Star Beauty Limited is a small private company incorporated in Hong Kong. The co

Question

Star Beauty Limited is a small private company incorporated in Hong Kong. The company has a retail shop selling cosmetics at Tsuen Wan. The Ho family owns 100% of the equity 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 issuance of shares will reduce the Ho family’s equity interest to 50%. In order to cope with the quick expansion of the business, a managing director 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 three reasons why Star Beauty Limited should have an independent audit of its financial statements. (8 marks)

(b) 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. (5 marks)

(c) According to Companies Ordinance, who is eligible to act as an auditor for statutory audits. (2 marks)

Explanation / Answer

a) Here I am discussing the three reasons :

Reason.1- Now as we can see that there is an agency relationship arises i.e between company's shareholders and managing director because company will now be managed by managing director. managers are act as an agent of owners of the company so there is a need of independent auditor who will check whether managers are presenting the books of accounts in prescribed manner or not

Reason.2- because of agency relationship there is conflict arises between owner's and manager's interest owners are more interested in profit maximisation and managers are interested in stable earning so they can manipulate the books of accounts

Reason.3- The auditor will make sure the books of accounts are free from any material errors and prepared acording to accounting standards which will protect the owners and other stakeholders in making wrong decisions about providing further resources to company

b) yes there is an agency risk because as we can see that there is an agency relationship arises i.e between company's shareholders and managing director because company will now be managed by managing director. managers are act as an agent of owners of the company because of agency relationship there is conflict arises between owner's and manager's interest owners are more interested in profit maximisation and managers are interested in stable earning. the nature of agency cost that will always conflicting e.g- as an owner they may want to take a risky project so that they can earn extraordinary profit but as a manager they will more inclined to take less risk and run its operations smoothly because they have fear of suspension if company will not make good profits

c) any independent auditor or auditor firm can be the auditor according to board members of the company they will appoint an independent auditor.

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