Question

Question 3 Keep Beautiful Company Limited (“KB”) is a Hong Kong company providing beauty care services through prepaid packages. Since hiring Ms Marie Tam as the CEO, KB has been developing rapidly. There are currently 10 beauty salons in Hong Kong, which five of them have been opened during the financial year ended 31 December 2019. Marie plans to open more beauty salons in Macau and the Mainland China. Although some Directors are concerned with the rapid development, Marie assures them that this strategy is essential to obtain the maximum market shares because beauty care services industry is highly competitive. In order to maintain competitive, beauty salons are often equipped with beauty care machines with the latest technology. Therefore, KB has signed lease agreements with various beauty care machine suppliers. Before the implementation of HKFRS 16, KB has always treated the leasing as operating leases. With HKFRS 16 effective for annual periods beginning on or after 1 January 2019, KB is now required to recognize the lease assets and the corresponding lease liabilities on the balance sheet. The Legislative Council may pass the bill for the statutory cooling-off period for prepaid consumer contracts, including those relating to beauty care services. Marie has been worried about this bill. She arranges training sessions for the staff to comfort and persuade consumers to stay in the prepaid packages when they have a second thought. Before joining KB, Marie was the COO of another beauty care services company which was eventually dissolved due to litigation of dishonest selling activities.

Required: Assume you are the audit manager of KB for the year ended 31 December 2019, evaluate the inherent risk for the audit of KB.

Answer 1

The inherent risk for the audit of KB: -

With effect from 01.01.2019, Lease has to be recorded in the books. That means lease is being considered as finance lease. Finance lease are leases in which assets get transferred to lessee after payment of all leases at the end of lease term and it is considered as Assets of the company and has to be recorded in the books.

In the given case, Since its a finance lease, asset(machine) has to be recorded in the books against liability (lease payments to be made at the end of month/year). therefore, inherent risk of the company increases as there was no such risk before, previously company used to recognise it as operating leases. The risk is if the caompany defaults in the lease payment then company may be in trouble. To counter thhis, company need to tight its working capital requirements and reduce its credit period so that its able to recover dues from debtors soon. Similiarly, creditors payment cycle can be increased so that company is available with required amount to pay off lease payments.

Moreover, A bill may be passed in parliament which prohibits prepaid receipts and our company major revenue is from prepaid not post paid. Prepaid receipts used to help us as we use to get money before providing services. If the bill gets passed it will adversely affect our working capital requirements.

Therefore, Two inherent risk arises for the company : -

1.) Recording of Assets in books which leads to payment of lease payments

2.) And Removal of prepaid receipts.

Necessary action is required in relation to working capital requirement as new beauty care revenue will not arise from day one, it will take time to generate revenue. Therefore, for that time, company need to increase their working capual requirements from different sources like Banks, NBFCs, Financial Institututions etc.