borrowing costs have been appropriately capitalised at $100,000, which represents
six months’ interest on the loan ($4m x 5% x 6/12).
The new processing area should be depreciated from 1 September, as according to HKAS 16 Property, Plant and Equipment,
depreciation of an asset begins when it is in the location and condition necessary for it to be capable of operating in the
manner intended by management.
There should therefore be five months’ depreciation included in profit for the year ended 31 January 2012, amounting to
$138,889 ($5m/15 years x 5/12).
Evidence
– A breakdown of the components of the $4·9 million capitalised costs (excluding $100,000 borrowing costs) reviewed
to ensure all items are eligible for capitalisation.
– Agreement of a sample of the capitalised costs to supporting documentation (e.g. invoices for tangible items such as
cement, payroll records for internal labour costs).
– A copy of the approved budget or capital expenditure plan for the extension.
– An original copy of the loan agreement, confirming the amount borrowed, the date of the cash receipt, the interest rate
and whether the loan is secured on any assets.
– Documentation to verify that the extension was complete and ready for use on 1 September, such as a building
completion certificate.
– Recalculation of the borrowing cost, depreciation charge and carrying value of the extension at the year end, and
agreement of all figures to the draft financial statements.
– Confirmation that the additions to property, plant and equipment are disclosed in the required note to the financial
statements.
(b) The titles and positioning of the two paragraphs included in the extract are not appropriate. According to HKSA 705
Modifications to the Opinion in the Independent Auditor’s Report, when the auditor modifies the opinion, a paragraph should
be placed immediately before the opinion paragraph entitled ‘Basis for Adverse Opinion’, which describes the matter giving
rise to the modification. This should then be followed by the opinion paragraph, which should be entitled ‘Adverse Opinion’.
In this case, the titles are incorrect, and the paragraphs should be switched round, so that the basis for modification is
provided before the opinion.
The description and explanation provided for the adverse opinion is not sufficient, for a number of reasons. Firstly, the matter
is not quantified. The paragraph should clearly state the amount of $10·5 million, and state that this is material to the
financial statements.
The paragraph does not say whether the pension plan is in surplus or deficit, i.e. whether it is an asset or a liability which is
omitted from the financial statements.
There is no description of the impact of this omission on the financial statements. Wording such as ‘if the deficit had been
recognised, total liabilities would increase by $10·5 million, and shareholders’ equity would reduce by the same amount’
should be included.
It is not clear whether any accounting for the pension plan has taken place at all. As well as recognising the plan surplus or
deficit in the statement of financial position, accounting entries are also required to deal with other items such as the current
service cost of the plan, and any actuarial gains or losses which have arisen during the year. Whether these have been omitted
as well, and their potential impact on profit or equity is not mentioned.
No reference is made to the relevant accounting standard HKAS 19 Employee Benefits. Reference should be made in order
to help users’ understanding of the breach of accounting standards that has been made.
The use of the word ‘deliberate’ when describing the omission of the pension plan is not professional, sounds accusatory and
may not be correct. The plan may have been omitted in error and an adjustment to the financial statements may have been
suggested by the audit firm and is being considered by management.
Finally, it is unlikely that this issue alone would be sufficient to give rise to an adverse opinion. HKSA 705 states that an
adverse opinion should be given when misstatements are both material and pervasive to the financial statements. The amount
of the deficit, and therefore the liability that should be recognised, is $10·5 million, which represents 6% of total assets. The
amount is definitely material, but would not be considered pervasive to the financial statements.
Tutorial note: According to HKSA 705 if a misstatement is confined to specific elements of the financial statements, it would
only be considered pervasive if it represents a substantial proportion of the financial statements.25
Professional Level – Options Module, Paper P7 (HKG)
Advanced Audit and Assurance (Hong Kong) June 2012 Marking Scheme
Marks
