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THE HONG KONG INSTITUTE OF CHARTERED SECRETARIESTHE INSTITUTE OF CHARTERED SECRETARIES AND

ADMINISTRATORS

International Qualifying Scheme Examination

HONG KONG FINANCIAL ACCOUNTINGDECEMBER 2015

Suggested Answer

The suggested answers are published for the purpose of assisting students in theirunderstanding of the possible principles, analysis or arguments that may be identifiedin each question

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SECTION A

1.

You are a recently qualified chartered secretary. One of your close friends, KellyWong, has asked you for advice as she is planning to start up a business providingtutoring services to secondary school students in Hong Kong who are going to takethe Hong Kong Diploma of Secondary Education or International Baccalaureateexam.

In order to prepare her business plan, Kelly wants to analyse the profitability andfinancial position of two private company tutoring businesses: Success Educationand Tutoring School (SET) and The Elite (Elite). Kelly has asked you to write areport analysing the two companies’ most recent financial information as providedby a local financial data mining company. Kelly is short of money and because ofyour friendship you have agreed to undertake the work for no fee.

SET was established in 2006 by a group of five ex-secondary school teachersseeking to ensure the provision of a high-quality tutoring service. The five teacherswho started the business are the company’s directors, and all continue to be activein the management of SET. The company’s premises, on six sites in Hong Kong,were custom-designed to create a better learning environment (such as byincluding free Wi-Fi and multimedia facilities) and built in 2006, financed by bothcommercial loans and loans from the directors. Since 2012, the company’s revenuehas been gradually declining.

Elite was established in 2009 by two businesses entrepreneurs who own severalother profitable businesses which are not involved in tutoring. All shares in thebusiness are currently owned by the two entrepreneurs, who are the sole directors.Elite is run from four sites in Hong Kong, each occupying premises rented underoperating leases. The directors draw an annual salary of $360,000 each. Elite hasnot paid any dividends since incorporation.

The two companies’ statements of profit or loss for the year ended 31 October2015 and statements of financial position at that date are as follows:

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Statements of profit or loss for the year ended 31 October 2015

SET Elite$’000 $’000

Sales 82,200 53,640Cost of sales (51,852) (44,592)

Gross profit 30,348 9,048Distributing and selling costs (588) (1,044)Administrative expenses (24,048) (3,840)

Operating profit 5,712 4,164Finance costs (4,500) (504)

Profit before tax 1,212 3,660Tax (372) (912)

Profit after tax 840 2,748

Statement of financial position as at 31 October 2015SET Elite$’000 $’000

ASSETSNon-current assetsProperty, plant and equipment 99,696 28,572

Current assetsInventories 12 24Trade receivables 660 444Cash and cash equivalents 9,792 24

Total assets 110,160 29,064

EQUITY AND LIABILITIESEquity and reservesOrdinary shares 480 2,400Retained earnings 27,672 15,504

28,152 17,904Non-current liabilitiesLong-term loans 80,460 5,400

Current liabilitiesTrade payables and other payables 1,176 2,004Bank overdraft - 2,844Tax payable 372 912

Total equity and liabilities 110,160 29,064

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Additional information relating to the year ended 31 October 2015

SET Elite

Operating lease rentals $572,100 $8,952,000

Average number of staff employed 288 180

Total directors’ remuneration $6,960,000 $720,000

Kelly is not certain about the impact of the two types of classification of lease in thefinancial statements.

REQUIRED:

Prepare a report for Kelly Wong covering the following issues:

1. (a) Discuss the types of classification and accounting treatment of leasesavailable from the point of view of a tenant with respect to HKAS 17 ‘Leases’.

(8 marks)

Ans (a) Report

To: Kelly WongFrom: Christy LamSubject: Analysis of the financial statements of SET and Elite for the year

ended 31 October 2015Date: XX December 2015

In response to your request for an analysis of the financial statements of SETand Elite, I have prepared the following information for your attention.

Issues to be considered in the classification and accounting treatment of alease

Per HKAS 17 ‘Leases’, a lease is an agreement whereby the lessor conveys tothe lessee the right to use an asset, for an agreed period of time, in return for apayment or series of payments. Other names for specific types of leasing arehire purchase, renting or letting.

There are two types of lease classification: finance and operating.

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A finance lease is defined as a lease that transfers substantially all the risks andrewards incidental to ownership of an asset to the lessee. Title may or may noteventually be transferred.

An operating lease is defined as a lease other than a finance lease.

Indicators of situations that individually or in combination would normally lead toa lease being classified as a finance lease are:(a) the lease transfers ownership of the asset to the lessee by the end of the

lease term;(b) 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 becomesexercisable for it to be reasonably certain, at the inception of the lease, thatthe option will be exercised;

(c) the lease term is for the major part of the economic life of the asset even iftitle is not transferred;

(d) at the inception of the lease the present value of the minimum leasepayments amounts to at least substantially all of the fair value of the leasedasset; and

(e) the leased assets are of such a specialised nature that only the lessee canuse them without major modifications.

Indicators of situations that individually or in combination could also lead to alease being classified as a finance lease are:(a) if the lessee can cancel the lease, the lessor’s losses associated with the

cancellation are borne by the lessee;(b) gains or losses from the fluctuation in the fair value of the residual accrue to

the lessee (for example, in the form of a rent rebate equalling most of thesales proceeds at the end of the lease); and

(c) the lessee has the ability to continue the lease for a secondary period at arent that is substantially lower than market rent.

The above indicators are not always conclusive. If it is clear from other featuresof the lease that the lease does not transfer substantially all risks and rewardsincidental to ownership, the lease is classified as an operating lease.

Accounting for a finance lease

HKAS 17 requires both lessee and lessor to classify each lease agreement as

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either an operating lease or a finance lease at the inception of the lease, whichis the earlier of:

the date of the lease agreement and the date of commitment by the parties to the principal provisions of the

lease.

An amount equal to the fair value of the leased asset or, if lower, the presentvalue of the minimum lease payments (each determined at the inception of thelease) is:– recognised as a non-current asset– recognised as a liability

The lessee should recognise a depreciation charge and a finance charge foreach accounting period after the inception and before end of lease term.

Accounting for an operating lease

– No capitalisation of the leased asset is allowed– The lessee should recognise lease payments on a straight-line basis over

the lease term.

1. (b) Present an analysis of the financial performance and financial position ofSET and Elite for the year ended 31 October 2015, suggesting possiblereasons for the key differences between the two companies’ financialstatements. Your analysis should at least cover the following items:

- Performance

- Capital structure

- Profitability

- Financial position

- Working capital

- Retained earnings

- Conclusion

(24 marks)

Ans (b) Analysis of financial performance and position of SET and Elite

Introduction

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SET and Elite are both profitable and successful businesses. Elite is apparentlymore profitable than SET, and there are other important differences between thetwo businesses that are apparent from their financial statements. Moreinformation is required to confirm the reasons; this is tentatively describedbelow.

Performance

Elite is around 2/3 (53,640/82,200) the size of SET, in terms of revenue.

However, judging by the bottom line in the financial statements, Elite hassignificantly outperformed SET. Its profit after tax, before tax and operating profitare all higher than SET’s. SET has performed much better in gross profit terms;however, when comparing two businesses, the gross profit comparison can beaffected by the classification of expenses. In this case, it is quite possible thatElite classifies some categories of expense as cost of sales while these mightbe classified as administrative expenses by SET. Therefore, this point ofcomparison is unreliable.

SET’s performance is significantly affected by its directors’ remuneration. Thefive directors share a total of $6,960,000, a very large amount when comparedto the total of $720,000 paid to Elite’s two directors.

From the information given it appears that Elite’s directors have several othersuccessful businesses, and it is likely that they are also paid by the otherbusinesses. $720,000 may not be a realistic charge in that it may not reflect thedirectors’ managerial expertise and the time they spend on the business.

However, nothing is known about the directors’ plans for Elite in the future; forexample, they may plan to expand, and prefer to finance expansion throughretained earnings. Or, they may plan to expand, and prefer to show a record ofhealthy earnings relatively unaffected by managerial remuneration.

It may not be valid to compare SET’s $6,960,000 with Elite’s $720,000 directors’remuneration for other reasons. SET’s directors may be very active in theday-to-day management of the business, thus reducing the need to employhigh-calibre professional managers.Elite, on the other hand, may employ highly paid managers, whose salaries and

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benefits are reflected in cost of sales or administrative expenses.

Capital structure

The two businesses have very different capital structures, which significantlyaffect their performance. SET’s premises were custom-designed and built fromits start in 2005. The custom design may have made the business particularlyattractive to potential customers. However, this approach clearly required asubstantial capital investment, as evidenced by the statement of financialposition.

The investment was funded by loans and, in consequence, finance costs arevery high indeed, and interest cover is very low at 1.3. If the financing cost is atvariable interest rates and interest rates increase, the need to meet financecosts could potentially leave SET in some difficulty.

Elite has very little ready cash, but its loans are relatively low compared toSET’s. This fact results in interest cover at a comfortable level of 8.3.

Profitability

The return ratios suggest that Elite is out-performing SET. However, the profitfigures used in the numerator of the fractions are affected by management’sremuneration policy in both cases and the difference between the twocompanies would not be so startling if management remuneration were to bestripped out.

Return on shareholders’ funds of only 3% for SET might appear very low, butbecause the directors and the shareholders are the same people, the individualsconcerned have already taken the bulk of their ‘return’ from the business in theform of remuneration.

Revenue per staff member is slightly better for Elite than for SET. Although itmight be expected that the larger business would outperform the smaller one(because of economies of scale) there is insufficient information available to beable to make any definitive comments on these ratios.

SET’s revenue has fallen by a small amount each year since 2012, and this maybe indicative of lack of effort as the business moves into a more mature phase of

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its existence. However, there are many other possible explanations and moreinformation is required about, for example, the location of the sites, competitionlocally and fees and staffing policies.

If Elite is relatively understaffed, the revenue per employee ratio would tend toimprove, but understaffing could result in other problems for the business.

Financial Position

The statements of financial position for the two businesses are significantlyaffected by their differing capital structures. The gearing ratio of SET is very highat 251%.

As already noted, the related finance costs put the business at some risk.However, the position may not be quite as risky as it appears. According to theinformation provided, the investment in premises was financed partly throughbank borrowing and partly through loans from the directors.

If the latter constituted a substantial element of the total loans the structure ispotentially more flexible in that the directors could agree a change in lendingconditions (for example, to reduce or eliminate the interest paid to them for aperiod of time or to repay the bank in preference to themselves). Moreinformation is required about the loans.

No information is provided about the measurement of non-current assets. If theyare held at depreciated cost, it is possible that the fair value of SET’snon-current property assets is considerably in excess of the carrying amount.This could provide collateral for further loans if required. If non-current assetswere valued at fair value, this could significantly reduce the gearing ratio.

In order to assess the potential effect, more information is required about currentvalues, and also about the split between property and other assets.

Elite’s non-current assets are not, presumably, property assets because thepremises that they occupy are all rented under operating leases. However, over$7,143,000 (28,572,000/4) per site for equipment is, on the face of it, asubstantial figure, and further information is required about this.

Elite’s policy of occupying premises under operating leases contributes to its

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relatively low gearing level. This allows the company flexibility in its operationsand reduces its risk. However, more information is needed about the nature ofthe leases and the conditions attached to them in order to confirm this flexibility.Operating leases of property are often quite lengthy and they may have quitestringent conditions attached to them.

Working capital

Working capital is not highly significant in either company; the highest singleitems by far are the cash in SET and the overdraft in Elite.

A tutoring business is unlikely to offer credit terms to its customers – payment inadvance would be more the norm, and receivables are therefore very low inrelation to revenue in both companies.

Trade payables are also relatively low amounts, presumably relating to utilities,salaries and possibly rent in the case of Elite. Elite’s payables are significantlyhigher than SET’s, but this may be due to, for example, rental payments due butnot paid.

Also, Elite is short of cash. It is possible that the overdraft facility is much higherthan the $2,844,000 listed in Elite’s statement of financial position, but it wouldbe useful to know how much headroom is available.Inventories are very low in both companies, as might be expected; theypresumably comprise consumables for the tutors’ teaching activities.

Retained earnings

The level of retained earnings in Elite tends to confirm that the company hasnever paid a dividend. Profits of around $2,584,000 per annum since 2009would account for the retained earnings figure.

The position in SET can be less easily explained. The level of retained earningsat $27,672,000 appears high in relation to profit for the year. It appears thatearlier years may have produced much higher profits than the 2015 financialyear. There is no information available about SET’s dividend policy, and it wouldbe helpful to know if the company has been in the habit of paying dividends inthe past. A full analysis of these two companies would, in any case, requirefinancial information from prior years.

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Conclusion

Both companies are profitable. Elite’s modest approach to directors’remuneration probably helps to ensure that it appears to be the more profitableof the two. It seems likely that SET has been more profitable in the past than it isat present, although this cannot be confirmed without further detailed financialinformation about prior years.

Although both companies are evidently run with a view to profit, the motivationsand objectives of the directors may be widely different. SET was established byteachers who were motivated to ensure that high-quality tutoring was availablein Hong Kong. They have presumably achieved this objective, but in doing sohave also created a profitable business. Elite’s directors are entrepreneurs andso are probably motivated principally by profit. The differing objectives may helpto explain the different capital structures and results.

Finally, a significant factor to be taken into account in the analysis is that Elite’sfinancial statements are in draft only. There could be significant changesbetween the figures analysed above and those that will be published.

1. (c) Calculate FIVE additional relevant ratios and identify additional information forfurther investigation.

(8 marks)

(Total: 40 marks)

Ans (c) Additional ratios

SET Elite

Gross profit margin (30,348 as % of 82,200) and(9,048 as % of 53,640)

36.9% 16.9%

Operating profit margin (5,712 as % of 82,200) and(4,164 as % of 53,640)

6.9% 7.8%

Net profit margin (before tax) (1,212 as % of 82,200)and (3,660 as % of 53,640)

1.5% 6.8%

Net profit margin (before tax and directors’remuneration ((1,212 + 6,960) as % of 82,200) and((3,660 + 720) as % of 53,640)

9.9% 8.2%

Revenue per number of staff (82,200/288) and $285,417 $298,000

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(53,640/180)

Revenue per site (82,200/6) and (53,640/4) $13.70m $13.41m

Interest cover (5,712/4,500) and (4,164/504) 1.3 times 8.3 times

Gearing ((80,460 – 9,792) as % of 28,152) and((5,400 + 2,844 – 24) as % of 17,904)

251.0% 45.9%

Non-current asset turnover (82,200/99,696) and(53,640/28,572)

0.82 1.88

Current ratio [(12 + 660 + 9,792) : (1,176 + 372)] and[(24 + 444 + 24) : (2,004 + 2,844 + 912)]

6.8 0.1

Return on capital employed (5,712 as % of (27,672 +80,460 – 9,792)) and (4,164 as % of (17,904 + 5,400+ 2,844 – 24))

5.8% 15.9%

Return on shareholders’ funds (840 as % of 28,152)and (2,748 as % of 17,904)

3.0% 15.3%

Additional information for further investigation

The analysis of the two companies could be strengthened if further informationwere available. This could include:

– A breakdown of expenses by type, to aid comparison between the twocompanies

– The extent of Elite’s overdraft facility, in order to assess headroom– The directors’ plans for the future (for both businesses)

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SECTION B

2. Abacus Ltd (Abacus) has investments in two companies, Bear Ltd (Bear) andCloud Ltd (Cloud). On 1 July 2015 Abacus acquired 490,000 (out of 700,000) ofBear’s ordinary shares. Abacus acquired 37,500 (out of 150,000) of Cloud’sordinary shares several years ago.

Bear is a subsidiary of Abacus as defined under HKFRS 10 ‘ConsolidatedFinancial Statements’. Cloud is an associate of Abacus as defined under HKAS 28‘Investment in Associates and Joint Ventures’.

The draft summarised statements of financial position of the three companies at31 October 2015 are shown below:

Abacus Bear Cloud

$ $ $

ASSETS

Non-current assets

Property, plant and equipment 1,600,600 1,289,100 322,570

Intangible assets 72,000 143,200 -

Investment in Bear 1,800,000 - -

Investment in Cloud 214,000 - -

Current assets

Inventories 105,920 200,000 46,500

Trade and other receivable 241,680 1,691,200 140,270

Cash and cash equivalents 144,000 379,000 52,780

Total assets 4,178,200 3,702,500 562,120

EQUITY AND LIABILITIES

Share capital 1,860,000 950,000 113,400

Retained earnings 1,501,440 1,496,520 291,390

Current liabilities

Trade and other payables 472,760 940,660 130,210

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Tax payable 344,000 315,320 27,120

Total equity and liabilities 4,178,200 3,702,500 562,120

Additional information:

(a) At the date of acquisition Bear’s retained earnings were $1,201,420. The fair

values of the assets and liabilities of Bear at the date of acquisition were the

same as their carrying amounts with the exception of a specialist piece of

equipment, which had a fair value $24,000 higher than its carrying amount

(this was not reflected in Bear’s books). The equipment was assessed as

having a remaining useful life of eight years at 1 July 2015.

In addition, Bear disclosed a contingent liability in the notes to its financial

statements involving a claim by some former staff for wrongful dismissal. The

lawyers estimated that the fair value of this contingent liability was $100,000.

The contingent liability of $100,000 in respect of legal claims was paid off by

Bear and recognised as an expense by Bear in the year ended 31 October

2015.

Abacus adopts the full method to account for goodwill. The amount of the

non-controlling interests as at 1 July 2015 was $640,000.

(b) At the date of acquisition Cloud had a credit balance on its retained earnings of

$185,110. The fair values of the assets and liabilities of Cloud at the date of

acquisition were the same as their carrying amounts.

(c) During the year Bear sold goods to Abacus for $68,000 on which its gross

profit margin was 40%. Abacus held half of these goods in its inventory at the

year end.

(d) Cumulative impairment losses at 31 October 2014 of $20,000 had arisen in

respect of Cloud. An impairment loss of $9,000 has been identified in respect

of goodwill arising on the acquisition of Bear for the year ended 31 October

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2015 and needs to be recognised.

(e) There has been no change in the share capital of Bear or Cloud since their

acquisition dates.

REQUIRED:

2. (a) Calculate the goodwill of Bear at the acquisition date.

(5 marks)

Ans (a) Goodwill – Bear as at acquisition date$

Consideration transferred 1,800,000Non-controlling interest at acquisition 640,000

2,440,000Less: Fair value of net assets at acquisition (950,000 +1,201,420 - 100,000 + 24,000)

(2,075,420)

364,580

2. (b) Calculate the investment in associates to be shown in theconsolidated statement of financial position of Abacus as at 31October 2015.

(5 marks)

Ans (b) Investment in associates – Cloud as at 31 October 2015$

Consideration transferred 214,000Add: Share of post-acquisition increase in retained earnings((291,390 - 185,110) x 25%)

26,570

Less: Impairment (20,000)

220,570

2. (c) Calculate the non-controlling interest to be shown in the consolidatedstatement of financial position of Abacus as at 31 October 2015. Ignore theeffect of deferred taxation.

(5 marks)

Ans (c) Non-controlling interest

$

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NCI as at acquisition date 640,000Share of post-acquisition retained earnings (1,496,520 –1,201,420 – 24,000 x 1/8 x 4/12) x 30%

88,230

Less: Share of unrealised profit on upstream sale of inventory(68,000 x 40% x 1/2 x 30%)

(4,080)

Add: Share of contingent liability (100,000 x 30%) 30,000Less: Share of impairment loss (9,000 x 30%) (2,700)

NCI as at acquisition date 751,450

Alternatively: $NCI share of book value of net assets (2,446,520 x 30%) 733,956NCI share of FV adjustment on inventory (24,000 – 24,000 x1/8 x 4/12) x 30%

6,900

Less: Share of unrealised profit on upstream sale of inventory(68,000 x 40% x 1/2 x 30%)

(4,080)

NCI share of goodwill (640,000 – 2,075,420 x 30% - 9,000 x30%)

14,674

NCI as at acquisition date 751,450

2. (d) Discuss the effect on the consolidated statement of financial position ofAbacus if it intends to sell 10% of its shares in Bear on 31 October 2015.

(5 marks)

(Total: 20 marks)

Ans (d) Where the parent disposes of part of its shareholding in a subsidiary, it mayretain control or lose control of the subsidiary, depending mainly on theamount of the share disposal. When there is no loss of control, , HKFRS 10‘Consolidated Financial Statements’ should be followed.

Under HKFRS 10, a decrease in shareholding in a subsidiary without loss ofcontrol should be treated as an equity transaction, (i.e. a transaction withowners in their capacity as owners). In this case there is no gain or loss, nochange in fair value adjustment, and no change in goodwill.

In fact, it is simply that the parent is selling out the non-controlling interests, i.e.there is an increase in the non-controlling interests and the difference betweenthe reduction in investment and the addition of non-controlling interests isrecognised through the retained earnings.

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Since the initial investment in shares in Bear is 70% and then there is a 10%reduction in investment, the subsequent reduction does not create a loss ofcontrol, as the investee continues to be a subsidiary. The difference betweenthe reduction of 10% in the investment and addition of non-controlling interests(also 10%) is recognised through retained earnings.

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3. Orange Computers & Solutions Ltd (OCSL) assembles computers and sells themto corporate and retail customers. During the year ended 31 July 2015, OCSLentered into the following transactions:

1) On 1 June 2015, OCSL supplied 30 notebook computers on credit to acustomer. The notebook computers had a list price of $300,000. Due to thesize of the order, the customer received a volume discount of $35,000 andthe customer invoice showed an amount payable of $265,000. The terms ofsale allowed the customer a prompt payment discount of $10,000 providedpayment was made before 31 July 2015. On 30 July 2015, the customer paid$255,000 in full and final settlement of the amount payable.

2) On 28 June 2015, OCSL supplied two mainframe computers (model no: 1XAand 2YB) to a customer. Both models were accepted by the customer on 31July 2015. Model 1XA is a model that is routinely supplied by OCSL to manycustomers and the installation process was very simple. Model 2YB wasmore specialised and the installation process more complicated, requiringsignificant assistance from OCSL. Model 1XA was installed on 2 August2015 by the customer’s employees. Model 2YB was installed between 3 and7 August 2015. For model 1XA, sale price, cost of production and cost ofinstallation (to OCSL) are $4,800,000, $2,400,000 and nil respectively. Formodel 2YB, sale price, cost of production and cost of installation (to OCSL)are $4,500,000, $2,250,000 and $150,000 respectively.

3) On 1 August 2014 OCSL sold a property to a financial institution for$45,000,000. The carrying amount of the property at 1 August 2014 was$30,000,000, of which $18,000,000 was depreciable. The remaining usefuleconomic life of the depreciable element was 30 years from 1 August 2014.OCSL continued to occupy the property and to be responsible for its securityand maintenance. The market value of the property on 1 August 2014 was$75,000,000 and it is considered unlikely that this will fall significantly in theforeseeable future. OCSL measures all its property, plant and equipmentunder the cost model. The terms of the sale allowed OCSL the option torepurchase the property on 31 July 2017 for $59,895,000. OCSL’s creditrating is such that the financial institution would require an annual interestrate of 10% on loan finance to OCSL.

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On 1 May 2015 OCSL transferred goods to an exclusive retail agent in Singapore,Merlion Computers Distribution Ltd (MDL), on a consignment basis. MDLundertook to sell the goods on behalf of OCSL and remit the proceeds, less acommission of 10%, when the ultimate purchaser paid MDL for them. The invoicedvalue of these goods by the ultimate purchaser was $600,000. The goods costOCSL $480,000 to manufacture. By 31 July 2015, MDL had sold goods at aninvoiced price of $360,000 and received payments of $240,000. No payment hadbeen made to OCSL by MDL by 31 July 2015. Since 31 July 2015 MDL has soldthe remaining goods, received all the proceeds, and remitted $540,000 to OCSL.

REQUIRED:

3. (a) Describe the meaning of revenue from sales of goods and from renderingservices and the basis on which they should be measured under HKAS 18‘Revenue’.

(8 marks)

Ans (a) HKAS 18 ‘Revenue’ defines revenue as the gross inflow of economic benefitsin a period arising in the course of the ordinary activities of an entity whenthose inflows result in an increase in equity, other than increases relating tocontributions from equity participants.

Revenue from the sale of goods should be recognised when:(i) The entity has transferred to the buyer the significant risks and rewards of

ownership of the goods.(ii) The entity retains neither managerial involvement in, nor effective control

over, the goods sold.(iii) The amount of revenue can be measured reliably.(iv) It is probable that the economic benefits associated with the transaction

will flow to the entity.(v) The costs incurred or to be incurred in respect of the transaction can be

measured reliably.

Revenue from the rendering of services should be recognised when:(i) The amount of revenue can be measured reliably.(ii) It is probable that the economic benefits associated with the transaction

will flow to the entity.(iii) The stage of completion of the transaction at the end of the reporting

period can be measured reliably(iv) The costs incurred or to be incurred in respect of the transaction can be

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measured reliably.

3. (b) Explain and show how the four transactions described above should bereported in the financial statements of OCSL for the year ended 31 July2015.

(12 marks)

(Total: 20 marks)

Ans (b) $265,000 is recognised as revenue. HKAS 18 states that revenue is reduced tothe extent that volume discounts are given.

The prompt payment discount of $10,000 does not reduce revenue but shouldbe recognised either as part of cost of sales or as a financing expense.

Because the installation process for model 1XA is simple, revenue from thismodel should be recognised on 31 July 2015.

Therefore, for model 1XA, $4,800,000 should be recognised as revenue and$2,400,000 as cost of sales.

Revenue from model 2YB will not be recognised until 7 August, the date theinstallation is complete. Until that date, OCSL has not transferred the risks andrewards of ownership.

Therefore no revenue or cost of sales should be recognised on model 2YB inthe year ended 31 July 2015.

The cost of producing model 2YB ($2,250,000) should be recognised ininventory at 31 July 2015 and the installation cost ($150,000) should berecognised as part of cost of sales when the revenue is recognised on 7August 2015 – within the year ended 31 July 2016.

For sale transactions with an option or commitment to repurchase, HKAS 18requires an analysis of the transaction to ascertain whether, in substance, theseller has transferred the risks and rewards of ownership to the buyer. If thistransfer has not occurred, the transaction is treated as a financing arrangementthat does not give rise to revenue.

In this case the terms of the sale leave OCSL occupying the property, with

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responsibility for its maintenance. Also it is highly likely that the option torepurchase will be exercised on 31 July 2017. Therefore, no revenue should berecognised and the sales proceeds should be treated as a loan.

This means that the asset should remain an asset of OCSL and be subject todepreciation of $600,000 ($18,000,000 x 1/30). The closing carrying amount ofthe asset should be $29,400,000 ($30,000,000 - $600,000).

The loan is treated as a financial liability measured at amortised cost with aneffective rate of interest of 10%. The finance cost for the year ended 31 July2015 should be $4,500,000 ($45,000,000 x 10%) and the closing borrowing$49,500,000 ($45,000,000 + $4,500,000). This should be shown as a liability.

Where goods are sold on consignment then the appendix of HKAS 18indicates that revenue should be recognised when MDL sells the goods to athird party. The only way this could be accelerated under the general principlesof the standard is where the terms of the consignment clearly transfer the risksand rewards of ownership of the consigned inventory to MDL on delivery,which is not the case here. Therefore, only those goods sold by MDL to theultimate purchaser prior to 31 July should be recognised as revenue.

The amount of revenue that should be recognised is the fair value of theconsideration payable by the ultimate purchaser, which in this case is$360,000. The manufactured cost of the goods treated as sold should be takento cost of sales. This amount is $288,000 ($480,000 x ($360,000/$600,000)).

The commission payable of $36,000 ($360,000 x 10%) should also be treatedas part of cost of sales. $324,000 ($360,000 - $36,000) should be debited totrade receivables. The cost of goods unsold by MDL at 31 July 2015 of$192,000 ($480,000 - $288,000) should be included in the inventory of OCSLat 31 July 2015.

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4. The following is an extract from Prosperity Ltd’s statement of profit or loss for theyear ended 31 July 2015 and its statement of financial position as at that date.

Statement of profit or loss for the year ended 31 July 2015 (extract)

$Operating profit 336,400Finance costs (5,925)

Profit before tax 330,475Income tax expense (66,250)

Profit for the year 264,225

Statement of financial position as at 31 July

2015 2014ASSETS $ $Non-current assets

Property, plant and equipment 1,919,375 1,586,300Intangible assets 112,500 125,000

Current assetsInventories 169,750 144,500Trade and other receivables 136,875 164,200Cash and cash equivalents 8,900 13,125

Total assets 2,347,400 2,033,175

EQUITY AND LIABILITIESShare capital 580,000 400,000Revaluation reserve - 387,500Retained earnings 1,383,075 881,200

1,963,075 1,668,700Non-current liabilities

Redeemable preference share 125,000 -Current liabilities

Trade and other payables 141,825 164,475Provisions 50,000 125,000Income tax payable 67,500 75,000

Total equity and liabilities 2,347,400 2,033,175

The following additional information is relevant.

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(i) During the year Prosperity made the following sales of property, plant andequipment.

Carrying amount Cash received$ $

Plant and equipment 141,750 150,000Land 500,000 550,000

The revaluation reserve in the statement of financial position above relateswholly to the land which was disposed of during the year.Depreciation of $419,750 was charged for the year.

(ii) The intangible assets balance in the statement of financial position aboverelates solely to a patent purchased in 2012 which is being amortised over itsestimated useful life.

(iii) Trade and other payables include accrued interest payable of $1,625 (2014:$1,250).

REQUIRED:

4. (a) Prepare a statement of cash flows in accordance with HKAS 7 ‘Statement ofCash Flows’ for Prosperity for the year ended 31 July 2015, using the indirectmethod.

(15 marks)

Ans (a) Statement of cash flows for the year ended 31 July 2015

$$

Cash flows from operating activities

Cash generated from operations 614,450

Interest paid (W1) (5,550)

Income tax paid (W2) (73,750)

Net cash from operating activities 535,150

Cash flows from investing activities

Purchase of property, plant and equipment (W2) (1,394,525)

Proceeds from sale of property, plant andequipment (W3)

700,000

Net cash used in investing activities (694,525)

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Cash flows from financing activities

Proceeds from issue of ordinary share capital(W4)

180,000

Proceeds from issue of borrowing 125,000

Dividends paid (W5) (149,850)

Net cash from financing activities 155,150

Net increase in cash and cash equivalents (4,225)

Cash and cash equivalents at 1 April 2014 13,125

Cash and cash equivalents at 31 March 2015 8,900

Note: Reconciliation of profit before tax to cash generatedfrom operations

$

Profit before tax 330,475

Finance costs 5,925

Depreciation 419,750

Amortisation 12,500

Gain on disposal of property, plant and equipment(700,000 – 641,750)

(58,250)

Increase in inventories (169,750 – 144,500) (25,250)

Decrease in trade and other receivables (164,200 –136,875)

27,325

Decrease in trade and other payables ((164,475 – 1,250)– (141,825 – 1,625))

(23,025)

Decrease in provision (125,000 – 50,000) (75,000)

Cash generated from operations 614,450

W1 = 1,250 + 5,925 - 1,625W2 = 75,000 + 66,250 - 67,500W3 = 641,750 + 419,750 + 1,919,375 – 1,586,350W4 = 580,000 – 400,000

W5 = 881,200 + 387,500 + 264,225 – 1,383,075

4. (b) How might a statement of cash flows be used by the management?

(5 marks)

(Total: 20 marks)

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Ans (b) A statement of cash flows may be used by the management of financial statementsto assist in:

(a) Evaluating an entity’s ability to generate cash and cash equivalents, and thetiming and certainty of their generation.

(b) Evaluating an entity’s liquidity and solvency, including its ability to meet itsobligations and to pay dividends.

(c) Evaluating the quality of an entity’s earnings by understanding the reasons forthe difference between an entity’s profit and the cash and cash equivalentsgenerated from operating activities. This evaluation is more readily conductedwhen an entity uses the indirect method of presenting net cash flows fromoperating activities.

(d) Comparing the operating performance of different entities. This comparison isassisted by the fact that net operating cash flows reported in a statement ofcash flows are unaffected by different accounting choices and judgments underaccrual accounting (although they may be affected by decisions such as whento pay accounts). However, the comparison can be confused by differences inthe time taken to collect revenues and to pay for goods and services.

(e) Developing models to assess and compare the present value of future cashflows of different entities. However, this process will not be entirely effective if itis not possible to identify non-recurring cash flows included in net operatingcash flows.

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5. Delicious Foods Limited (DF), a Hong Kong incorporated company, plans todevelop a worldwide food catering network through investment in its competitor’sregional companies. DF prepares its financial statements in accordance withHKFRSs.

DF invested in the following companies during the year ended 31 July 2015:

Contemporary Curry Limited (CC)

CC operates takeaway Indian food business in the UK. DF acquired 40% of theissued ordinary shares of CC. CC’s other shareholders are Mr and Mrs Amin, eachholding 30% of the issued ordinary shares of CC. Mr and Mrs Amin are currentlyinvolved in the day-to-day running of the company. CC’s board of directorscomprises Mr and Mrs Amin and two seats for representatives of DF. CC wasprofitable during the year ended 31 July 2015.

Real Veggie Limited (RV)

RV’s business is producing fresh organic foods for the Australian market. Themajor shareholder is Mr Lavery who holds 70% of the issued ordinary shares ofRV. DF acquired 30% of the issued ordinary shares of RV together with 50 options(which could take DF’s shareholding up to 51% of the issued ordinary shares andreduce Mr Lavery’s shareholding down to 49% of the issued ordinary shares)which are exercisable at any time at an 80% discount to the fair value of the sharesat the exercise date. The day-to-day operations are primarily run by DF who alsohas two out of three seats on the board. Mr Lavery is a director and regularlyattends meetings. RV was profitable during the year ended 31 July 2015.

Fabulous Pizza Limited (FP)

DF acquired 90% of the issued ordinary shares of FP from FP’s original sole trader,Mr Otto. FP is a pizza restaurant business in Italy. It has only made losses sinceincorporation and has struggled to pay its debts, including a loan of $15 millionfrom a finance company (‘the lender’) controlled by RV. The lender has used its

27

powers under the terms of the loan to monitor FP’s financing activities in order toprotect its loan – the lender must approve all expenditure over $10,000. FP cannotchange operations significantly without the lender’s approval and all newrestaurants planned for opening in the years 2015 to 2017 have been put on holdby the lender. The board of directors is dominated by DF.

REQUIRED:

Advise how the investments in CC, RV and FP should be classified in the consolidatedfinancial statements of DF group as at 31 July 2015 with reference to HKFRS 10‘Consolidated Financial Statements’ and HKAS 28 ‘Investments in Associates and JointVentures’.

(Total: 20 marks)

Ans HKFRS 10 ‘Consolidated Financial Statements’ defines a subsidiary as an entitythat is controlled by the parent. An investor controls an investee if and only if theinvestor satisfies all the following:

1) has power over the investee;

2) is exposed, or has rights, to variable returns from its involvement with theinvestee ; and

3) has the ability to use its power over the investee to affect the amount of itsreturns.

Power over the investee is defined as existing rights that give the current abilityto direct the relevant activities of the investee.

In assessing whether it has power over the investee, an investor shouldconsider the purpose and design of the investee to (i) identify the relevantactivities, how decision about those activities are made; and (ii) who has thecurrent ability to direct those activities.

In the absence of other factors, an investor with more than 50% (majority) of thevoting rights would meet the power criteria if the rights are substantive and arewith no restrictions.

The proportion of shares not owned by the parent is termed the non-controllinginterest.

If it holds less than the majority of the voting rights, an investor could still havepower (de facto power) in certain cases, such as through:

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a) agreements with other vote holders;b) other contractual agreements;c) size and dispersion of its holding voting rights relative to other holders; andd) potential voting rights.

Potential voting rights that arise from convertible instruments or options,including forward contracts, are rights to obtain voting rights of an investee.Such rights are considered only if they are substantive, i.e. the holder has thepractical ability to exercise the option.

Investment in CC

DF does not own more than half of the voting power of CC.

There is no agreement between Mr and Mrs Amin and DF such that DF haspower over the relevant activities of CC or other power to control CC. It istherefore very unlikely that DF can control CC in the manner recognised byHKFRS 10.

CC is not a subsidiary of DF under HKFRS 10.

HKAS 28 ‘Investment in Associates and Joint Ventures’ defines an associate as‘an enterprise in which an investor has significant influence but not control orjoint control’.

The key aspect to this definition of an associate revolves around the concept ofsignificant influence. This is in turn defined as the power to participate in thefinancial and operating policy decisions but not control them.

A holding of 20% or more (but not more than 50%) of the shares presumes thatsignificant influence, and therefore associate status, exists. If the holding is lessthan 20%, the investor will be presumed not to have significant influence unlesssuch influence can be clearly demonstrated.

The existence of significant influence by an investor is usually evidenced in oneor more of the following:– representation on the board of directors– participation in the policy-making process– material transactions between the investor and the investee

29

– interchange of managerial personnel– provision of essential technical information

As DF owns 40% of CC and DF has two seats on the board of CC, we maypresume that DF has significant influence over the financial and operatingpolicies of CC and the investment in CC should be brought into DF’sconsolidated financial statements as an associate using the equity method ofaccounting under HKAS 28.

Investment in RV

Currently, DF has a 30% voting power in RV and has options that could take theshareholding up to 51%; these options can be currently exercised at a bigdiscount to the market, i.e. deeply in-the-money. Such options are consideredas potential voting rights and have an effect on the potential shareholdingstructure in RV and implications when consolidating RV into the DF group. AlsoDF has two out of three seats on RV’s board.

In conclusion, when considering the existence of the potential voting rights aswell as the other factors described in HKFRS 10, it appears that DF controlsRV and DF should capture 30% of RV’s profits in its group accounts.

Investment in FP

There are two different views to consider in deciding whether to treat FP asDF’s subsidiary:i) DF has a 90% voting power in FP; and the board of FP is dominated by DF.

These facts suggest that FP is a subsidiary of DF under HKFRS 10.ii) DF’s control over FP seems to be restricted since the lender must approve

all major finance policy changes.

The lender is merely operating within the terms of the loan agreement toensure prompt and full repayment of its loan. If and when the loan is fullyrepaid, the lender will have no continuing involvement in the management ofthe company. Therefore the actions of the finance company do not affect DF’scontrol over FP.

Since the lender is controlled by RV and RV is controlled by DF (as concludedabove), FP should be consolidated in the DF’s financial statements.

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6. The following information is relevant in preparing the provision note for thefinancial statements for the year ended 31 July 2015 of Spock Limited (Spock), amanufacturer and retailer of electrical goods:

1) Spock uses two buildings for general administrative work. Both buildingshave been damaged by a typhoon and it is estimated repairing the damagewill cost $15 million each. Only one of the buildings is owned by Spock theother is used under an operating lease under which Spock is required torepair all damage. The accountant has proposed providing $30 million forthe repairs of the buildings.

2) On 1 May 2015, Spock entered into a contract for the future purchase of1,500 tons of copper, which were to be used in plate manufacture during theyear ended 31 July 2015. On 15 July 2015, Spock sold off its platemanufacturing division but was unable to assign this future contract. Thecontract price is $525 per ton and at the year end the spot price is $420 perton. The terms of the contract specify that a cancellation fee of $150,000 ispayable.

On 1 July 2015 Spock entered into negotiations with employee representatives torestructure its operations and close down two of its five retail outlets. The broadagreement was reached with the representatives on 25 July 2015 with a detailedplan and the plan publicly announced on 27 July 2015. Relevant employees weresent letters on 28 July 2015 offering them redundancy or redeployment. Therestructuring was completed on 31 September 2015. Spock expects to incur thefollowing costs/(revenues) as a result of the restructuring:

$m

Training of staff for redeployment elsewhere in the business 3.0

Salaries of internal solicitors for time spent handling

redundancies arising as a result of the restructuring

0.3

Write-down of assets to be sold off to their fair value less costs to

sell

4.5

Expected profit on sale of intellectual property rights (1.95)

Penalty to exit a contract that became onerous as a result of the

restructuring (and which cannot be fulfilled as a result of the

0.75

31

restructuring)

Operating losses to be incurred between the date of theannouncement of the restructuring and closure of the division

2.7

REQUIRED:

Advise Spock Limited on how to account for the above situations as at 31 July 2015with reference to HKAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’.

(Total: 20 marks)

Ans HKAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’defines a provision as a liability of uncertain timing or amount. It isaccrued on the statement of financial position as it is probable it will besettled and a reliable estimate can be made of the amount that will besettled.

There are two types of obligation:

a) A legal obligation arises from the conclusion of a legal contract,legislation or other operation of law.

b) A constructive obligation derives from the actions of theenterprise where:

– By an established pattern of past practice, published policiesor a sufficiently specific current statement, the entity hasindicated to other parties that it will accept certainresponsibilities; and

– It has created valid expectations on the part of those partiesthat it will discharge those responsibilities.

Contingent liabilities are defined in HKAS 37 as either:(i) A liability which is not provided for because either it is not probable

that it will be settled or a reliable estimate cannot be made of theamount that will be settled; or

(ii) A possible liability arises from past events, the existence of whichwill only be confirmed by the occurrence or non-occurrence offuture events not wholly within the control of the enterprise.

1) Faculty goods provision

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HKAS 37 requires that a present obligation be caused by a pastevent or events. But the past events need to have created both thecause of the outflow of benefits in the future and also an obligationto make the outflow.

In both cases the past event is a typhoon, but it is only in the caseof the operating lease that the obligation is as a result of a pastevent – the lease obligation. Where the asset is wholly ownedthere is no obligation on part of the owner to repair damage.

Only a provision for the damage on the building under theoperating lease of $15 million should be provided.

2) Provision for onerous contract

An onerous contract is a contract in which the unavoidable costs ofmeeting the obligations under the contract exceed the economicbenefits expected to be received under it. If an entity is a party toan onerous contract, a provision for the present obligation underthe contract must be recognised.

Spock is unable to assign this contract to purchase copper. Itshould be able to sell copper at the spot rate on the date itrequires to purchase it. As the spot rate is lower than contractprice, the contract will be loss-making and classified as onerous.

A provision is recognised for the best estimate of the net cost ofexiting from the contract which is set at the lower of:– the net cost of fulfilling the terms of the contract: (1,500 x

($525 - $420)) = $157,500– the compensation payable (i.e. cancellation fee) arising from

failure to fulfill it = $150,000

Therefore, a provision for such onerous contract of $150,000should be provided.

3) Restructuring provision

In respect of restructurings, HKAS 37 sets out further specific

33

criteria that must be met before a constructive obligation torestructure is deemed to exist. These are the enterprise has adetailed formal plan for restructuring identifying at least:a. the business or part of a business concerned;b. the principal locations affected;c. the location, function, and approximate number of employees

who will be compensated for terminating their services;d. the expenditure that will be undertaken; ande. that the entity has raised a valued expectation in those

affected that it will carry out the restructuring by starting toimplement that plan or announcing its main features to thoseaffected by it.

A restructuring provision shall include only the direct expendituresarising from the restructuring, which are those that are both: (a)necessarily entailed by the restructuring; and (b) not associatedwith the ongoing activities of the entity.

A board decision was reached with a detailed formal plan on 25July 2015.

The plans were publicly announced on 27 July 2015 and relevantemployees were sent letters on 28 July 2015 offering themredundancy or redeployment. A constructive obligation wastherefore created on 28 July 2015.

A provision of $1.05m should be made in the financial statementsfor the year ended 31 July 2015.

$mTraining of staff for redeployment elsewhere in the business

Retraining costs are associated with the ongoing activities of theentity so cannot be included in a restructuring provision, HKAS 37para 81(a).

-

Allocation of a portion of the salaries of internal solicitors handlingredundancies arising as a result of the restructuring

Even though these are internal costs, these are necessarily entailedand directly attributable expenditure, HKAS 37 para 80.

0.3

Write down of assets to be sold off to their fair value less costs to sellThe write-down should be credited to the asset (HKFRS 5) rather

-

34

than credited to a provision.Expected profit on sale of intellectual property rights

Gains on expected disposal of assets are not taken into account inmeasuring a provision, HKAS 37 paras 51 and 83.

-

Penalty to exit a contract that became onerous as a result of therestructuring (and which cannot be fulfilled as a result of therestructuring)

Onerous contracts are recognised as a provision, and the costs aredirectly attributable to the restructuring.

0.75

Operating losses to be incurred between the date of the announcementof the restructuring and closure of the division

Provisions for future operating losses are not permitted as they donot meet the definition of a liability, HKAS 37 para 63 (as there is nopresent obligation arising from past events).

-

1.05

END