Provision of mobile telecommunications and related services - recognised when the services are provided to customers.

Transcription

1 SECTION A CASE QUESTIONS (Total: 75 marks) Answer 1(a) (i) Provision of mobile telecommunications and related services - recognised when the services are provided to customers. The prepaid service fees received from customers which are generally not refundable in respect of standard service plans are included under deferred revenue and stated at the amount of proceeds received less the amount already recognised as revenue. (ii) (iii) Sale of mobile phones - recognised on delivery of equipment to customers and when the significant risks and rewards of ownership and title have been transferred to the customers. Bundled sale alternative 1: the total contract consideration is allocated to revenues generated from the provision of mobile telecommunications and related services and the sales of discounted mobile phones. The provision of telecommunication services is measured at fair value, and the remainder of the contract consideration is allocated to the sales of mobile phones. Alternative 2: the total contract consideration is allocated to service revenue and sales of discounted mobile phones based on their relative fair values. HKAS 18 - The recognition criteria are usually applied separately to each transaction. However, in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction. In determining the substance of a transaction, all of its aspects and implications should be identified and greater weight given to those more likely to have economic significance to the transacting parties at the time of entering into the transaction. Judgement should be used in each case to select a method that will reasonably approximate the amount that the customer is paying for each component. Answer 1(b) For transactions which offer customers points rewards when services are provided, the consideration allocated to the customers points rewards is based on its relative fair value. The fair value is recorded as deferred revenue when the rewards are granted and recognised as revenue when the points are redeemed or expired. Final Examination (June 2015 Session) Paper II 1 of 12

2 Items to be considered for disclosures: The entity should disclose accounting policies regarding the recognition of the customer points reward system. In the notes to the consolidated financial statements, the entity should disclose: amount recorded as deferred revenue of which the current portion and non-current portion should be separately shown; amount recognised as revenue during the period; and the management s key estimations as input to assess the fair value of the customer points reward system. Answer 2(a) Date: To: From: Subject: xx xx xx Stacy Chan, Chief Financial Officer Supertel Group Sean Pang, Financial Controller Supertel Group Financial impact on 3G financing arrangement Dear Stacy, There are two financial impacts arising from such a loan arrangement, which are (i) the capitalisation of interest incurred on such a loan and (ii) the fair value recognition of such a loan. HKAS 23 (Revised) - An entity shall capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. An entity shall recognise other borrowing costs as an expense in the period in which it incurs them. HKAS 23 (Revised) - Assets that are ready for their intended use or sale when acquired are not qualifying assets. Based on the background information as provided, Supertel obtained a loan of US$50 million to meet its increasing demand for operating funds and working capital, even a portion of a loan may be utilised in obtaining the 3G spectrum licence, which is ready for intended use as defined in HKAS 23 (Revised), therefore there is no qualifying asset identified and the interest should be recorded as an expense. HKAS 39 specifies that when a financial asset or financial liability is recognised initially, an entity shall measure it at its fair value plus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability. Final Examination (June 2015 Session) Paper II 2 of 12

3 HKFRS 13 also specifies that if another HKFRS requires or permits an entity to measure an asset or a liability at fair value and the transaction price differs from its fair value, the entity shall recognise the resulting gain or loss in profit or loss unless that HKFRS specifies otherwise. Since the interest rate of the loan receivables from Supercom is far lower than Supertel s prevailing market borrowing rate, this suggests that the transaction price is not the fair value of the loan at its initial recognition. The difference between fair value and the transaction price would be treated as a capital contribution from Supercom and recognised directly in equity as this does not meet the definition of income according to Conceptual Framework for Financial Reporting. Best regards Sean, Financial Controller Supertel Group Answer 2(b) Currency risk Based on the background information provided, Supertel Group is principally engaged in the provision of mobile telecommunications and related services and the sale of mobile phones and accessories in Hong Kong, according to HKAS 21 para 20, the functional currency of Supertel Group is likely to be the HK$. However, the loan advanced from Supercom is denominated in US$, therefore there is an exposure to currency risk with this loan. However, as the HK$ is pegged to the US$, the associated currency risk is not expected to be significant. Interest rate risk fair value interest rate risk in relation to the fixed-rate loan Liquidity risk liquidity risk arising from the remaining contractual maturity for the inter-group loan; or undiscounted cash flows of the inter-group loan based on the earliest date on which the Group can be required to pay (i.e. the agreed repayment dates) Fair value risk since the interest rate of the inter-group loan is lower than the Group s prevailing market borrowing rate, the Group will consider the difference in finance costs as a contribution from Supercom and take this into account in Equity. Final Examination (June 2015 Session) Paper II 3 of 12

4 Answer 2(c) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - extract Interest rate risk The Group is exposed to cash flow interest rate risk 1 in relation to the fixed rate loan from the immediate holding company (see note xx for details of the loan). The Group currently has not entered into interest rate swaps to hedge against its exposure to changes in the fair values of the above said financial instruments. Sensitivity analysis The sensitivity analysis below has been determined based on the exposure to interest rates of the financial instruments. The analysis is prepared assuming the financial instruments outstanding at the end of the reporting period were outstanding for the whole year. If interest rates had been 50 basis points higher/lower and all other variables were held constant, the Group s profit for the year ended 31 December 2014 would decrease/increase by approximately HK$1,950,000 (2013: nil). This is mainly attributable to the Group s exposure to interest rates on its loan from the immediate holding company. 2 Liquidity risk In the management of the liquidity risk, the Group monitors and maintains a level of cash and cash equivalents deemed adequate by the management to finance the Group s operations and mitigate the effects of fluctuations in cash flows. 3 The Group finances its working capital requirements through a combination of funds generated from operations and loans from the immediate holding company. The following table details the Group s remaining contractual maturity for its non-derivative financial liabilities based on the agreed repayment terms. The table has been drawn up based on the carrying amount of financial liabilities 4 based on the earliest date on which the Group can be required to pay. The maturity dates for the non-derivative financial liabilities are based on the agreed repayment dates. Comments: (1) Since the loan from the immediate holding company bears interest at a fixed rate, the interest rate risk associated should be fair value interest rate risk. (2) Sensitivity analysis of the interest rate is not applicable as the contracted interest rate is fixed throughout the loan period. Instead, sensitivity analysis of the fair value of the loan may be applicable if the fair value change is material. (3) HKFRS 7 the entity should disclose a description of how it manages the liquidity risk inherent in both the non-derivative and derivative financial liabilities. The entity should also disclose whether the management monitors the utilization of the loan and ensures compliance with the loan covenants. Final Examination (June 2015 Session) Paper II 4 of 12

5 (4) HKFRS 7 The contractual amounts disclosed in the maturity analyses are the contractual undiscounted cash flows. The liquidity risk table should be based on the undiscounted cash flows of the financial liabilities instead of the carrying value. The table should include both interest and principal cash flows. Answer 2(d) Under general circumstance, when the company breaches the loan covenants before the year end date, related non-current loan should be reclassified to current loan as at the year end date; and such breach of covenant is required to be disclosed in the financial statements. Given that Supertel obtained from Supercom a waiver for not demanding payment as a consequence of the breach on 20 February 2015 which is after the reporting period and before the authorisation of the consolidated financial statements for issue, Supertel is required to classify the whole amount of outstanding balance as a current liability because, as at 31 December 2014, it does not have an unconditional right to defer its settlement for at least twelve months after that date. According o HKAS1, the rectification of a breach should be disclosed either in the consolidated statement of financial position or as a post balance sheet event in the notes to the consolidated financial statements. Answer 3(a)(i) r e = r u + d/e(r u r d ) (1-t) = 12% (12% 5%) (1-16.5%) = % Key: r e = expected return, geared r u = expected return, ungeared d/e = debt to equity ratio r d = cost of debt pre-tax t = tax rate Answer 3(a)(ii) This change will increase the expected return on equity to shareholders. The expected return on equity will be: r e = 12% (12% 7%) (1-16.5%) = % Final Examination (June 2015 Session) Paper II 5 of 12

6 Answer 3(b)(i) Based on MM theory with taxes and without taxes, the management should not invest any time in analyzing the firm s capital structure. With no taxes, capital structure is irrelevant. With taxes, a firm will use 100% debt to maximize its value. Under both scenarios, the manager has nothing to decide. Based on the Pecking Order theory, the management will first use internal financing, such as its retained earnings. Then the company will issue safe securities like debt and the last resort is to issue equity. The implications of the Pecking Order theory include: there is no target amount of leverage; and profitable firms use less debt. Answer 3(b)(ii) No, it is because moderate borrowing will not significantly affect the probability of bankruptcy, but it will increase the variability and also the market risk faced by stockholders. This additional risk must be compensated by a higher expected rate of return to stockholders. Answer 3(c) The fair value today (FV 0 ) is the total amount of equity divided by the shares outstanding, so, FV 0 = HK$76 million equity / 8 million shares = HK$9.50 per share Ignoring any tax effects, the ex-dividend fair value tomorrow (FV x ) will be today s stock price minus the amount of the dividend per share, so: FV x = HK$9.50 HK$0.5 = HK$9.0 The total dividends paid will be: HK$0.5 per share (8 million shares) = HK$4 million The equity account will remain as HK$72 million. The cash account will remain as HK$2 million. Final Examination (June 2015 Session) Paper II 6 of 12

7 Answer 3(d) Repurchasing the shares will reduce shareholders equity by HK$3.8 million. The shares repurchased will be the total purchase amount divided by the current fair value, so: Shares bought = HK$ 3.8 million / HK$9.50 = 400,000 And the new shares outstanding will be: New shares outstanding = 8,000, ,000 = 7,600,000 After the repurchase, the new stock price is: Fair value = $72.2 million / 7.6 million shares = HK$9.5 The repurchase is effectively the same as the cash dividend because you either hold a share worth HK$9.50 or a share worth HK$9 and HK$0.5 in cash. Therefore, if you participate in the repurchase according to the dividend payout percentage, you are unaffected. Answer 4(a)(i) HKSA 610 (Revised) Using the Work of Internal Auditors states that the external auditor shall determine whether the work of the internal audit function can be used for the purposes of the audit by evaluating the following: the extent to which the internal audit function s organizational status and relevant policies and procedures support the objectivity of the internal auditors; the level of competence of the internal audit function; and whether the internal audit function applies a systematic and disciplined approach, including quality control. The following areas should be discussed with Mr. Ivan Auyeung: the Internal Audit Department includes 1 senior manager, 2 managers, 2 senior internal auditors and 2 internal auditors does it have adequate resources to perform the internal audit work for the Supertel Group? the nature of work performed by the Internal Audit Department are there any planned work programmes and what is the basis of rotation in covering different functional units? the employment process of the internal auditors - the minimum years of experience that will be considered and whether the internal auditors are members of relevant professional bodies and have adequate technical training and proficiency in auditing; how are the internal auditors being trained within Supertel and assigned to different tasks and do the internal auditors possess the required knowledge relating to Supertel s financial reporting and the applicable financial reporting framework? Final Examination (June 2015 Session) Paper II 7 of 12

8 are internal auditors involved in other functions or activities of Supertel which may create conflicts of interest? does the work performed by the internal auditors follow any internally developed policy, procedures or guidance? is the work performed by the internal auditors supervised and reviewed? are there any quality control reviews that provide an objective evaluation of the work performed by the internal auditor and will there be any quality review performed by the Internal Audit Department of Supercom? how often will the Head of the Internal Audit Department attend Board Meetings and are there any remediation plans prepared for the findings identified? Answer 4(a)(ii) Since Albert Wong was an audit manager of Smart CPA previously, he should have a good understanding of Smart CPA s audit approach and methodology. This may have an impact on the audit evidence obtained by the engagement team. The engagement team has to revisit and amend the audit approach by considering: (i) (ii) (iii) whether Albert was one of the engagement team members of the Supertel Group when he was in Smart CPA and his extent of involvement in the engagement; the nature of other engagements that Albert has worked on when he was in Smart CPA; and Albert s role and responsibilities as a finance manager of the subsidiary. As a safeguard, the engagement team should avoid involving Albert s girlfriend, Carmen Cheung, in the audit of the Supertel Group. Answer 4(b) HKSA 570 (Clarified) Going Concern states that the objectives of the auditor are to: obtain sufficient appropriate audit evidence regarding the appropriateness of the management s use of the going concern assumption in the preparation of the financial statements; conclude, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the entity s ability to continue as a going concern; and determine the implications for the auditor s report. Final Examination (June 2015 Session) Paper II 8 of 12

9 The breach of debt covenant obligations is an indicator that may cast doubt about the going concern assumption, additional audit procedures have to be performed to obtain information about the management s plans that may alleviate substantial doubts. Management s assessment - they should request that the management extends its assessment as the assessment must cover a period of not less than 12 months from the date of the financial statements. Breach of bank covenants ensure the waiver is obtained prior to the issuance of the auditor s report and the financial statements. Plan of disposal of investment properties assess the market value of the investment properties and whether the net proceeds are adequate to repay the bank borrowings as planned. Financial support from Supertel-assess whether Supertel has sufficient financial strength to continue as a going concern and is able to honour its financial support to Fortune Ltd. In addition, the engagement team has to request written representation from the management and those charged with governance concerning plans for further action and the feasibility of these plans. Answer 4(c)(i) The objectives of establishing a remuneration committee are to assist the board of directors in maintaining a formal and transparent procedure for setting policy with regard to director s remuneration, and to determine an appropriate remuneration package for all directors. A majority of the members of the remuneration committee should be independent nonexecutive directors. The Chairman of the remuneration committee should be an independent non-executive director. No director should be involved in deciding his own remuneration. Answer 4(c)(ii) Directors the remuneration and any other reimbursement of emolument payable to a director must be disclosed in full in the annual report and financial statements of Supertel on an individual and named basis. Senior management the remuneration will be disclosed by band. It is only a recommended best practice to disclose on an individual and named basis the details of any remuneration payable to members of senior management in the annual report. * * * END OF SECTION A * * * Final Examination (June 2015 Session) Paper II 9 of 12

10 SECTION B ESSAY QUESTIONS (Total: 25 marks) Answer 5(a) For the SUF payment to be tax deductible in Hong Kong, it has to satisfy the following two criteria: (a) (b) It was incurred in the production of assessable profits under s.16(1) of the IRO; and It is not capital in nature under s.17(1)(c) of the IRO. For condition (a), this is satisfied as Supertel is engaged in the provision of wireless telecommunication services to Hong Kong customers and the 4G licence would be used in generating assessable profits in Hong Kong. For condition (b), according to tax cases such as Wharf Properties Ltd v CIR (1997 STC 351) and Commissioner of Taxes v Nchanga Consolidated Copper Mines Ltd [(1964) AC 948], the following tests have been adopted to distinguish whether an expenditure is capital in nature or not: (i) (ii) (iii) (iv) once and for all test; enduring benefit test; profit yielding structure test; and fixed/circulating capital test. For (i), the once and for all test, since the SUF payment was made only once and for all, as opposed to being paid every year, the SUF is more likely a capital expenditure. See also Vallambrosa Rubber Co Ltd v Farmer [(1910) 5 TC 529]. Under (ii), the enduring benefit test, the SUF payment was made to bring about 15 years right of use of the 4G licence and Supertel will be able to enjoy recurring subscription income in these years. This could be considered as an enduring benefit to Supertel, and therefore the SUF is more likely a capital expenditure. See also Atherton v British Insulated & Helsby Cables Ltd [(1926) 10 TC 155]. For (iii), the profit yielding structure test, the key is whether the expenditure was incurred on the business entity structure or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay. As the SUF payment was spent on the business structure (i.e. the 4G licence) as opposed to the earning process, the SUF payment is more likely a capital expenditure. See also Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation [(1938) 61 CLR 337]. For (iv), the fixed capital vs circulating capital test distinguishes expenditure on the acquisition of fixed capital or circulating capital. As the 15-year right of use of the 4G licence is generally regarded as fixed capital of Supertel, the SUF payment is more likely a capital expenditure. Final Examination (June 2015 Session) Paper II 10 of 12

11 Based on the above, the SUF payment is more likely a capital expenditure under s.17(1)(c). Failing condition (b), the SUF payment is non-deductible. Answer 5(b) For an interest expense to be deductible, it has to satisfy the following conditions: (a) (b) (c) (d) it was incurred in the production of assessable profits under s.16(1) of the IRO; one of the six conditions specified in s.16(2); s.16(2a), (2B) & (2C) are not contravened; and it is not capital in nature under s.17(1)(c) of the IRO. For condition (a), this is satisfied as Supertel is engaged in the provision of wireless telecommunication services to Hong Kong customers, and the cost in financing the acquisition of the 4G licence should be incurred in generating assessable profits in Hong Kong. For condition (b) & (c), s.16(2)(f)(iii) is relevant. Since the loan money arises entirely from the proceeds of an issue by the Supertel associated corporation (i.e. Supercom) of debentures listed in the US stock exchange. Assuming (i) the US stock exchange is recognized by the IRD; and (ii) the interest flow back test under s.16(2c) is satisfied (i.e. interest on Supercom debentures is not paid directly or through any interposed person to Supercom or its related parties), the portion of interest expense not exceeding 7% would satisfy this condition due to the limitation under s.16(2)(f)(iii). In other words, the interest expense representing the 1.5% portion (i.e. 8.5% - 7%) is not deductible. For condition (d), where a person incurs expenditure on the acquisition of a capital asset (i.e. the 4G licence rights) to be used for the production of telecommunication income, the expenditure including financing costs attributable to the acquisition of the capital asset should be properly capitalised. Based on the Wharf case, finance expenses up to the date when the property (in this case the rights to use 4G licence) is capable of being used for production of profits should be capitalised. Accordingly, the interest expense incurred by Supertel before 1 January 2015 (i.e. the first date on which the 4G licence could be used for producing assessable profits) is capital in nature and is not deductible. An interest expense incurred thereafter is, however, revenue in nature. To sum up, interest expense incurred during the period from 30 June 2014 to 30 December 2014 is not deductible because it is capital in nature. For the interest expense incurred on or after 1 January 2015, the portion that exceeds 7% threshold is not deductible whereas the portion up to 7% is deductible as all the conditions (a), (b) (c) & (d) are satisfied. Final Examination (June 2015 Session) Paper II 11 of 12

12 Answer 5(c) Mr. Tai would be obligated to report the director s quarters benefit provided by an associated company of his employer (i.e. Supercom) as the director s quarters benefit is taxable under s.9(1)(b). The taxable amount is 10% of the director s fee (i.e. HK$300,000) pursuant to s.9(2). Answer 5(d) The major China taxes Supertel would be subject to are Enterprise Income Tax at 25% and Business Tax at 3%. However, under the Value Added Tax ( VAT ) Reform, Business Tax will be replaced by VAT going forward. * * * END OF EXAMINATION PAPER * * * Final Examination (June 2015 Session) Paper II 12 of 12