module preparation seminar (part i) for module a on ... · module preparation seminar (part i) for...

Module Preparation Seminar (Part I)

for

Module A on Financial Reporting

Speaker

Mr. Ted Chan

9 April 2014

Table of Contents HKICPA QPA Financial Reporting Jun 2014

Prepared by Ted Chan, CPA, CFA 1 Copyright © Kaplan Financial 2014

HKICPA QPA Seminar

Table of Contents

1. Introduction

P.2

2. Leases (LP 9)

P.4

3. Revenue (LP 14)

P.51

Introduction HKICPA QPA Financial Reporting Jun 2014


Exam No. Exam A Financial Reporting 1,257 61% May-2005

A Financial Reporting 1,342 57% Feb-2006 A Financial Reporting 2,041 52% Sep-2006 A Financial Reporting 2,063 44% May-2007 A Financial Reporting 2,396 50% Feb-2008 A Financial Reporting 2,626 55% Sep-2008 A Financial Reporting 2,912 49% May-2009 A Financial Reporting 2,579 44% Feb-2010 A Financial Reporting 2,381 46% Dec-2010 A Financial Reporting 1,459 45% Jun-2011

A Financial Reporting 2,240 50% Dec-2011 A Financial Reporting 1,700 50% Jun-2012 A Financial Reporting 2,150 45% Dec-2012 A Financial Reporting 1,910 38% Jun-2013 A Financial Reporting 2,355 40% Dec-2013

35%

40%

45%

50%

55%

60%

65%

May

-20

05

No

v-2

00

5

May

-20

06

No

v-2

00

6

May

-20

07

No

v-2

00

7

May

-20

08

No

v-2

00

8

May

-20

09

No

v-2

00

9

May

-20

10

No

v-2

01

0

May

-20

11

No

v-2

01

1

May

-20

12

No

v-2

01

2

May

-20

13

No

v-2

01

3

QPA

QPA

Introduction HKICPA QPA Financial Reporting Jun 2014


Key points to note in Education Class:

1. QPA has the lowest passing rate out of all papers.

2. The most important thing is to make sure you can complete the statement of financial position,

income and the cash flow quickly. Every year in section A there is a long question testing some of

these statements.

3. QPA emphasises on application, so it is important that you understand in details the theories

discussed in the class. It is an open-book exam, and it relies heavily on the notes because you are

expected to quote the relevant standards, so please do referencing.

Leases (LP Ch.9) HKICPA QPA Financial Reporting Jun 2014


Standards under this Chapter 1. HKAS 17 Leases (LP Ch. 9) 2. HK – Int 4 Leases – Determination of the length of lease term in respect of Hong Kong Land

Leases 3. HK (SIC) Int 15 – Operating Lease – Incentives 4. HK (SIC) Int 27 – Evaluating the substance of transactions involving the legal form of a lease 5. HK (IFRIC) Int 4 – Determining whether an arrangement contains a lease

Examinable Areas of Leases 1. Classification of Leases 2. Accounting for Finance Lease (lessee, manufacturer lessors, other lessors) 3. Accounting for Sales and Leaseback Relatively Minor Area 1. Operating lease is relatively easier and less important



Definitions (LP 9.1.2.1) A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred An operating lease is a lease other than a finance lease [HKAS 17.4] Lease term is the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option [HKAS 17.4] A non-cancellable lease is a lease that is cancellable only: 1. Upon the occurrence of some remote contingency; 2. With the permission of the lessor; 3. If the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or 4. Upon payment by the lessee of such an additional amount that, at inception of the lease,

continuation of the lease is reasonably certain Minimum lease payments are the payments over the lease term that the lessee is or can be required to make, together with: 1. For a lessee, any amounts guaranteed by the lessee or by a party related to the lessee; or 2. For a lessor, any residual value guaranteed to the lessor by:

a. The lessee; b. A party related to the lessee; or c. A third party unrelated to the lessor that is financially capable of discharging the

obligations under the guarantee [HKAS 17.4] However, if the lessee has an option to purchase the asset at a price that is expected to be sufficiently lower than fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised, the minimum lease payments comprise the 1. Minimum payments payable over the lease term to the expected date of exercise of this purchase

option and 2. The payment required to exercise it [HKAS 17.4] Minimum lease payments exclude 1. Contingent rent 2. Costs for services, and 3. Taxes to be paid by and reimbursed to the lessor [HKAS 17.4]

Leases

Lease Term (LP 9.1.3)

Lease Payment



Classification of Leases

Classification of leases is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee [HKAS 17.7] Risks include 1. Possibilities of losses from idle capacity 2. Technological obsolescence, or 3. Variations in return because of changing economic conditions [HKAS 17.7]

Rewards include 1. Expectation of profitable operation over the asset’s economic life 2. Gain from appreciation in value, or 3. Realisation of a residual value [HKAS 17.7]

Lease classification is made at the inception of the lease [HKAS 17.13] Inception of the lease is the earlier of the 1. Date of the lease agreement, and 2. Date of commitment by the parties to the principal provisions of the lease [HKAS 17.4] A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership [HKAS 17.8] A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership [HKAS 17.8] Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract [HKAS 17.10]

Risks and Rewards (LP 9.1.2.2)

2 Classifications

Examinable!!



Examples of Finance Leases 1. The lease transfers ownership of the asset to the lessee by the end of the lease term; [HKAS

17.10] 2. The lessee has the option to purchase the asset at a price that is expected to be

sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised [HKAS 17.10]

This option is called a bargain purchase option 3. The lease term is for the major part of the economic life of the asset even if title is not

transferred; [HKAS 17.10] 4. At the inception of the lease the present value of the minimum lease payments amounts to at

least substantially all of the fair value of the leased asset; [HKAS 17.10] ‘Substantially all’ usually means ‘more than 90%’ 5. The leased assets are of such a specialised nature that only the lessee can use them without

major modifications [HKAS 17.10] 6. If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are

borne by the lessee; [HKAS 17.11] 7. Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee;

[HKAS 17.11] 8. The lessee has the ability to continue the lease for a secondary period at a rent that is

substantially lower than market rent [HKAS 17.11] In all the above 8 situations, the lessee bears the risks and rewards incidental to ownership of the asset

Examples of Operating Leases [HKAS 17.12] 1. If ownership of the asset transfers at the end of the lease for a variable payment equal to its then

fair value 2. If contingent rents are included in the lease The lessee does not have substantially all the risks and rewards The above 2 leases are classified as operating leases



Lessee – Finance Lease At the commencement of the lease term, lessees shall recognise finance leases as assets and liabilities in their statements of financial position at amounts equal to the lower of 1. The fair value of the leased property or, 2. The present value of the minimum lease payments

a. The discount rate to be used is the interest rate implicit in the lease b. If cannot determine the implicit interest rate

Use the lessee’s incremental borrowing rate [HKAS 17.20] Each of the 2 above is determined at the inception of the lease If such lease transactions are not reflected in the lessee’s F/P, the economic resources and the level of obligations of an entity are understated, thereby distorting financial ratios At the commencement of the lease term, the asset and the liability for the future lease payments are recognised in the F/P at the same amounts except for any initial direct costs Any initial direct costs of the lessee are added to the amount recognised as an asset [HKAS 17.24]

Example of Initial Direct Cost Cost for negotiating and securing leasing arrangement [HKAS 17.24]

Minimum lease payments shall be apportioned between the finance charge and the reduction of the outstanding liability [HKAS 17.25] The finance charge shall be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability [HKAS 17.25] Contingent rents shall be charged as expenses in the periods in which they are incurred [HKAS 17.25] The lessee does not capitalise the contingent rents A finance lease gives rise to depreciation expense for depreciable assets as well as finance expense for each accounting period [HKAS 17.27] Depreciation policy for depreciable leased asset shall be consistent with that for depreciable assets that are owned (either based on HKAS 16 PPE or HKAS 38 IA) [HKAS 17.27]

Initial Recognition (LP 9.2.2.1)

Examinable!!

Is Asset = Liab at initial recognition?

Why recognise asset + Liab?

Subsequent Measurement (LP 9.2.2.1)

DR Asset x+y CR Liab x CR Cash for initial direct costs y

2 expenses in P&L throughout the lease terms



If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset shall be fully depreciated over the shorter of 1. The lease term, and 2. Its useful life [HKAS 17.27] If there is reasonable certainty that the lessee will obtain ownership by the end of the lease term, the depreciation should be over its useful life [HKAS 17.28] We should adopt the actuarial method to allocate lease payment into finance cost and principal Sum of digits method is not examinable

Subsequent Measurement – Allocation of Lease Payment into Finance Cost and

Principal



Examinable Area – Accounting Finance Lease by Lessee Entity X acquired some PPE on 31 Dec 2008. The acquisition is financed by a non-cancellable 10-year finance lease. At the end of the lease, the lessor will not grant any ownership to Entity X. The asset has a fair value of $700k which approximates to the present value of the minimum lease payments under the lease. The 10 equal annual repayments of $90,000 are made in advance with the first installment due on 31 Dec 2008. The interest rate implicit in the lease is 6.08%. The asset has an estimated useful life of 11 years and Entity X has a policy to carry PPE on a historical cost basis and provides for depreciation on a straight-line basis Q1: Calculate the finance charges allocated to each period Q2: Prepare journal entries to account for the lease in the books of Entity X for the two years ended 31 Dec 2009 Answers

Beginning Principal O/S

Finance Cost (6.08%) Repayment

Ending Principal O/S

$ $ $ $

31-Dec-08 700,000 0 (90,000) 610,000 31-Dec-09 610,000 37,088 (90,000) 557,088 31-Dec-10 557,088 33,871 (90,000) 500,959 31-Dec-11 500,959 30,458 (90,000) 441,417 31-Dec-12 441,417 26,838 (90,000) 378,255 31-Dec-13 378,255 22,998 (90,000) 311,253 31-Dec-14 311,253 18,924 (90,000) 240,177 31-Dec-15 240,177 14,603 (90,000) 164,780

31-Dec-16 164,780 10,019 (90,000) 84,799 31-Dec-17 84,799 5,201 (90,000) -

200,000 (900,000)

PPE $700,000 Finance Lease Payable $700,000 (31 Dec 2008) To recognise the acquisition of asset by finance lease Finance Lease Payable $90,000 Cash $90,000 (31 Dec 2008) To recognise the lease payment

Finance Lease Payable $52,912 Finance Cost $37,088 Cash $90,000 (31 Dec 2009) To recognise the lease payment Depreciation $70,000 Accumulated Depre $70,000 (31 Dec 2009) To recognise the depreciation expense

The PPE is depreciated by 10 years because at the end of the lease term Entity X (the lessee) will not possess the ownership, so the PPE is depreciated over the shorter of its useful life (11 years) and the lease term (10 years)

First depre in 2009 and final depre in 2018, so no depre in 2008



Examinable Area – Accounting Finance Lease by Lessee Same as above except the lease payment is made in arrears (ie the first installment was paid on 31 Dec 2009) and the interest rate implicit in the lease is 4.85% Q1: Calculate the finance charges allocated to each period Q2: Prepare journal entries to account for the lease in the books of Entity X for each of the two years ended 31 Dec 2009 Q3: What are the amounts of current liabilities and non-current liabilities as at 31 Dec 2011? Answers


Finance Cost (4.85%) Repayment


$ $ $ $

31-Dec-09 700,000 33,950 (90,000) 643,950 31-Dec-10 643,950 31,232 (90,000) 585,182 31-Dec-11 585,182 28,381 (90,000) 523,563 31-Dec-12 523,563 25,393 (90,000) 458,956 31-Dec-13 458,956 22,259 (90,000) 391,215 31-Dec-14 391,215 18,974 (90,000) 320,189 31-Dec-15 320,189 15,529 (90,000) 245,718 31-Dec-16 245,718 11,917 (90,000) 167,635 31-Dec-17 167,635 8,130 (90,000) 85,765 31-Dec-18 85,765 4,235 (90,000) -

200,000 (900,000)

PPE $700,000 Finance Lease Payable $700,000 (31 Dec 2008) To recognise the acquisition of asset by finance lease

Finance Lease Payable $56,050 Finance Cost $33,950 Cash $90,000 (31 Dec 2009) To recognise the lease payment Depreciation $70,000 Accumulated Depre $70,000 (31 Dec 2009) To recognise the depreciation expense

As at 31 Dec 2011, in F/P PPE – cost = $700,000 PPE – Accu Depre = $210,000 Net PPE = $490,000 Current Liab = $64,607 Non-current Liab = $458,956 Total Liab = $523,563



Lessor – Finance Lease Lessor shall recognise assets held under a finance lease in F/P and present them as a receivable at an amount equal to the net investment in the lease [HKAS 17.36] Net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the lease [HKAS 17.4] Gross investment in the lease is the aggregate of 1. The minimum lease payments receivable by the lessor under a finance lease, and 2. Any unguaranteed residual value accruing to the lessor [HKAS 17.4] Unearned finance income is the difference between 1. The gross investment in the lease, and 2. The net investment in the lease [HKAS 17.4] Unearned finance income + Net investment in the lease = Gross investment in the lease Initial direct costs are included in the initial measurement of the finance lease receivable and reduce the amount of income recognised over the lease term [HKAS 17.38] The recognition of finance income shall be based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the finance lease [HKAS 17.39] Use the actuarial method to allocate lease receipt into finance income and reduction of principal Estimated unguaranteed residual values used in computing the lessor’s gross investment in a lease are reviewed regularly [HKAS 17.41] If there has been a reduction in the estimated unguaranteed residual value, the income allocation over the lease term is revised and any reduction in respect of amounts accrued is recognised immediately [HKAS 17.41]

Examinable!!

Initial Recognition (LP 9.3.2.1)

Subsequent Measurement

1 income in P&L throughout the lease terms



Examinable Area – Accounting Finance Lease by Lessor Entity X leases machine to Entity Y. The finance lease is for four years at an annual cost of $2,000 payable annually in arrears. The normal cash price (and fair value) of the asset is $5,900. The present value of the minimum lease payments is $5,610. Legal cost incurred for the lease is $100. Marketing costs for the lease is $200. The implicit rate of interest is 15%. Q: Show how the net investment in the lease is present in Entity X’s F/P at the end of Year 1 Answers HKAS 17 requires the lessor (Entity X) to recognise a receivable at the net investment amount. Net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the lease (15%) Gross investment in the lease is the aggregate of 1. The minimum lease payments receivable by the lessor under a finance lease ($5,610), and 2. Any unguaranteed residual value accruing to the lessor ($0) The fair value of the PPE ($5,900) is not relevant to the initial recognition amount of the finance lease receivable Initial direct costs are added into the initial measurement of the finance lease receivable. Therefore, $100 legal cost should be added into the finance lease receivable. Marketing costs $200 is not initial direct cost so it is excluded


Finance Income (15%) Repayment


$ $ $ $

Year 1 5,710 857 (2,000) 4,567 Year 2 4,567 685 (2,000) 3,252 Year 3 3,252 488 (2,000) 1,740 Year 4 1,740 260 (2,000) -

2,290 (8,000)

F/P at the end of Year 1, Current Asset: Net Investment in Finance Lease = $1,315 Non-current Asset: Net Investment in Finance Lease = $3,252 P&L for Year 1, Finance income = $857



Manufacturer or Dealer Lessor – Finance Lease Manufacturer or dealers often offer to customers the choice of either buying or leasing an asset [HKAS 17.43] A finance lease of an asset by a manufacturer or dealer lessor gives rise to two types of income: 1. Profit or loss equivalent to the profit or loss resulting from an outright sale of the asset being

leased, at normal selling prices, reflecting any applicable volume or trade discounts; and 2. Finance income over the lease term [HKAS 17.43] Sales revenue = the lower of 1. Fair value of the asset, or 2. The present value of the minimum lease payments accruing to the lessor

a. Computed at a market rate of interest [HKAS 17.44] Cost of sale = Cost / Carrying amount of the leased property – Present value of the unguaranteed residual value [HKAS 17.44] All initial direct costs are expensed when the sale is made [HKAS 17.46] If interest rate is artificially low in order to attract customers Excessive portion of the total income being recognised at the time of sale (Because higher revenue at the time of sale, but lower finance income throughout the leasse) Selling profit is restricted to that which would apply if a market rate of interest were charged [HKAS 17.46]

Example of Artificially Low Interest Rate If a manufacture lessor leases out an asset with fair value $100. The present value of the minimum lease payment discounted at market interest rate (10%) is $80 The sales revenue = $80 (because $80 is lower than $100) However, if the lessor provides a artificially low interest rate to attract lessee, say 5% The present value of the minimum lease payment becomes $160 The sales revenue = $100 (because $100 is lower than $160) HKAS 17 requires that the sales revenue has to be recognised at the market rate (ie 10%). Therefore, the sales revenue = $80

Examinable!!

Initial Recognition (LP 9.3.3)

Initial Recognition – Interest Rate

Initial Recognition – Sales & COS



Examinable Area – Accounting Finance Lease by Manufacturer Lessor Entity X acquired some PPE on 31 Dec 2008. The acquisition is financed by a non-cancellable 10-year finance lease with Entity Y being the lessor. The carrying amount of the leased asset in Entity Y’s books is $660,000. At the end of the lease, the lessor will not grant any ownership to Entity X. The asset has a fair value of $700k which approximates to the present value of the minimum lease payments under the lease. The 10 equal annual repayments of $90,000 are made in advance with the first installment due on 31 Dec 2008. The interest rate implicit in the lease is 6.08%. Q1: Calculate the finance income allocated to each period Q2: Prepare journal entries to account for the lease in the books of Entity Y for the two years ended 31 Dec 2009 Answers


Finance Income (6.08%) Repayment


$ $ $ $

31-Dec-08 700,000 0 (90,000) 610,000 31-Dec-09 610,000 37,088 (90,000) 557,088 31-Dec-10 557,088 33,871 (90,000) 500,959 31-Dec-11 500,959 30,458 (90,000) 441,417 31-Dec-12 441,417 26,838 (90,000) 378,255 31-Dec-13 378,255 22,998 (90,000) 311,253 31-Dec-14 311,253 18,924 (90,000) 240,177 31-Dec-15 240,177 14,603 (90,000) 164,780

31-Dec-16 164,780 10,019 (90,000) 84,799 31-Dec-17 84,799 5,201 (90,000) -

200,000 (900,000)

Net Investment in Fin Lease $700,000 Revenue $700,000 (31 Dec 2008) To recognise the initial sale of asset by finance lease COS $660,000 Inventory $660,000 (31 Dec 2008) To recognise the initial sale of asset by finance lease Cash $90,000 Net Investment in Fin Lease $90,000 (31 Dec 2008) To recognise the receipt of lease payment

Cash $90,000 Finance Income $37,088

Net Inv in Fin Lease $52,912 (31 Dec 2009) To recognise receipt of lease payment and interest income



Lease of Land and Buildings When a lease includes both land and building elements, an entity assesses the classification of each element as a finance or an operating lease separately [HKAS 17.15A] In additions, land normally has an indefinite economic life [HKAS 17.15A] Freehold land means the users own the land Leasehold land means the users lease the land from the government. This is the situation in HK. In Nov 2009, HKICPA has issued a Q&A to provide guidance about the classification of interests in leasehold land situated in HK In practice, transaction values in the Hong Kong property market have typically demonstrated that the property market does not materially distinguish between Government land leases of varying duration unless there is no expectation of renewal. It means that the market believes that the lease term specified in the land lease will be capable of extension for a nominal amount If the market is in effect behaving as if the land interest were substantially the same as a freehold interest, then the lessee of such a lease is in effect exposed to substantially all the risks and rewards of ownership of the land Leases of land in Hong Kong can be classified as finance lease Whenever necessary to classify and account for a lease of land and buildings, the minimum lease payments (including any lump-sum upfront payments) are allocated between the land and the buildings elements in proportion to the relative fair values of the lease hold interests in the land element and buildings element of the lease at the inception of the lease [HKAS 17.16]

Example of Separate Classification Entity X pays $50m to purchase land together with a commercial building constructed on it. The fair value of the land is $15m and the building is $35m. The building is expected to have useful life of 20 years and the lease of land is 50 year. At the end of the useful life of the building, Entity X will build another new building on the land. DR PPE – Land $15m DR PPE – Building $35m CR Cash $50m DR Depreciation expense $0.3m CR Accu Depre $0.3m ($15m ÷ 50 years) DR Depreciation expense $1.75m CR Accu Depre $1.75m ($35m ÷ 20 years)

Separate Classification



In one of the below situations, the lessee of land can classify the land and building together 1. When HKAS 40 IP and fair value model is adopted [HKAS 17.18] 2. When the land element is immaterial

a. Economic life of the buildings is regarded as the economic life of the entire leased asset [HKAS 17.17]

3. When the allocation of minimum lease payments into land and buildings cannot be done reliably [HKAS 17.16]

Joint Classification



Lessee – Operating Lease (LP 9.2.1) Lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit [HKAS 17.33] HK(SIC) Int-15 states that in negotiating a new or renewed operating lease, the lessor may provide incentives for the lessee to enter into the agreement.

Examples of Incentives 1. Up-front cash payment to the lessee by the lessor 2. Reimbursement of costs of the lessee by the lessor (such as leasehold improvements, relocation

costs, etc) 3. Rent-free period 4. Reduced rent in the early stages of rent

All incentives for the agreement of a new or renewed operating lease shall be recognised as an integral part of the net consideration agreed for the use of the leased asset, irrespective of the incentive’s nature or form or the timing of payments The lessor shall recognise the aggregate cost of incentives as a reduction of rental income over the lease term, on a straight-line basis unless another systematic basis is representative of the time pattern over which the benefit of the leased asset is diminished The lessee shall recognise the aggregate benefit of incentives as a reduction of rental expense over the lease term, on a straight-line basis unless another systematic basis is representative of the time pattern of the lessee’s benefit from the use of the leased asset Costs incurred by the lessee shall be accounted for by the lessee in accordance with relevant HKFRSs Lessor – Operating Lease (LP 9.3.1.1) With an operating lease, the accounting for the rental income and lease incentives is essentially a mirror of the corresponding rental expense of the lessee Lessors shall present assets subject to operating leases in their F/P according to the nature of the asset [HKAS 17.49] The depreciation policy for leased assets shall be consistent with the lessor’s normal depreciation policy for similar assets (HKAS 16 PPE / HKAS 38 IA) [HKAS 17.53] Initial direct costs incurred by lessors should be added to the carrying amount of the leased asset recognised as an expense over the lease term on the same basis as the lease income [HKAS 17.52]

Payments for a year ≠ Expense for a year

Operating Lease Incentives (LP 9.2.1.1)

General



Example of Treatment about Incentive An entity agrees to enter into a new lease arrangement with a new lessor. The lessor agrees to pay the lessee’s relocation costs as an incentive to the lessee for entering into the new lease. The lessee’s moving costs are $1,000. The new lease has a term of 10 years, at a fixed rate of $2,000 per year. Answers The lessee recognises relocation costs of $1,000 as an expense in year 1. It is because cost incurred by the lessee is accounted for in accordance with the relevant HKFRS. Net consideration of $19,000 consists of $2,000 for each of the 10 years in the lease term, less a $1,000 incentive for relocation costs. Both the lessor and lessee would recognise the net rental consideration of $19,000 over 10 year lease term using a single amortisation method DR Expense $1,000 CR Operating Lease Incentive $1,000 At the first day, in the lessee’s books DR Rental Expense $1,900 DR Operating Lease Incentive $100 CR Cash $2,000 In each year from Year 1 to Year 10, in lessee’s books

Example of Treatment about Incentive An entity agrees to enter into a new lease arrangement with a new lessor. The lessor agrees to a rent-free period for the first three years as incentive to the lessee for entering into the new lease. The new lease has a term of 20 years, at a fixed rate of $5,000 per year for year 4 through 20 Answers Net consideration of $85,000 consists of $5,000 for each of the 17 years in the lease term Both the lessor and lessee would recognise the net rental consideration of $85,000 over 20 year lease term using a single amortisation method (ie $4,250 every year) DR Rental Expense $4,250 CR Operating Lease Incentive $4,250 In each year from Year 1 to Year 3 in lessee’s books DR Rental Expense $4,250 DR Operating Lease Incentive $750 CR Cash $5,000 In each year from Year 4 to Year 20 in lessee’s books

Offset each other after 10 years



Definition of Sales and Finance Leaseback (LP 9.4) A sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset [HKAS 17.58] The lease payment and the sale price are usually interdependent because they are negotiated as a package [HKAS 17.58] The seller is the lessee The buyer is the lessor The accounting treatment of a sale and leaseback transaction depends upon the type of lease involved [HKAS 17.58] Sales and Finance Leaseback (LP 9.4) If a sale and leaseback transaction results in a finance lease, any excess of sales proceeds over the carrying amount shall not be immediately recognised as income by the seller (lessee) [HKAS 17.59] Instead, it shall be deferred and amortised over the lease term [HKAS 17.59] It is because sales and finance leaseback is in substance a means whereby the lessor (buyer) provides finance to the lessee (seller) [HKAS 17.60] No real sale has happened!!

Examinable!!

Seller (Lessee) Buyer (Lessor)

Asset

$

Seller (Lessee) Buyer (Lessor)

Regular Lease Payment ($)

Asset

1st Step - Sale

2nd Step - Leaseback



Examinable Area - Sales and Finance Leaseback On 1 Jan 2009, Entity X purchased a PPE for $2.6m. On 1 Jan 2010, Entity X entered into a sale and leaseback arrangement with a major commercial back, whereby Entity X sold the machine with a then carrying amount of $2.4m to the bank for its fair value of $2.9m for cash. Entity X then leased the machine back from the bank with a finance lease over 4 years Q: What are the accounting treatments in Entity X’s books in 2010? Answers HKAS 17 states that a sale and finance leaseback transaction is in substance not a sale, so the seller (Entity X) cannot recognise the excess of sales proceeds ($2.9m) over the carrying amount ($2.4m) immediately as income Instead, it shall be deferred and amortised over the lease term (4 years). Therefore, the gain in sale $0.5m shall be deferred over 4 years DR Cash $2.9m CR PPE $2.4m CR Deferred Income $0.5m (1 Jan 2010) Entity X to recognise the sale of the PPE DR PPE $2.9m CR Finance Lease Obligation $2.9m (1 Jan 2010) Entity X to recognise the acquisition of the leased PPE DR Depreciation $725k CR Accu Depre $725k ($2.9m ÷ 4 years) (31 Dec 2010) Entity X to recognise the depreciation expense DR Deferred Income $125k CR Other Income $125k ($0.5m ÷ 4 years) (31 Dec 2010) Entity X to recognise amortisation of the deferred income DR Finance Lease Obligation $xx DR Finance Cost $xx CR Cash $xx (31 Dec 2010) Entity X to recognise the lease payment



Sales and Operating Leaseback (LP 9.4) If selling price is at fair value Seller (lessee) recognises immediately the profit or loss (because this is a normal sale) [HKAS 17.61] If the selling price is above fair value Excess over fair value shall be deferred and amortised in proportion to the lease payments over the period for which the asset is expected to be used [HKAS 17.61] If the selling price is below fair value Any profit or loss should be recognised immediately (Exception!! if the loss suffered by the seller (lessee) is compensated for by future lease payments at below market price, the loss shall be deferred and amortised in proportion to the lease payments over the period for which the asset is expected to be used) [HKAS 17.61]

Summary of Sales and Operating Leaseback

Examinable!!



Examinable Area - Sales and Operating Leaseback (All Situations) (HKAS17 IG)

Sale Price = FV =

$100

CV = FV = $100 CV ($80) < FV ($100) CV ($130) > FV ($100)

Profit N/A $20 profit immediately N/A

Loss N/A N/A $30 loss immediately

Sale Price ($60) < FV CV = FV = $100 CV ($80) < FV ($100) CV ($130) > FV ($100)

Profit N/A N/A N/A (Note 1)

Loss not

compensated for by

future lease

payments at below

market price

$40 loss immediately $20 loss immediately $70 loss immediately

(Note 1)

Loss compensated

for by future lease

payments at below

market price

$40 loss deferred and

amortised


amortised

$30 loss immediately;


amortised (Note 1)

Sale Price ($95) < FV CV = FV = $100 CV ($80) < FV ($100) CV ($130) > FV ($100)

Profit N/A $15 profit immediately N/A

Loss not

compensated for by

future lease

payments at below

market price

$5 loss immediately N/A $35 loss immediately

(Note 1)

Loss compensated

for by future lease

payments at below

market price


amortised

N/A $30 loss immediately;


amortised (Note 1)

Sale Price ($180) > FV CV = FV = $100 CV ($80) < FV ($100) CV ($130) > FV ($100)

Profit $80 profit deferred and

amortised

$20 profit immediately;

$80 profit deferred and

amortised (Note 3)



amortised (Note 2)

Loss N/A N/A N/A



Sale Price ($115) > FV CV = FV = $100 CV ($80) < FV ($100) CV ($130) > FV ($100)

Profit $15 profit deferred and

amortised

$20 profit immediately;


amortised (Note 3)


$15 gain deferred and

amortised (Note 2)

Loss N/A N/A N/A

Note 1: HKAS 17 requires the carrying amount of the asset to be written down to fair value where it is subject to a sale and leaseback $30 loss already before the sales and operating leaseback Note 2: Profit is the difference between fair value and sale price because the carrying amount would have been written down to fair value in accordance with Note 1 Note 3: The excess profit (the excess of sale price over fair value) is deferred and amortised over the period for which the asset is expected to be used. Any excess of fair value over carrying amount is recognised immediately



Examinable Area - Sales and Operating Leaseback (Selling Price < CV < Fair Value)

Answers



Examinable Area - Sales and Operating Leaseback (Selling Price > Fair Value > CV)

Answers



May 2005 Q3a BCL

Bloom Company Limited (“BCL”) is engaged in the business of property development and holding.

During the year ending 31 December 2005, the company has completed the following transactions:

(a) Lease of five floors of an investment property for five years from 1 July 2005 at a monthly

rental of HK$1.8 million. A six-month rent-free period was given to the lessee for the period 1

July to 31 December 2005.

(b) Sale of a house with a consideration of HK$12 million. 10% of the consideration was paid at

the agreement date, and the remaining 90% of the consideration was settled with nine semi-

annual installment payments of HK$1.2 million each.

(c) Pre-sale of 50 units out of the 180 units of a self-developed residential property which was still

under construction (75% completion). Total consideration for the 50 units is HK$322 million

and BCL had received HK$38.5 million as down payments.

Required:

Determine and explain how BCL should recognize and measure these transactions in the

financial statements for the year ending 31 December 2005 in accordance with relevant Hong

Kong Financial Reporting Standards.

(13 marks)



May 2005 Q3a (4P + 1 = 5)

HINTS!

Flow of discussion Operating lease / finance lease Lessor / lessee Relevant accounting treatment

Five years is short when compared to the useful life of the investment property, so risks and rewards have not been transferred to the lessee. As a result, this is considered as an operating lease [ Alternatively, you may make other assumption that leads to the conclusion of an operating lease ] HKAS 17 requires that lease receipts under an operating lease should be recognised as income on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern HKAS 17 also requires that all incentives for an operating lease shall be recognised as an integral part of the net consideration agreed for the use of the leased asset In this case, BCL should allocate the total rental receipts over 5 years and recognise the income over a straight-line basis Total rental receipt = $1.8m x 54 months = $97.2m Income to be recognised in 2005 = $97.2m ÷ 60 months x 6 months = $9.72m

Examiner’s Comments – May 2005 Q3a This question tested candidates’ knowledge on the revenue recognition concept in three different accounting standards and interpretations Some candidates failed to demonstrate their understanding of the lessor’s accounting for an operating lease with lease incentive in transaction (a)

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Sep 2006 Case Q1ai

Ultimate Holdings Limited (“UHL”)

Assume that you are Mr. David Lee, the accounting manager of Ultimate Holdings Limited (“UHL”).

UHL is a company incorporated in Hong Kong and is principally engaged in the trading of toys in

Hong Kong.

On 31 March 2005, UHL acquired 20 per cent of the issued share capital of Successful Toys Limited

(“STL”), a retail chain store incorporated in Hong Kong. The cost of the investment was seven million

Hong Kong Dollars (HKD7,000,000), which UHL paid all in cash. This 20 per cent shareholding

enables UHL to exercise significant influence on STL. On 31 March 2005, the fair value of STL’s

identifiable assets was HKD20,000,000, and the carrying amount of those assets was

HKD15,200,000. STL had no liabilities or contingent liabilities at that date. The following shows STL’s

balance sheet at 31 March 2005 together with the fair values of the identifiable assets:

Carrying Fair

amounts values

HKD’000 HKD’000

Plant and equipment (net) 11,200 16,000

Net current assets 4,000 4,000

15,200 20,000

Issued equity:

1,000,000 ordinary shares 10,000

Retained earnings 5,200

15,200

During the year ended 31 March 2006, STL reported a profit of HKD12,000,000 but did not pay any

dividends. In addition, the fair value of STL’s plant and equipment further increased to

HKD20,000,000.

On 31 March 2006, UHL acquired a further 50 per cent of the issued share capital of STL thereby

obtaining control. The cost of investment was thirty million Hong Kong Dollars (HKD30,000,000),

which UHL paid all in cash. At 31 March 2006, STL had a contingent liability of HK$1,000,000

regarding a lawsuit with a supplier. STL expects to settle the case by March 2007.



The following shows the balance sheets of UHL and STL at 31 March 2006 together with the fair

values of STL’s identifiable assets at that date:

UHL STL STL

Carrying Fair

amounts values

HKD’000 HKD’000 HKD’000

Land lease premium 10,000 - -

Property, plant and equipment (net) 21,000 9,800 20,000

Investment in a subsidiary 37,000 - -

Net current assets 9,000 17,400 17,400

77,000 27,200 37,400

Issued equity:

Ordinary shares 65,000 10,000

Retained earnings 12,000 17,200

77,000 27,200

UHL has adopted an accounting policy to depreciate and amortise plant and equipment using the

straight-line method over a 10-year life with no residual value.

UHL has no investment other than STL.

The fair values of STL’s assets at 31 March 2005 and subsequent changes in the fair values have not

been reflected in STL’s financial statements.



You have a draft consolidated financial statements of UHL for the year ended 31 March 2006. After

you have sent them to UHL’s directors for review, one of the directors, who is not a certified public

accountant, sends you an e-mail as follows:

To: David LEE, Accounting Manager, UHL

From: Danielle WONG (Director)

c.c.: Crystal HO, Stephen LEE, Christopher YUNG (Directors)

Date: 18 May 2006

Consolidated financial statements of UHL as at 31 March 2006

Could you please clarify the following points relating to UHL’s draft consolidated balance sheets which

I have just reviewed?

(a) So far as I understand, the company owns a warehouse in the New Territories and an office in

Kowloon. I am not aware that we have purchased or leased any land. Why is there an item “Land

lease premium” in the consolidated balance sheet?

(b) In last year’s financial statements, I see an item “Investment in an associate” of an amount of

HK$7,000,000 in the balance sheet. This item disappeared in the current year’s “consolidated”

balance sheet as at 31 March 2006. Interestingly, I find an item “Share of profit of an associate”

in the “consolidated” income statement for the current year. Is there something wrong with the

financial statements? What does the term “consolidated” mean?

(c) In your notes to the consolidated cash flow statement describing assets and liabilities acquired in

business combination, there is an item “Provision for contingent liabilities” of HK$1,000,000

under current liabilities assumed. I recall that in the financial statements of some listed

companies I have read, contingent liabilities are in fact not liabilities. They are only disclosed in

the notes. Why do we treat them as a liability in our accounts?

(d) What is “Goodwill”?

I would appreciate your clarification in time for the upcoming board meeting.

Best regards,

Danielle



Required:

Question 1 (50 marks – approximately 90 minutes)

(a) Prepare a memorandum in response to the issues raised by Ms. Danielle WONG. In your

memorandum, you should:

(i) discuss the reasons for the item “Land lease premium” in the consolidated balance

sheet;

(5 marks)

(ii) discuss how UHL should account for its interest in STL from 31 March 2005 to 31

March 2006. For this purpose, you should explain (1) the treatments of the 20%

interest in STL in UHL’s balance sheet at 31 March 2005; (2) the effect of the 50%

interest acquired at 31 March 2006 on the status of STL and (3) the meaning of

“consolidated” financial statements;

(10 marks)

(iii) determine the carrying amount of the 20% interest in STL at 31 March 2006 (i.e. before

the acquisition of the 50% interest at 31 March 2006);

(5 marks)

(iv) discuss why the “contingent liability” is recognised as a liability in UHL’s

consolidated balance sheet; and

(5 marks)

(v) why goodwill is recognised in UHL’s consolidated balance sheet and its implications

for financial statements in future. You should also demonstrate the calculation of the

carrying amount of the goodwill as at 31 March 2006.

(10 marks)

(b) Prepare an annex to your memorandum showing the consolidated balance sheet as at 31

March 2006. Ignore deferred taxation. [Alternatively, you may list the consolidation

journals necessary for the purpose of drafting the consolidated balance sheet.]

(15 marks)



HINTS!! The word ‘Land lease premium’ hints HKAS 17

Q1ai (5)

The original answer is outdated!! Old treatment Land is operating lease Land lease premium, being treated like a prepayment, is partly classified as current and partly non-current asset Land lease premium is amortised over the lease term New treatment Judgement is required to determine whether the land is under operating lease / finance lease Land lease premium is classified as non-current asset Land lease premium is subject to depreciation over the shorter of useful life / lease term of the land

Note: It is unlikely to see classification of land lease in future exams because, practically in Hong Kong, now most of the lease can be classified as finance lease

When UHL acquired the warehouse and the office, the consideration was attributable to both the land and the buildings

In HK, land is owned by the government, not by UHL

HKAS 17 requires that when a lease includes both land and building elements, UHL must consider each of these elements separately and classify them as finance or operating lease separately

As a result, the land lease premium represents the part of consideration paid for the land HKAS 17 requires a lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership

In practice, transaction values in the Hong Kong property market have typically demonstrated that the property market does not materially distinguish between Government land leases of varying duration unless there is no expectation of renewal It means that the market believes that the lease term specified in the land lease will be capable of extension for a nominal amount

Therefore, the land interest is substantially the same as freehold interest, then the lessee of such a lease is in effect exposed substantially all the risks and rewards of ownership of the land

Therefore, in this case there is no indication that UHL is leasing the land under operating lease, so it is assumed that UHL’s land is subject to finance lease

As a result, the ‘land lease premium’ is subject to depreciation, according to HKAS 17, over the shorter of the lease term and its useful life

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Since land normally has an indefinite economic life, the depreciation should be over the lease term

Examiner’s Comments – Sep 2006 Case Q1ai The question discussed the reasons for the item “Land lease premium” in the consolidated balance sheet Many candidates could not answer the question at all Some discussed in a general way the accounting treatments for land and buildings without specifically relating to the lease of these two elements separately Some misunderstood that the “premium” was the appreciation of land value

Giving up is not a good idea

The question has not mentioned ‘PPE at revaluation model’ / ‘IP at fair value model’ Not reasonable to think about appreciation of value

A common problem: You don’t know what standards to be discussed

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Sep 2006 Q4b Phoenix

Phoenix Real Estate Limited (“Phoenix”) is a property developer in China. In 2003, Phoenix acquired

the land use rights of two pieces of land in Beijing for hotel development:

Property One - Since the date of the acquisition of the land, the board of Phoenix has decided to run

the hotel on its own and commenced the pre-operating activities of the hotel on 1 January 2005 when

the development is completed and the hotel is available for its intended use. The hotel’s grand

opening took place on 1 July 2005.

Property Two - Since the date of the acquisition of the land, the board of Phoenix decided to lease the

whole property to earn rental. A lease agreement was entered into to lease the whole property to its

holding company (the “Tenant”) for a period of eighteen years for the operation of a hotel. According

to the lease agreement, in addition to the minimum annual rental, Phoenix is entitled to receive a

turnover rent which represents the excess of 5% annual revenue of the hotel operation over the

minimum rental. The monthly revenue amount of the hotel operation is provided by the Tenant at the

close of business of each month-end date.

Other information on these two properties:

Property One Property Two

RMB’000 RMB’000

Cost of land use right 45,000 48,000

Cost of construction (excluding the amortisation of land use right) 303,000 267,000

Fair value of the land use right as at 31 December 2005 60,000 100,000

Fair value of the building at existing status as at 31 December 2005 560,000 340,000

Date of purchase of land use right 1 July 2003 1 October 2003

Term of land use right (from date of purchase by Phoenix) 75 years 60 years

Estimated useful life of the property 50 years 40 years

Completion of construction of the building December 2004 June 2005

Phoenix has adopted the cost model under HKAS 16 for property, plant and equipment and the fair

value model under HKAS 40 for investment property (buildings only). Depreciation is provided to write

off the cost of property, plant and equipment using the straight-line method. The land use right is

considered as a lease and accounted for in accordance with the requirements under HKAS 17.

Amortisation of the cost of the land during the construction period is capitalised as part of the

development cost of the property.

Required:

(a) Calculate the amount of (1) land use right and (2) carrying amount of the building for each

property to be reflected in Phoenix’s balance sheet as at 31 December 2005.

(9 marks)

(b) Explain the accounting treatment for the turnover rent under the lease agreement entered

into with the Tenant for Property Two in Phoenix’s financial statements. (3 marks)



Sep 2006 Q4b (2P + 1 = 3) The 5% turnover rent is a form of contingent rent because its amount is not known at the inception of the lease HKAS 17 requires the lessor (ie Phoenix) to recognise the contingent rent as income in the period when it is earned The turnover rent is an embedded derivative in the host lease contract From Phoenix’s point of view, the hybrid contract is a financial asset because it gives Phoenix the rights to receive cash Per HKFRS 9, Phoenix should account for the hybrid contract in entirety

Examiner’s Comments – Sep 2006 Q4b In part (b), most candidates could identify that the turnover rent was a form of contingent rent governed by HKAS 17 A more comprehensive answer would have been elaborated by explaining that the subject matter was an embedded derivative in the host least contract under HKAS 39

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Feb 2008 Case Q1ai

Most Capital Limited (“MCL”)

Assume that you are Ms. Pindy Lee, the accounting manager of Most Capital Limited (“MCL”). MCL is

a company incorporated and listed in Hong Kong and is principally engaged in the manufacturing of

sanitary ware.

As at 1 April 2007, MCL had two subsidiaries, First Successful Limited (“FSL”) and Second Winning

Limited (“SWL”). A summary of the acquisitions of these subsidiaries by MCL is as follows:

Date of

acquisition

%

acquired

Cost of

investment

Retained earnings

at acquisition date

Net assets at

acquisition date

HK$’000 HK$’000 HK$’000

FSL 31 March 2006 70 20,000 15,000 25,000

SWL 31 March 2006 60 10,000 7,000 15,000

The fair value of the identifiable net assets of these subsidiaries at the respective date of acquisition

was the same as the carrying amount of those assets.

The retained earnings of MCL, FSL and SWL, as at 31 March 2007, were $32 million, $20 million and

$8 million respectively. The companies did not have any reserves other than retained earnings. The

details of the issued share capital of MCL, FSL and SWL as at 31 March 2007 are as follows:

Issued capital Number of shares Par value per share

HK$ million Million HK$

MCL 60 10 6

FSL 10 5 2

SWL 8 8 1

MCL made a rights issue of one share for every two ordinary shares that was fully exercised on 1

January 2008. The exercise price was $9 per share and the fair value of one ordinary share of MCL

immediately before the rights issue was $12. The issued share capital of FSL and SWL has not

changed since their acquisition by MCL.



The following table summarises information from the three companies’ income statements for the year

ended 31 March 2008:

MCL FSL SWL

HK$’000 HK$’000 HK$’000

Turnover

Cost of sales

300,000

(243,000)

140,000

(112,000)

72,500

(58,000)

Gross profit

Distribution costs

Administrative expenses

Depreciation and amortisation

57,000

(15,000)

(10,000)

(3,000)

28,000

(7,500)

(5,000)

(1,500)

14,500

(4,000)

(2,500)

(1,000)

Profit from operations

Finance costs

29,000

(4,000)

14,000

(2,000)

7,000

(1,000)

Profit before tax

Tax

25,000

(7,000)

12,000

(5,000)

6,000

(2,000)

Profit for the year 18,000 7,000 4,000

On 30 September 2007, MCL sold 2.4 million shares in SWL for $8 million. The gain on this disposal

has not been included in the above income statements.

On 31 March 2008, MCL sold all its plant and equipment, with an original purchase cost of $20 million

and a carrying amount of $12 million, to a bank for its fair value of $16 million cash. MCL then leased

the plant and equipment back from the bank under a finance lease over four years. The lease

arrangement called for annual year-end payments of $1.6 million. At the end of the lease term, the

bank is obligated to return the plant and equipment to MCL at an amount that has the overall effect,

taking into account the lease payments, of providing the bank with a yield of the best lending rate

minus 1% per annum. The remaining useful lives of the plant and equipment at 31 March 2008

ranged from 8 to 10 years. No entries relating to the disposal have been recorded by MCL and the

group.

During the year ended 31 March 2008, FSL sold goods to MCL at an invoiced value of $1 million. FSL

usually sold goods at cost plus 25%. Half of the goods were still held in MCL’s inventory at 31 March

2008.

MCL has adopted an accounting policy which depreciates plant and equipment using the straight-line

method over a 10-year life with no residual value. It is also the group’s policy that interests in

subsidiaries and associates are carried at cost in the separate financial statements. SWL’s results for

the six months ended 30 September 2007 were exactly half of its annual results in the year ended 31

March 2008.



You have then added the gain on disposal of investment in SWL into MCL’s financial statements and

prepared draft consolidated financial statements of MCL for the year ended 31 March 2008. After you

sent these draft consolidated financial statements to MCL’s directors for review, one of the directors,

who is not a certified public accountant, sent you an e-mail as follows:

To: Pindy LEE, Accounting Manager, MCL

From: Faria LEE (Director)

c.c.: Beverly CHOW, Emily WILSCON, Charmaine YUEN (Directors)

Date: 18 May 2008

Consolidated financial statements of MCL as at 31 March 2008

Could you please clarify the following points relating to MCL’s draft consolidated financial statements

which I have just reviewed?

(A) So far as I understand, we have already disposed of all our plant and equipment. I am not aware

that we have purchased any new plant and equipment. Why is there still an amount of HK$12

million of plant and equipment in the consolidated balance sheet?

(B) I find two new items, namely an “Investment in an associate” in the consolidated balance sheet

and a “Share of profit of an associate” in the consolidated income statement for the year ended

31 March 2008. Why are these items with the consolidated financial statements?

(A) I note that the amount of gain on disposal of our investment in SWL as shown in our separate

income statement and that in the consolidated income statement are different. Why is there such

a difference?

(D) I note that MCL made a rights issue during the year. Will this have any impact on its EPS of MCL

for the year?

I would appreciate your clarification in time for the upcoming board meeting.

Best regards,

Faria



Required:

Question 1 (50 marks – approximately 90 minutes)

(a) Prepare a memorandum in response to the issues raised by Ms. Faria LEE. In your

memorandum, you should:

(i) discuss the reasons for the amount of HK$12 million of plant and equipment as

shown in the consolidated balance sheet;

(5 marks)

(ii) discuss how MCL should account for its interest in SWL before and after the

disposal of the 2.4 million shares in SWL (no computation is expected in this part);

(10 marks)

(iii) discuss why the amount of the gain on disposal of the investment in SWL as shown

in the separate income statement and in the consolidated income statement is

different; and

(5 marks)

(iv) discuss with appropriate calculation, the impact of the rights issue on the earnings

per share of MCL for the year ended 31 March 2008.

(10 marks)

(b) Prepare an annex to your memorandum showing the consolidated income statement for

the year ended 31 March 2008. (Journal entries are not required.) Ignore deferred taxation.

(20 marks)



Q1a (3P + 2 = 5)

Hints! The question asks ‘reason for $12m’ You should discuss ‘initial recognition of $12m’ Go to the notes and copy why sale and finance leaseback = no sale If you discuss why it is a finance lease Wrong direction because the question has clearly stated ‘finance lease’ If you discuss the accounting treatment of finance lease Your focus becomes ‘subsequent measurement of $12m’ Wrong direction NOT what the question wants

This is a sale and leaseback arrangement, so we have to evaluate the substance of the transaction instead of its form before we determine the appropriate accounting treatment

HKAS 17 defines a finance lease as a lease that transfers substantially all the risk and reward to the lessee

As given in the question, MCL sold all its PPE to the bank which then leased the PPE to MCL at finance lease, so MCL is the lessee and the bank is the lessor

As a result, MCL, after the sales and leaseback, retains substantially all the risk and reward of the PPE

In substance, this is a transaction where the bank (ie lessor) provides finance to MCL (ie lessee) using the PPE as security

Since MCL has retains the risks and rewards of the PPE, the amount of PPE should continue to exist in the consolidated statement of financial position

Examiner’s Comments – Feb 2008 Case Q1ai This question required candidates to discuss the reasons for the amount of plant and equipment as shown in the consolidated balance sheet Many candidates got the idea of sale and leaseback arrangement and substance over form However, many candidates could not earn more marks as they did not analyse the classification by discussing from the risk and reward perspective Instead, they spent most of their effort in discussing the meaning and accounting treatment of finance lease

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Sep 2008 Q3 Thompson

On 1 January 2007, Thompson Manufacturing Inc. (“TMI”), the lessor, entered into a non-cancellable

lease agreement for equipment with Silver Rod Company (“SRC”), the lessee. The following

information pertains to the lease:

Annual lease payment due at the beginning of each year, beginning on 1 January

2007

HK$53,069

Option to purchase at the end of lease term HK$10,000

Lease term 5 years

Economic useful life of leased equipment 8 years

Lessor’s manufacturing cost HK$200,000

Fair value of leased equipment at 1 January 2007 $227,500

Estimated unguaranteed residual value of leased equipment at the end of lease term HK$30,000

Lessor’s implicit rate 12.93%

Lessee’s incremental borrowing rate 10%

Required:

a) Discuss how the purchase option at the end of the lease term offered by TMI to SRC will

affect the classification of this lease by SRC.

(3 marks)

b) Prepare an amortisation schedule that would be suitable for TMI for the lease term.

(5 marks)

c) Prepare all the journal entries that TMI should make for each of the years ended

31 December 2007 and 2008.

(7 marks)



Sep 2008 Q3a (2P + 1 = 3) HKAS 17 defines a finance lease as a lease that transfers substantially all the risks and rewards of incidental to ownership from the lessor to the lessee

One example is the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain at the inception of the lease, that the option will be exercised

In our case, the option to purchase the equipment at the end of the lease term is $10k

The fair value of the equipment on 1 Jan 2007 is $227,500, and the equipment has useful life 8 years and lease term 5 years.

Therefore, it is reasonable to assume that the fair value at the end of the lease term should be much higher than $10k because there are still 3 years to go before the end of the useful life

In conclusion, SRC will probably exercise the option and hence SRC has accepted substantially all the risks and rewards of the equipment. This should be classified as a finance lease

Examiner’s Comments – Sep 2008 Q3a This question tested candidates’ understanding of the concept of leases from both the perspective of the lessee and lessor Part (a) asked candidates to explain how the purchase option at the end of the lease term would affect the classification of the lease by the lessee Candidates were able to identify how the existence of the purchase option might affect the classification of the lease under HKAS17.10 in general, but not too many could put the details of the terms and circumstances given into the discussion

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Sep 2008 Q3b (3.5P + 1.5 = 5)

NOTES! The official answer is wrong

HKAS 17 requires the finance lessor (ie TMI) to recognise a receivable at an amount equal to the net investment in the lease

Net investment is the gross investment in the lease discounted at the interest rate implicit in the lease (ie 12.93%)

Gross investment is the aggregate of 1. The minimum lease payment receivable by the lessor, and 2. Any unguaranteed residual value accruing to the lessor

In this case, gross investment is equal to

$216,596 = $53,069

+ $53,069

+ $53,069

+ $53,069

+ $53,069

+ $10,000

1 (1 + 12.93%)

1

(1 + 12.93%)

2

(1 + 12.93%)

3

(1 + 12.93%)

4

(1 + 12.93%)

5

Beginning Principal O/S Repayment

Finance Income

(12.93%) Ending Principal

O/S

$ $ $ $

31-Dec-07 216,596 (53,069) 21,144 184,671 31-Dec-08 184,671 (53,069) 17,016 148,618 31-Dec-09 148,618 (53,069) 12,354 107,903 31-Dec-10 107,903 (53,069) 7,090 61,924 31-Dec-11 61,924 (53,069) 1,145 10,000

Examiner’s Comments – Sep 2008 Q3b Part (b) required candidates to prepare the amortisation schedule of the lease for the lessor Candidates tried hard to prepare the detailed calculation, but the performance was poor as many candidates ignored the circumstance that the annual instalments were made in advance at the beginning of each year Also, some candidates did not take into account the unguaranteed residual value in the calculation

0.5

0.5

0.5

2P

1.5P

Please read the question carefully



Sep 2008 Q3c (4P + 3 = 7)

NOTES! The official answer is wrong

HINTS! The word ‘Thompson Manufacturing Inc’ / ‘Lessor’s manufacturing cost’ This is a case of manufacturer / dealer lessor

DR Net investment in finance lease $216,596 CR Revenue $216,596 DR COS $200,000 CR Inventory $200,000 (1 Jan 2007) To recognise the sale of equipment in the form of finance lease DR Cash $53,069 CR Net investment in finance lease $53,069 (1 Jan 2007) To recognise the rental receipt DR Net investment in finance lease $21,144

CR Finance income $21,144 (31 Dec 2007) To recognise the finance income

DR Cash $53,069 CR Net investment in finance lease $53,069 (1 Jan 2008) To recognise the rental receipt DR Net investment in finance lease $17,016

CR Finance income $17,016 (31 Dec 2008) To recognise the finance income

Examiner’s Comments – Sep 2008 Q3c Part (c) asked candidates to prepare the journal entries for the lessor Part of the answer was based on the amortisation schedule prepared in part (b) A few candidates scored full marks in both parts (b) and (c) The candidates who failed in part (b) were mostly unable to prepare all the entries correctly Some candidates prepared the journal entries from the perspective of the lessee and scored no marks

1

1P

1P

1P

1P

2

Please read the question carefully



Dec 2011 Q2 PBL (a) Paper Box Limited (PBL) is a manufacturer of paper-based packaging products. Due to

insufficient production capacity to meet the market demand for its products, PBL leased two new printing machines from United Machinery Corporation (UMC) for a fixed term of four years. Monthly rental for the two machines is $200,000 for the first year and then increased by $10,000 annually. The lease is non-cancellable and there are no rights to extend the lease term or purchase the machines at the end of the term. The machines are required to be returned to UMC upon expiry of the lease term. UMC sells similar machines at a price of $12,000,000 per unit and the estimate useful life of the each machine is 10 years.

Required:

Discuss PBL’s accounting treatment of the lease arrangement with UMC.

(5 marks) (b) PBL has three other printing machines which have been used for four years and their

estimated useful life is ten years. The carrying amount and the estimated fair value of the machines are $15,000,000 and $18,000,000 respectively on 1 October 2011. On the same date, PBL entered into an agreement with Easy Finance Limited (EFL) to sell the three machines at $17,000,000 and lease them back for 5 years with an annual future lease payment of $4,500,000. At the end of the lease term, PBL has an option to buy the machines from EFL at $50,000.

Required: “As PBL has sold the machines to EFL, no amount should be reflected in the balance of plant and equipment on the statement of financial position of PBL” according to PBL’s Chief Operating Officer.

(i) Do you agree with the Chief Operating Officer? Explain PBL’s accounting

treatment for the lease arrangement with EFL. (Discount rate of 8% is used, if applicable)

(8 marks)

(ii) Discuss the impact on the accounting treatment of PBL of shortening the lease term to 3 years with an annual future lease payment of $4,000,000 and cancellation of PBL’s options to buy the machines from EFL.

(4 marks)



Dec 2011 Q2a PBL (4P + 1 = 5) At the end of the lease term, the machines are required to be returned to UMC There is no option to purchase the machines The lease term (ie 4 years) is not for the major part of the economic life of the machine (ie 10 years) The present value of the lease retanls = $200k x 12 ÷ (1 + 8%)

1 + $210k x 12 ÷ (1 + 8%)

2 + $220k x 12 ÷ (1 + 8%)

3 + $230k x 12 ÷ (1 + 8%)

4

= $8.5m which is not substantively all of the fair value of the leased asset (ie $24m = $12m x 2) As a result, the risk and rewards incidental to ownership of the machines are not transferred to PBL Per HKAS 17, this is an operating lease Per HKAS 17, the lease payment should be recognised as an expense on a straight-line basis over the lease term Monthly rental expense = ($200k x 12 + $210k x 12 + $220k x 12 + $230k x 12) ÷ 48 = $215k

Examiner’s Comments – Dec 2011 Q2a This part was relatively easy and straightforward Candidates were able to explain the reasons that contributed to the arrangement as an operating lease and the accounting treatment, ie to recognise the lease payments as an expense on a straight-line basis over the lease term. A complete answer included both a correct calculation of the present value of the minimum lease payment amount and comparison with the fair value of the leased asset

Dec 2011 Q2bi PBL (5P + 3 = 8) It is important to assess the substance rather than the form of the transaction The lease term 5 years is a major part of the economic life (ie 6 years) Present value of rental payment = $4.5m ÷ (1 + 8%)

1 + $4.5m ÷ (1 + 8%)

2 + $4.5m ÷ (1 + 8%)

3 + $4.5m ÷ (1 + 8%)

4 + $4.5m ÷ (1 +

8%)5

= $18m which is substantively all of the fair value of the assets (ie $18m) PBL has an option to buy the machines from EFL at $50k at the end of the lease term. Now the fair value of the machines is $18m with useful life of 6 years. It is reasonable to assume their fair values would be higher than $50k with useful life of only 1 year As a result, the option to purchase the asset is at a price that is expected to be sufficiently lower than fair value at the date the option becomes exercisable and the option will be exercised by PBL As a result, PBL has not transferred the risk and rewards incidental to ownership of the machines to EFL The transaction is considered to be a sale and finance leaseback whereby EFL provides finance to PBL

0.5P

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1

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1P

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1

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1P

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0.5 0.5P



The apparent profit $2m ($17m - $15m) should be deferred and amortised over the lease term (5 years) The $17m received are accounted for as finance lease obligation The annual lease payment shall be apportioned between the finance charge and the reduction of the outstanding liability The finance charge shall be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability

Examiner’s Comments – Dec 2011 Q2bi Most candidates could determine that the statement of the Chief Operating Officer was incorrect and the sales and leaseback resulted in a finance lease. Higher marks could be scored for an appropriate interpretation of the implication of the price of the option to buy the machines at the end of the lease term and the correct calculation of minimum lease payment in assessment of the leaseback arrangement

Dec 2011 Q2bii PBL (3P + 1 = 4) There is no option to purchase the machines The lease term (ie 3 years) is not for the major part of the economic life of the machine (ie 6 years) The present value of the lease retanls = $4m ÷ (1 + 8%)

1 + $4m ÷ (1 + 8%)

2 + $4m ÷ (1 + 8%)

3

= $10m which is not substantively all of the fair value of the leased asset (ie $18m) As a result, the risk and rewards incidental to ownership of the machines have been transferred to EFL Per HKAS 17, this is a sale and operating leaseback The annual rental expense is $4m Since the selling price $17m is less than $18m, the profit $2m ($17m - $15m) should be recognised immediately

Examiner’s Comments – Dec 2011 Q2bii Candidates who had managed part bi in a satisfactory manner, were also able to explain the implication of the changes in the features of the leaseback arrangement which resulted in an operating lease. However, the calculation of gain/loss on disposal to be recognised immediately in the profit or loss was a challenge for many candidates

1P

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0.5P

Revenue (LP Ch.14) HKICPA QPA Financial Reporting Jun 2014


Standards under this Chapter 1. HKAS 18 Revenue (LP Ch. 14) 2. HK (IFRIC) Interpretation 12 Service Concession Arrangements 3. HK (IFRIC) Interpretation 13 Customer Loyalty Programmes 4. HK (IFRIC) Interpretation 15 Agreements for the Construction of Real Estate

Examinable Areas 1. Sales of goods 2. Rendering of services 3. Interest, Royalties, Dividends 4. Revenue from construction contracts 5. Service concession arrangement 6. Customer Loyalty Programmes

Scope (LP 14.2.1) HKAS 18 shall be applied in accounting for revenue arising from the following transactions and events: 1. Sale of goods; 2. Rendering of services; and 3. Use by others of entity assets yielding interest, royalties and dividends Out of Scope HKAS 18 does not deal with revenue arising from: 1. Lease agreements (HKAS 17) 2. Dividends arising from investments which are accounted for under the equity method (HKAS 28) 3. Insurance Contracts (HKFRS 4) 4. Changes in the fair value of financial assets and financial liabilities or their disposal (HKFRS 9 &

HKAS 39); and 5. Changes in the value of other current assets Definitions (LP 14.2.2) Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction



Measurement of Revenue (LP 14.2.3) Revenue shall be measured at the fair value of the consideration received or receivable, taking into account the amount of any trade discounts and volume rebates allowed by the entity In most cases, the amount of revenue is the amount of cash received or receivable [HKAS 18.9] However, when the inflow of cash is deferred, the fair value of the consideration may be less than the nominal amount of cash received or receivable [HKAS 18.11] For example, an entity may provide interest-rate credit to the buyer. When the arrangement effectively constitutes a financing transaction, the fair value of the consideration is determined by discounting all future receipts using an imputed rate of interest The difference between the fair value and the nominal amount of the consideration is recognised as interest revenue [HKAS 18.11] Same as the effective interest method used to account for F.A. at amortised cost When goods or services are exchanged for goods or services which are of a similar nature and value, the exchange is not regarded as a transaction which generates revenue When goods are sold or services are rendered in exchange for dissimilar goods or services, the exchange is regarded as a transaction which generates revenue The revenue is measured at the fair value of the goods or services received, adjusted by the amount of any cash or cash equivalents transferred When the fair value of the goods or services received cannot be measured reliably, the revenue is measured at the fair value of the goods or services given up, adjusted by the amount of any cash or cash equivalents transferred

General

When receipt is deferred

Barter Transactions



Determining whether an entity is acting as a principal or as an agent (LP 14.2.8) In an agency relationship, the gross inflows of economic benefits include amounts collected on behalf of the principal and which do not result in increases in equity for the entity. [HKAS 18.8] The amounts collected on behalf of the principal are not revenue. [HKAS 18.8] Instead, revenue is the amount of commission. [HKAS 18.8] An entity is acting as a principal when it has exposure to the significant risks and rewards associated with the sale of goods or the rendering of services. [HKAS 18.IE21] An entity is acting as an agent when it does not have exposure to the significant risks and rewards associated with the sale of goods or the rendering of services. [HKAS 18.IE21] One feature indicating that an entity is acting as an agent is that the amount the entity earns is predetermined, being either a fixed fee per transaction or a stated percentage of the amount billed to the customer [HKAS 18.IE21] Features that indicate that an entity is acting as a principal include: a. The entity has the primary responsibility for providing the goods or services to the

customer or for fulfilling the order, for example by being responsible for the acceptability of the products or services ordered or purchased by the customer;

b. The entity has inventory risk before or after the customer order, during shipping or on return; c. The entity has latitude in establishing prices, either directly or indirectly, for example by

providing additional goods or services; and d. The entity bears the customer’s credit risk for the amount receivable from the customer [HKAS

18.IE21]



Sale of Goods (LP 14.2.5) [HKAS 18.14] Revenue from the sale of goods shall be recognised when ALL the following conditions have been satisfied: 1. The entity has transferred to the buyer the significant risks and rewards of ownership of the

goods In most cases, the transfer of risks and rewards coincides with the transfer of the legal title or passing of possession to the buyer

Examples of Retaining Risks and Rewards When the seller retains an obligation for unsatisfactory performance not covered by normal warranty provisions When the receipt of the revenue from a particular sale is contingent on the derivation of revenue by the buyer from its sale of the goods When the goods are shipped subject to installation and the installation is a significant part of the contract which has not yet been completed by the seller (Sales of escalators with no installations ≠ sales) When the buyer has the right to rescind the purchase for a reason specified in the sales contract and the seller is uncertain about the probability of return

If an entity retains only an insignificant risk of ownership, the transaction is a sale and revenue is recognised

Examples of Retaining Insignificant Risks and Rewards A seller may retain the legal title to the goods solely to protect the collectability of the amount due The retail seller has a common practice to refund if the customer is not satisfied

2. The entity retains neither continuing managerial involvement to the degree usually associated

with ownership nor effective control over the goods sold

Examples of Retaining Insignificant Managerial Involvement A software house may sell and install a software system for a customer and then continue to oversee and manage the use of the system This managerial control over the system does not prohibit the software house from revenue recognition because the risks and rewards of the software have been transferred to the customer

3. The amount of revenue can be measured reliably

Examinable!!



4. It is probable ethat the economic benefits associated with the transaction will flow to the entity;

and In some cases, this may not be probable until the consideration is received or until an uncertainty is removed

Example of No Economic Benefits It may be uncertain that a foreign governmental authority will grant permission to remit the consideration from a sale in a foreign country When the permission is granted, the uncertainty is removed and revenue is recognised However, when an uncertainty arises about the collectability of an amount already included in revenue, the uncollectible amount or the amount in respect of which recovery has ceased to be probable is recognised as expense, rather than as an adjustment of the amount of revenue originally recognised DR Expense CR Receivable but not DR Revenue CR Receivable

5. The costs incurred or to be incurred in respect of the transaction can be measured reliably

Revenue and expenses that relate to the same transaction or other event are recognised simultaneously Revenue cannot be recognised when the expenses cannot be measured reliably Any consideration already received for the sales of the goods is recognised as a liability DR Cash / CR Liability

All the examples below are extracted from HKAS 18



Rendering of Services (LP 14.2.6) [HKAS 18.20] When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be reocgnised by reference to the stage of completion of the transaction at the end of the reporting period The outcome of a transaction can be estimated reliably when ALL the following conditions are satisfied: 1. The stage of completion of the transaction at the end of the reporting period can be measured

reliably Depending on the nature of the transaction, the methods may include

a. Surveys of work performed b. Services performed to date as a percentage of total services to be performed; or c. The proportion that costs incurred to date bear to the estimated total cost of the

transaction Progress payments and advances received from customers often do not reflect the services performed When the outcome cannot be estimated reliably, revenue shall be recognised only to the extent of the expenses recognised that are recoverable

2. The amount of revenue can be measured reliably

3. It is probable that economic benefits associated with the transaction will flow to the entity

4. The costs incurred for the transaction and the costs to complete the transaction can be measured reliably The above 3 conditions (Point 2, 3, 4) are the same as those in sales of goods

All the examples below are extracted from HKAS 18

Examinable!!



Interest, Royalties and Dividends (LP 14.2.7) Revenue arising from the use by others of the entity assets yielding interest, royalties and dividends shall be recognised when 1. It is probable that economic benefits associated with the transaction will flow to the entity; and 2. The amount of the revenue can be measured reliably [HKAS 18.29] Revenue shall be recognised on the following bases 1. Interest shall be recognised using the effective interest method 2. Royalties shall be recognised on an accrual basis in accordance with the substance of the

relevant agreement; and 3. Dividends shall be recognised when the shareholder’s right to receive payment is established

[HKAS 18.30]

Examinable!!



HK (IFRIC) Interpretation 13 Customer Loyalty Programmes (LP 14.3.2) Customer loyalty programmes are used by companies to provide customers with incentives to buy their goods or services If a customer buys goods or services, the seller grants the customer award credits (often described as ‘points’) The customer can redeem the award credits for awards such as free or discounted goods or services Award credits should be treated as a separately identifiable component of the sales transactions in which they are granted The fair value of the consideration received or receivable in respect of the sale shall be allocated between the award credits and the other components of the sale If the entity supplies the awards itself, it shall recognise the consideration allocated to award credits as revenue when award credits are redeemed and it fulfils its obligations to supply awards The amount of revenue recognised shall be based on the number of award credits that have been redeemed, relative to the total number expected to be redeemed [HK (IFRIC) Int 13.7] If a third party supplies the awards, the entity shall assess whether it is collecting the consideration allocated to the award credits on its own account (ie as the principal in the transaction) or on behalf of the third party (ie as an agent for the third party) If the entity is collecting the consideration on behalf of the third party, it shall: (i) measure its revenue as the net amount retained on its own account, ie the difference between the consideration allocated to the award credits and the amount payable to the third party for supplying the awards; and (ii) recognise this net amount as revenue when the third party becomes obliged to supply the awards and entitled to receive consideration for doing so. These events may occur as soon as the award credits are granted. Alternatively, if the customer can choose to claim awards from either the entity or a third party, these events may occur only when the customer chooses to claim awards from the third party. If the entity is collecting the consideration on its own account, it shall measure its revenue as the gross consideration allocated to the award credits and recognise the revenue when it fulfils its obligations in respect of the awards. [HK (IFRIC) Int 13.8] Please look at the 2 examples below for more details

Self-operated Award

Outsourced Award



Example 1 – Awards Supplied by the Entity (Source: HK IFRIC Int 13.IE1)

A grocery retailer grants programme members loyalty points. The points have no expiry date. At the end of 2005, the entity grants 100 points Management expects 80 of these points to be redeemed Management estimates the fair value of each loyalty point to be $1.25 In 2006, 40 of the points have been redeemed In 2007, 41 points were redeemed, and management revised its expectation that now 90 points to be redeemed altogether In 2008, a further 9 points were redeemed Analysis DR Cash $xx CR Deferred revenue $100 (100 x 80% x $1.25) CR Revenue $xx (2005) DR Deferred revenue $50 CR Revenue $50 ($100 x 40 points ÷ 80 points) (2006) (As at the end of 2007, 40 points have been redeemed out of 80 points) DR Deferred revenue $40 CR Revenue $40 ($100 x 81 points ÷ 90 points – $50) (2007) (As at the end of 2007, 81 points have been redeemed out of 90 points) DR Deferred revenue $10 CR Revenue $10 ($100 x 90 points ÷ 90 points – $50 – $40) (2008) (As at the end of 2008, 90 points have been redeemed out of 90 points)



Example 2 – Awards Supplied by a Third Party (Source: HK IFRIC Int 13.IE6)

A retailer of electrical goods participates in a customer loyalty programme operated by an airline It grants programme members one air travel point with each $1 they spend on electrical goods Programme members and redeem the points for air travel with the airline The retailer pays the airline $0.009 for each point In 2005, the retailer sells electrical goods for consideration totaling $1m, and grants 1m points. The retailer estimates the fair value of a point is $0.01 Analysis DR Cash $1m CR Revenue from goods $990k CR Revenue from points $10k ($1m x $0.01 = $10k) (In 2005) (Having granted the points, the retailer has fulfilled its obligations to the customer. The airline is obliged to supply the awards. Therefore, the retailer recognises revenue from the points when it sells the electrical goods) DR Expense $9k CR Cash $9k (1m points x $0.009) (In 2005) If the retailer has collected the consideration on its own account (ie the retailer buys the points directly from the airline and gives its customer), it separately recognises the $9k paid to the airline as expense DR Revenue $9k CR Cash $9k (1m points x $0.009) (In 2005) If the retailer has collected the consideration on behalf of the airline (ie as an agent for the airline) (ie the retailer collects the point from the airline and gives its customer), it measures its revenue as the net amount it retains on its own account



HK (IFRIC) Interpretation 15 Agreements for the Construction of Real Estate (LP 14.3.3.3)

HKAS 11 / 18?

HKAS 11

HKAS 18 - Services

HKAS 18 - Goods



It depends on the terms of the agreement and all the surround facts Such a determination requires judgement When the buyer is able to specify the major structural elements of the design of the real estate before construction begins and/or specify major structural changes once construction is in progress (whether or not it exercises that ability) HKAS 11 If an agreement for the construction of real estate in which buyers have only limited ability to influence the design of the real estate (eg to select a design from a range of options specified by the seller, or to specify only minor variations to the basic design) HKAS 18 If the agreement is in the scope of HKAS 11, and its outcome can be estimated reliably, the entity shall recognise revenue by reference to the stage of completion of the contract activity

If the agreement is in the scope of HKAS 18, the entity shall determine whether the agreement is for rendering of services / for sales of goods If the entity is not required to acquire and supply construction materials Rendering of services in HKAS 18 Recognise revenue by reference to the stage of completion (ie similar to the contract of HKAS 11) If the entity is required to acquire and supply construction materials in order to perform its contractual obligation to deliver the real estate to the buyer Sale of goods in HKAS 18 When sales of goods, if the 5 conditions are satisfied as construction progresses Recognse revenue based on the stage of completion When sales of goods, if the 5 conditions are satisfied at a single time Recognise revenue when the 5 conditions are satisfied

HKAS 11

HKAS 18

HKAS 11 / 18?



HK (IFRIC) Interpretation 12 Service Concession Arrangements (LP 14.3.1) An arrangement within the scope of this Interpretation typically involves a private sector entity (an operator) constructing the infrastructure used to provide the public service or upgrading it (for example, by increasing its capacity) and operating and maintaining that infrastructure for a specified period of time The operator is paid for its services over the period of the arrangement. Such an arrangement is often described as a ‘build-operate-transfer’ service concession arrangement This Interpretation is only for accounting by the operators The operator does not recognise the infrastructure as its own PPE The consideration received or receivable by the operator shall be recognised at its fair value The consideration may be rights to: 1. A financial assets, or

a. If the operator has an unconditional contractual right to receive cash or another financial asset from the grantor

2. An intangible asset a. If the operator receives a right (a license) to charge users of the public service

If the operator is paid for the construction services partly by a financial asset and partly by an intangible asset it is necessary to account separately for each component of the operator’s consideration The operator shall account for revenue and costs relating to operation services per HKAS 18

Scope

Accounting Treatment – Consideration

Accounting Treatment – Operation Services



Example –Service Concession Arrangements (Source: HKICPA Learning Pack Dec 2010 P.263)



Practice Question (Source: HKICPA Learning Pack Feb 2010 P.7-26)



May 2005 Q3bc BCL

Bloom Company Limited (“BCL”) is engaged in the business of property development and holding.

During the year ending 31 December 2005, the company has completed the following transactions:

(a) Lease of five floors of an investment property for five years from 1 July 2005 at a monthly

rental of HK$1.8 million. A six-month rent-free period was given to the lessee for the period 1

July to 31 December 2005.

(b) Sale of a house with a consideration of HK$12 million. 10% of the consideration was paid at

the agreement date, and the remaining 90% of the consideration was settled with nine semi-

annual installment payments of HK$1.2 million each.

(c) Pre-sale of 50 units out of the 180 units of a self-developed residential property which was still

under construction (75% completion). Total consideration for the 50 units is HK$322 million

and BCL had received HK$38.5 million as down payments.

Required:

Determine and explain how BCL should recognise and measure these transactions in the

financial statements for the year ending 31 December 2005 in accordance with relevant Hong

Kong Financial Reporting Standards.

(13 marks)



May 2005 Q3b (3P + 2 = 5) Per HKAS 18, revenue from the sale of goods (ie the house) shall be recognised when all the following conditions have been satisfied: 1. BCL has transferred to the buyer the significant risks and rewards of ownership of the

house 2. BCL retains neither continuing managerial involvement to the degree usually associated

with ownership nor effective control over the goods sold 3. The amount of revenue can be measured reliably 4. It is probable that the economic benefits associated with the transaction with flow to BCL 5. The costs incurred or to be incurred in respect of the transaction can be measured

reliably Assume all these conditions are satisfied, the revenue from the sale of the house can be recognised Per HKAS 18, revenue shall be measured at the fair value of the consideration received or receivable In this case, BCL will receive 90% of the consideration by installments, so the fair value is less than the nominal value Per HKAS 18, the fair value of the consideration is determined by discounting all future receipts using an imputed rate of interest The imputed rate of interest is the more clearly determinable of either 1. The prevailing rate for a similar instrument of an issuer with a similar credit rating; or 2. A rate of interest that discounts the nominal amount of the instrument to the current cash

sales price of the goods In this case, the revenue = $1.2m + discounted present value of the future $10.8m Per HKAS 18, the difference between the fair value and the nominal amount of the consideration is recognised as interest revenue

Examiner’s Comments – May 2005 Q3b Basic revenue recognition criteria under HKAS 18 were cited in the answer for transaction (b), but some candidates had problems in analysing the deferred consideration situation

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May 2005 Q3c (1P + 2 = 3) The pre-completion sale of the 50 self-developed residential properties does not meet the definition of construction contracts per HKAS 11 because these 50 properties are not likely to have been negotiated specifically for the construction of the properties Per HKAS 18, revenue shall only be recognised when all of the revenue conditions are met The $38.5m received should only be recognised as revenue after the conditions are met, but should be recognised as a liability before the conditions are met

Examiner’s Comments – May 2005 Q3c The performance when considering transaction (c) showed that candidates were not familiar with the new interpretation Many of them still thought that the percentage of completion method was applicable to the situation

1

1P

1



May 2007 Q5a PMT

Peak Medical Technology Corporation (“PMT”) conducts research and product development for an

anesthetic injection under contract with WY Corporation (“WY”), a pharmaceutical company. The

research and development contract requires that WY pays PMT an up-front amount of HK$1.5 million

when the contract is signed, HK$2 million upon the successful completion of clinical trials, and HK$1.5

million upon the delivery of the first pilot unit of the injection. All payments are non-refundable. The

total cost of completion of the project is estimated to be HK$3 million.

PMT has invested HK$25 million in equipment for its research and development centre, which has an

anticipated useful life of eight years. Depreciation is charged on a straight-line basis. In the period of

acquisition, PMT received a government grant of HK$10 million towards purchase of the equipment,

which is conditional on certain employment targets being achieved within the next four years.

Required:

Determine how PMT should recognize and measure by reference to the relevant accounting

standards:

(a) the research and development contract; and

(7 marks)

(b) the government grant.

(5 marks)



May 2007 Q5a PMT (5P + 2 = 7) This is a sale from rendering of services because PMT provides research and development services to WY Per HKAS 18, when the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the end of the reporting period Per HKAS 18, when the outcome of the transaction involving the rendering of services cannot be estimated reliably, revenue shall be recognised only to the extent of the expenses recognised that are recoverable In this case, the total cost is estimated to be $3m, so it is assumed that the outcome can be estimated reliably Per HKAS 18, the stage of completion of a transaction may be determined by 1. Surveys of work performed 2. Services performed to date as a percentage of total services to be performed; or 3. The proportion that costs incurred to date bear to the estimated total costs of the

transaction In this case, the $1.5m up-front payment and the $2m receipt should be recognised as revenue over the performance of the R&D project The $1.5m receipt upon delivery shall be recognised only after delivery is successfully made

Examiner’s Comments – May 2007 Q5a This question tested candidates’ knowledge and application of HKAS 18 in connection with recognition of service income by reference to the stage of completion Many candidates did not attempt this part of the question at all Candidates stated the accounting treatment for research and development under HKAS 38 and scored no marks Many candidates discussed this question by referring to the general revenue recognition requirements and failed to explain how specifically the stage of completion method should be applied thus scoring low marks

1P

1P

1

1P

1P

1P

1



Feb 2010 Case Q1e

Customer loyalty programme

SNT is a regional chain of convenience stores. It operates a customer loyalty programme and it grants

programme members loyalty points when they spend a specified amount on foodstuffs. Programme

members can redeem the points for further foodstuffs. The points have no expiry date. Before 1 April

2008, the entity granted 200,000 points. Management expected 180,000 of these points to be

redeemed. Management estimated the fair value of each loyalty point to be HK$1.

During the year ended 31 March 2009, 81,000 of the points were redeemed in exchange for foodstuffs. In the year ended 31 March 2010, management revised its expectations. It expected 190,000 points to be redeemed altogether. During the year, 90,000 points were redeemed.

(e) discuss and calculate the amount of revenue in relation to 200,000 loyalty points, granted

before 1 April 2008, to be recognised for the year ended 31 March 2009 and 31 March 2010.

(11 marks)



Feb 2010 Case Q1e (6P + 5 = 11)

NOTES! The original answer is outdated followed by an update in April 2012 in HK (IFRIC) – INT 13.IE1

HINTS! What can you do if you haven’t studied customer loyalty before the exam? Go to your notes / LP, use 5 mins to look at the basic examples Try to do the calculations and copy some standards Should be able to get at least 3 to 4 marks

Per HK (IFRIC) – Int 13, SNT should apply HKAS 18 and accounts for points of the loyalty programme as a separately identifiable component of the sales transactions in which they are granted (the ‘initial sales’) The fair value of the consideration received or receivable in respect of the initial sales shall be allocated between the award credits (the loyalty points) and the other component of the sale Since SNT supplies the awards itself, it shall recognise the consideration allocated to loyalty points as revenue only when loyalty points are redeemed and it fulfils its obligations to supply awards In other words, a portion of the consideration shall be allocated to loyalty points and recognition of revenue thereof shall be deferred In this case, since SNT’s management has estimated that the fair value of each loyalty point is $1, SNT shall recognise $200,000 ($1 x 180,000) as revenue only when the loyalty points are redeemed and thus the recognition of revenue of this portion of consideration amounting to $180,000 has been deferred to a period after 1 Apr 2008 Year ended 31 Mar 2009 81,000 points have been redeemed 180,000 points are expected to be redeemed Revenue = (81,000 ÷ 180,000) x $180,000 = $81,000

2P

1

1

1

1

1



Year ended 31 Mar 2010 90,000 points have been redeemed 190,000 points are expected to be redeemed Revenue = [(81,000 + 90,000) ÷ 190,000] x $180,000 – $81,000 = $81,000

Examiner’s Comments – Feb 2010 Case Q1e This question required candidates to discuss and calculate the amount of revenue in relation to loyalty points This was a straightforward question However, variation in performance was extreme Many candidates did not perform well in this question because they failed to calculate the correct amount of the revenue to be recognised in each year Some candidates did not know that the consideration allocated to loyalty points should be recognised only when loyalty points are redeemed Those who understood the principle scored high marks in this question

4P



Jun 2012 Q3 NFL

Nero Fashion Limited (NFL) is a clothing manufacturer in mainland China and distributes its products

through the following channels:

Counter sales at department stores – walk-in customers purchase and collect the goods upon

the issue of an invoice by and make cash or credit card payments to the department stores. In

accordance with the consignment contract signed between the department store and NFL, the

selling price is determined and inventory is managed by NFL, the sales teams are employed by

NFL while the cashier service is provided by the department stores. The department stores pay

80% of the retail price of the goods sold to NFL on a monthly basis. The department stores

accept their customers to return or exchange the goods sold within 7 days from the invoice date

and they would return all these items to NFL and deduct the invoice amounts to be remitted to

NFL.

Distributors – NFL ships the goods to the designated location in accordance with the instructions

of the distributors, including the items and quantity requested. Distributors can open their own

retail store to sell the goods, but NFL will determine the retail prices for the goods, which are

normally the same as the prices offered in counter sales at department stores. Goods are not

returnable except for items with quality problems which can be returned within 7 days of delivery.

The distributors have to sign and return an acceptable confirmation at the completion of quality

inspection or 7 days of delivery, whichever is earlier. NFL will issue an invoice to the distributors

at 50% of the pre-determined retailing price of items delivered on a monthly basis.

Based on the past three years historical data, less than 0.1% of sales were returned from customers

of department stores within the 7-day period and around 5% of sales were returned from distributors

before signing the confirmation under the above return policies.

Required:

(a) Discuss how NFL should account for the sales revenue through these channels, with

reference to HKAS 18 “Revenue”.

(i) Counter sales at department stores (7 marks)

(ii) Distributors (6 marks)

(b) Discuss how NFL should account for monthly revenue if it will give a 10% discount of the

invoiced amount to the distributors when the respective annual quantity delivered is

above 100,000 pieces.

(3 marks)



Jun 2012 Q3ai NFL (4P + 3 = 7)

1P

1P

0.5P

0.5P

1P

1

0.5

0.5

0.5

0.5



Examiner’s Comments – Jun 2012 Q3ai NFL This part of the question expected the candidates to analyse the counter sales contractual arrangements between the manufacturer and the department store. Candidates who could explain the exposure to and transfer of the significant risks and rewards associated with the sales obtained average scores. Better answers included the assessment of the role of the two parties, i.e. the principal against the agent. On the other hand, there were candidates who performed poorly because they mistakenly considered the department store to be the customer of the manufacturer.

Jun 2012 Q3aii NFL (3P + 3 = 6)

Examiner’s Comments – Jun 2012 Q3aii NFL The scenario regarding sales to distributors was straightforward. Candidates awarded an average mark could point out that the distributors were customers of the manufacturer. The terms of sales return presented a challenge to candidates who needed to determine the timing of the recognition of sales.

1

1P

1

1

1P

1P



Jun 2012 Q3b NFL (0P + 3 = 3)

Examiner’s Comments – Jun 2012 Q3b NFL HKAS 18 provides guidance on the accounting treatment of a volume rebate, but there were candidates who treated the discount as a separate component, but not deducted from sales revenue. Some answers stated that it was a customer loyalty programme which was also incorrect.

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