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

Transcription

1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination HONG KONG FINANCIAL ACCOUNTING JUNE 2012 Suggested Answer The suggested answers are published for the purpose of assisting students in their understanding of the possible principles, analysis or arguments that may be identified in each question 1

2 SECTION A 1. You are John Wong, the accounting manager of Legend Limited (LGL), which is a company incorporated in Hong Kong. LGL is principally engaged in the sales of digital products in Hong Kong. The following is an extract from LGL s trial balance at 31 March 2012: $ 000 $ 000 6% non-current bank loan 60,000 Accumulated amortisation 1 April 2011 lease premium for land 12,600 Accumulated depreciation 1 April 2011 office building 10,800 Accumulated depreciation 1 April 2011 office furniture & fixtures 13,500 Administrative expenses 90,000 Bank 8,000 Distribution costs 64,000 Finance cost 4,000 Inventory at 1 April ,000 Lease premium for land at cost 126,000 Office building at cost 108,000 Office furniture & fixtures at cost 45,000 Purchase 610,000 Retained earnings at 1 April ,000 Revenue 770,000 Share capital 140,000 Trade payables 8,100 Trade receivables 63,000 1,178,000 1,178,000 In the process of preparing the financial statements of LGL for the year ended 31 March 2012, Sunny Choi, a director of LGL, is disappointed by the draft reported profit for the year. In a written report, an extract from which is produced below, she suggests three items where she believes that the reported profit can be improved: 1. Lease premium for land So far as I understand, LGL owns an office building in Kowloon. Certainly there is an element of land. I understand that land is land and it will not disappear. Therefore, I believe that we don t need to depreciate the land. The amount that we have amortised in the past ($12.6 million) should be reversed and credited to the income statement. 2

3 2. Depreciation of office furniture & fixtures I know that the useful life of an asset should be reviewed at least at each financial year-end. Now, our office furniture & fixtures that cost $45 million, representing the renovation cost of our office building on 1 April 2008, are being depreciated on a straight-line basis over 10 years with no residual value. I believe that our office furniture & fixtures can last for 15 years from the date of the renovation instead of only 10 years. A longer useful life means lower depreciation expense and hence higher reported profit. 3. Inventory cost formulas Moreover, I know that we are allowed to have a choice between first-in-first-out (FIFO) or weighted-average cost formulas. The average cost formula that we are using now results in a closing inventory of only $80 million as at 31 March 2012 and hence we have a low reported profit. If we switch to FIFO, the closing inventory at 31 March 2012 would be valued at $90 million. Switching to FIFO will therefore achieve a higher closing inventory and hence a higher annual profit. Additional information Depreciation and amortisation have not yet been charged on the non-current assets for the year ended 31 March Depreciation and amortisation are to be provided for on a monthly basis using the straight-line method and are all to be charged to administrative expenses. The land is leasehold land with a remaining lease term of 30 years when the office building was purchased. The office building also has a useful life of 30 years. LGL s inventory at 1 April 2011, on average cost formula, was reported as $60 million. However, using FIFO, it would have been reported as $68 million. The 6% non-current bank loan has an effective interest rate of 6%. The interest has to be paid bi-annually on 1 January and 1 July each year. The finance cost as shown in the trial balance contains the bi-annual interest paid for the non-current bank loan amounting to $1.8 million. 3

4 REQUIRED: Draft a memorandum to LGL director Sunny Choi. In your memorandum, covering her questions on the financial statements of LGL for the year ended 31 March 2012: 1. (a) Justify the requirement for amortising the Lease premium for land and identify the proper accounting treatment; Ans (a) To : Sunny Choi, Director From : John Wong, Accounting Manager Date : dd/mm/yyyy Subject : Financial statements of LGL as at 31 March 2012 I refer to your queries about the accounting treatments for the lease premium for land, depreciation of office furniture & fixtures and inventory cost formula and their impacts on the financial statements of LGL as at 31 March Lease premium for land HKAS 17 Leases specifies that when classifying a lease of land and buildings, an entity should normally consider the land and buildings elements separately. The minimum lease payments are allocated between the land and buildings elements in proportion to the relative fair values of the leasehold interests in the land and buildings elements of the lease. In our case, it is true that a significant amount of the purchase consideration was paid for the land element since the office building was built on land under a government lease and thus the land and buildings elements should be considered separately. However, a characteristic of land is that it normally has an indefinite economic life. In our case, since the title of the land is not expected to pass to LGL by the end of the lease term, LGL does not receive substantially all the risks and rewards incidental to ownership. Thus, in this case the lease of land should be classified as an operating lease. The leasehold land, classified as an operating lease, is actually prepaid lease payments (lease premium for land), which should be initially stated at cost ($126 million) and subsequently amortised on a straight-line basis over the lease term. Therefore the annual amortisation of the lease premium for land amounting to $4.2 million ($126 million / 30 years) should be debited to the income statement each year and we cannot reverse the amount that we have amortised in the past. 4

5 1. (b) Analyse and identify the proper accounting treatment for the change in depreciation of office furniture & fixtures, being a change in accounting estimate. Support your answer with calculations of the depreciation charges; Ans (b) Change in depreciation for office furniture & fixtures (change in accounting estimate) HKAS 16 Property, Plant and Equipment requires that the useful life of an asset should be reviewed at least at each financial year-end. If the expected useful life differs from the previous estimate, the change should be accounted for as a change in an accounting estimate in accordance with HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. An estimate may need revision if changes occur in the circumstances on which the estimate was based or as a result of new information or more experience. By its nature, the revision of an estimate does not relate to prior periods and is not the correction of an error. Therefore, a reassessment of the useful life of the office furniture & fixtures as a result of new information or more experience can be an acceptable reason for a revision of the asset s useful life. However, it would be unacceptable to increase the estimated useful life merely with the purpose of improving LGL s reported profit, i.e. it is unacceptable if it is revised only for the purpose of earnings management. Paragraph 36 of HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires that the effect of a change in an accounting estimate should be recognised prospectively by including it in profit or loss in the period of the change if the change affects that period only; or the period of the change and future periods if the change affects both. A change in the estimated useful life of a depreciable asset affects depreciation expense for the current period and for each future period during the asset s remaining useful life. In both cases, the effect of the change relating to the current period is recognised as income or expense in the current period. The effect, if any, on future periods is recognised as income or expense in those future periods. Therefore, where there is a change in the estimated remaining useful life of a non-current asset, its carrying amount, at the time of the revision, should be allocated over the revised remaining useful life. The carrying amount of the office furniture & fixtures at 1 April 2011 is $31.5 5

6 million ($45 million $13.5 million accumulated depreciation) and this should be depreciated over the estimated remaining useful life of 12 years. Therefore, a depreciation expense of $2.625 million ($31.5 million / 12 years) should be charged in the year ended 31 March 2012 resulting in a carrying amount of $ million ($31.5 million $2.625 million) in the statement of financial position on 31 March As a result, there is an improvement in the reported current year profit, due to the revision to the estimated useful life of the furniture & fixtures, by $1.875 million, which represents the difference between the depreciation expense based on the original useful life ($4.5 million) and the revised useful life ($2.625 million). 1. (c) Analyse and identify the proper accounting treatment for the change in inventory cost formulas, being a change in accounting policy. Support your answer with calculations of the necessary adjustments; and Ans (c) Change in inventory cost formulas (change in accounting policy) HKAS 2 Inventories specifies that the cost of inventories may be assigned using the first-in-first-out (FIFO) or weighted-average cost formula. LGL shall use the same cost formula for all inventories having a similar nature and use to LGL. The cost formula used represents the accounting policies adopted by LGL in measuring inventories. HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires LGL to select and apply its accounting policies consistently for similar transactions, unless the HKFRS specifically requires or permits. LGL shall change an accounting policy only if the change is required by an HKFRS; or it results in the financial statements providing reliable and more relevant information about the effects of transactions on LGL s financial position, financial performance or cash flows. In this case, it would be unacceptable to change the inventory cost formula merely for the purpose of improving LGL s reported profit, i.e. it is unacceptable if it is revised only for the purpose of earnings management. Paragraph 19 of HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors specifies that when LGL changes an accounting policy voluntarily, it shall apply the change retrospectively. When a change in accounting policy is applied retrospectively, LGL should 6

7 adjust the opening balance of each affected component of equity for the earliest prior period presented and the other comparative amounts disclosed for each prior period presented as if the new accounting policy had always been applied. In this case, for the year ended 31 March 2012, both the opening and closing inventories would need to be measured at FIFO: Average cost FIFO Difference $ million $ million $ million Opening inventory Closing inventory Increase in profit 2 The inventory as at 31 March 2012, measured at FIFO, results in an increase in the closing inventory of $10 million at 31 March However, with the increase in the opening inventory by $8 million, the net effect of the change is only an increase of profit by $2 million for the year ended 31 March Therefore, the opening retained earnings would be increased by $8 million and this, together with the increase of profit by $2 million for the year ended 31 March 2012, results in a total increase of $10 million in the closing retained earnings, as at 31 March I hope the above explanation has answered your questions. For the details, please refer to the annex. Please feel free to contact me if you have further queries. Best regards, John Wong 7

8 1. (d) Prepare as an annex to your memorandum the statement of comprehensive income, statement of changes in equity and statement of financial position as at 31 March 2012, assuming that the lease premium for land should be amortised, the useful life of the office furniture & fixture is revised to 15 years and the inventory cost formula is changed to FIFO. (Notes to the financial statements are NOT required.) Ans (d) LGL Statement of comprehensive income for the year ended 31 March 2012 $ 000 Revenue 770,000 Cost of sales ($68m + $610m - $90m) (588,000) Gross profit 182,000 Distribution costs ( 64,000) Administrative expenses (note (i)) (100,425) Finance costs ($4m + $60m x 6% / 2) ( 5,800) Profit for the year 11,775 LGL Statement of changes in equity for the year ended 31 March 2012 Share capital Retained earnings Total $ 000 $ 000 $ 000 Balance at 1 April , , ,000 Change in accounting policy for inventory cost formula -- 8,000 8,000 Balance at 1 April 2011 as restated 140, , ,000 Profit for the year ended 31 March ,775 11,775 Balance at 31 March , , ,775 8

9 LGL Statement of financial position as at 31 March 2012 $ 000 $ 000 Assets Non-current assets Lease premium for land At cost Less: accumulated depreciation ($12.6m + $4.2m) (16,800) 109,200 Office building At cost Less: accumulated depreciation ($10.8m + $3.6m) (14,400) 93,600 Office furniture & fixtures At cost 45,000 Less: accumulated depreciation ($13.5m + $2.625m) (16,125) 28, ,675 Current assets Inventory 90,000 Trade receivables 63,000 Bank 8, ,000 Total assets 392,675 Equity and liabilities Equity Share capital 140,000 Retained earnings ($163m + $8m m) 182, ,775 Non-current liabilities 6% non-current bank loan 60,000 Current liabilities Trade payables 8,100 Accrued interest 1,800 9,900 Total equity and liabilities 392,675 Working: (i) Administrative expenses $ 000 Per trial balance 90,000 Amortisation of lease premium for land ($126m/30) 4,200 Depreciation of office building ($108m/30) 3,600 Depreciation of furniture & fixtures ($45m-$13.5m)/12) 2, ,425 9

10 SECTION B 2. On 1 April 2011 Peace Limited (PCL) acquired 3 million equity shares in Safe Limited (SFL) by an exchange of one share in PCL for every two shares in SFL plus $1 per acquired SFL share in cash. The market price of each PCL share at the date of acquisition was $6. The draft statements of financial position of the two companies at 31 March 2012 are: Non-current assets PCL SFL $ 000 $ 000 Property, plant and equipment (net) 24,900 10,400 Investments in SFL 12,000 - Current assets Inventory 6,900 6,200 Trade receivables 3,200 1,500 47,000 18,100 Share capital of $1 each 19,000 4,000 Retained earnings At 31 March ,000 6,500 For the year ended 31 March ,000 2,400 43,000 12,900 Current liabilities Accounts payable 4,000 5,200 47,000 18,100 The following information is relevant: (i) At the date of acquisition, the fair value of SFL s assets was equal to their carrying amount. (ii) During the year ended 31 March 2012, SFL sold goods to PCL for $2.7 million. SFL had marked these goods up by 50% on cost. PCL still had a third of the goods in its inventory at 31 March There were no intra-group payables/receivables at 31 March (iii) Impairment tests on 31 March 2012 concluded that goodwill was impaired by $900,000. (iv) No dividends were paid during the year by any of the companies. (v) Non-controlling interests are measured at their fair value, being $2,400,

11 (vi) On 1 April 2011, PCL sold an item of plant to SFL at its agreed fair value of $2.5 million. Its carrying amount prior to the sale was $2 million. The estimated remaining life of the plant at the date of sale was five years (straight-line depreciation). REQUIRED: 2. (a) Analyse and justify the accounting requirement to present non-controlling interests in the equity section of the consolidated statement of financial position. Ans (a) Presenting non-controlling interests within equity Non-controlling interest was defined in HKFRS 10 Consolidated Financial Statements as the equity in a subsidiary not attributable, directly or indirectly, to a parent. HKFRS 10 requires non-controlling interests to be presented in the consolidated statement of financial position within equity, separately from the equity of the shareholders of the parent. It is concluded that a non-controlling interest is not a liability because it does not meet the definition of a liability in the Conceptual Framework for Financial Reporting. The Conceptual Framework states that a liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. It explains that an essential characteristic of a liability is that the entity has a present obligation and that an obligation is a duty or responsibility to act or perform in a particular way. It is noted that the existence of a non-controlling interest in the net assets of a subsidiary does not give rise to a present obligation. Instead, non-controlling interests represent the residual interest in the net assets of those subsidiaries held by some of the shareholders of the subsidiaries within the group, and therefore meet the Framework s definition of equity. The Conceptual Framework concludes that equity is the residual interest in the assets of the entity after deducting all its liabilities. Therefore, non-controlling interests should be presented in the consolidated statement of financial position within equity. 11

12 2. (b) Prepare the consolidated statement of financial position for PCL as at 31 March Show the detailed calculations for each item (consolidation journal entries are NOT required). Ans (b) PCL group consolidated statement of financial position as at 31 March 2012 ASSETS Non-current assets Property, plant and equipment (net) Adjustment PCL SFL Dr Cr Group $ 000 $ 000 $ 000 $ 000 $ ,900 10, ,900 Goodwill 3, ,000 Investments in SFL 12,000-12,000 - Current assets Inventory 6,900 6, ,800 Trade receivables 3,200 1,500 4,700 47,000 18,100 55,400 EQUITY AND LIABILITIES Share capital 19,000 4,000 4,000 19,000 Retained earnings 24,000 8,900 6, , NCI 2,400 3, Current liabilities Accounts payable 4,000 5,200 9,200 47,000 18,100 55,400 12

13 3. As part of its remuneration package, in addition to a cash salary and other employment benefits, Forever Young Limited (FYL) is considering adopting a share option scheme which allows the board of directors of FYL to award share options to employees at nil consideration. Two alternative share options schemes are being considered: Alternative 1 On 1 July 2012, 2.4 million share options are granted to the general manager with vesting of the options conditional upon the general manager completing three years service. FYL presume that the services to be rendered by the general manager as consideration for the share options will be received in the future, over a three-year vesting period. FYL expects that all the awarded share options will vest at the end of the three-year period. Alternative 2 On 1 July 2012, 2.4 million share options are granted to the general manager. Subject to the continued employment of the general manager with FYL, one-third of the awarded share options shall become vested at the end of each anniversary from the date of grant. FYL expects that all the awarded share options will vest. In both alternatives, assume that the fair value of the share options of FYL at the date of grant is $9 each. 13

14 REQUIRED: Analyse and identify, giving detailed calculations, the appropriate accounting treatment of the two alternatives in relation to the share options awarded by FYL for the years ended 30 June 2013 and 30 June 2014 respectively. Ans Share options - Equity settled share-based payment HKFRS 2 Share-based Payment sets out measurement principles and specific requirements for equity-settled share-based payment transactions, in which FYL receives goods or services as consideration for equity instruments of FYL (including shares or share options). For equity-settled share-based payment transactions, FYL shall measure the goods or services received, and the corresponding increase in equity, directly, at the fair value of the goods or services received, unless that fair value cannot be estimated reliably. If FYL cannot estimate reliably the fair value of the goods or services received, FYL shall measure their value, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted. There is a general assumption that transactions with employees cannot be reliably measured on the basis of the value of the services being provided. Therefore, transactions with employees are typically measured at the fair value of the equity instruments being granted. The fair value of the equity instruments granted is measured at the grant date. Vesting conditions, other than market conditions, shall not be taken into account when estimating the fair value of the shares or share options at the measurement date. Instead, vesting conditions shall be taken into account by adjusting the number of equity instruments included in the measurement of the transaction amount so that, ultimately, the amount recognised for goods or services received as consideration for the equity instruments granted shall be based on the number of equity instruments that eventually vest. Alternative 1 According to alterative 1, on 1 July 2012, 2.4 million share options are granted to the general manager conditional upon him completing three years future service. Thus the whole lot of 2.4 million share options will be granted at the end of the three-year period. In other words, at the end of year 1 (30 June 2013), 1/3 of the vesting period is passed and thus 1/3 of the share-based compensation expense 14

15 should be recognised: Share-based compensation expense for the year ended 30 June 2013: = (2.4 million / 3) x $9 = $7.2 million At the end of year 2 (30 June 2014), 2/3 of the vesting period is passed and thus a total of 2/3 of the share-based compensation expense should be recognised as at 30 June However, the $7.2 million share-based compensation expense recognised for the year ended 30 June 2013 should be deducted. Hence: Share-based compensation expense for the year ended 30 June 2014: = (2.4 million x 2/3 x $9) - $7.2 million = $14.4 million - $7.2 million = $7.2 million Alternative 2 For alternative 2, one-third of the awarded share options shall become vested at the end of each anniversary from the date of grant. Therefore, it is expected that 1/3 of the 2.4 million will be granted at the end of year 1 (30 June 2013). In addition, for the 1/3 that is expected to be granted at the end of year 2 (30 June 2014), half of the vesting period has been completed. For the 1/3 that is expected to be granted at the end of year 3 (30 June 2015), 1/3 of the vesting period has been completed. Hence: Share-based compensation expense for the year ended 30 June 2013: = (2.4 million / 3 x $9) + [(2.4 million / 3 x $9) / 2] + [(2.4 million / 3 x $9) / 3] = $7.2 million + $3.6 million + $2.4 million = $13.2 million At the end of year 2 (30 June 2014), 2/3 of the vesting period is passed and thus a total of 2/3 of the share-based compensation expense should be recognised as at 30 June Moreover, for the 1/3 that is expected to be granted at the end of year 3 (30 June 2015), 2/3 of the vesting period has been completed. However, the $13.2 million share-based compensation expense recognised for the year ended 30 June 2013 should be deducted. Hence: Share-based compensation expense for the year ended 30 June 2014: = (2.4 million/3x$9) + (2.4 million/3 x $9) + [(2.4 million/3 x $9) x 2/3] - $13.2 million = $7.2 million + $7.2 million + $4.8 million - $13.2 million = $6 million 15

16 4. The following income statement and statement of financial position relate to Fortune Limited: Income statement for the years ended 31 March 2011 and 31 March ($m) 2012 ($m) Turnover 3,740 3,000 Cost of sales (2,980) (2,360) Gross profit Administrative expenses (490) (490) Finance costs - (20) Profit before tax Dividends paid for the years ended 31 March 2011 and 31 March 2012 are $80 million and $90 million respectively. There is no disposal of furniture and equipment during the year ended 31 March Depreciation of furniture and equipment for the year ended 31 March 2012 amounts to $90 million. Statement of financial position as at 31 March 2011 and 31 March ($m) 2012 ($m) Non-current assets Furniture and equipment (net) Current assets Inventory 1,400 1,000 Accounts receivable Cash Current liabilities Accounts payable (1,300) (350) Total assets less current liabilities 1,360 1,850 Share capital 1,000 1,200 Reserves Total equity 1,360 1,600 Debentures ,360 1,850 REQUIRED: 4. (a) Prepare the statement of cash flows of Fortune Limited for the year ended 31 March

17 Ans (a) Statement of cash flows of Fortune Limited for the year ended 31 March $m Operating activities Profit before tax 130 Adjustment for: Interest expense 20 Depreciation 90 Operating cash flow before working capital changes 240 Decrease in inventory 400 Decrease in accounts receivable 200 Decrease in accounts payable (950) Cash (used) in operations (110) Interest paid (20) Net cash (used in) operating activities (130) Investing activities Purchase of furniture and equipment ((360-90)-->500) (230) Financing activities Issue of share capital 200 Issue of debenture 250 Dividend paid (90) Net increase (decrease) in cash and cash equivalent Cash and cash equivalent at beginning of the year 200 Cash and cash equivalent at end of the year (b) Compute the quick ratio, current ratio, net profit margin, total asset turnover, and return on capital employed of Fortune Limited for both years. (Round your answers to two decimal places.) Ans (b) Ratios Quick ratio = Quick assets / Current liabilities 2011: ( ) / 1,300 = : ( ) / 350 = 2.00 Current ratio = Current assets / Current liabilities 2011: (1, ) / 1,300 = : (1, ) / 350 = 4.86 Net profit margin = profit before tax / sales 2011: 270 / 3,740 = 7.22% 2012: 130 / 3,000 = 4.33% 17

18 Total asset turnover = sales / total assets 2011: 3,740 / (360+1, ) = : 3,000 / (500+1, ) = 1.36 Return on capital employed = profit before tax / total assets less current liabilities 2011: 270 / 1,360 = 19.85% 2012: 130 / 1,850 = 7.03% 4. (c) Evaluate Fortune Limited s liquidity and profitability based on the accounting ratios as calculated in (b). Ans (c) Liquidity and profitability The liquidity ratios reveal that the liquidity position of Fortune Limited is improving. There is an increase in the current ratio which is mainly due to a major cut in current liabilities. During the year ended 31 March 2012, inventory and accounts receivable have been reduced by $400 million and $200 million respectively. In addition, ordinary share capital and debentures were issued yielding cash of $200 million and $250 million respectively. It appears that a substantial part of these cash resources have been used to reduce accounts payable considerably. However, the assets turnover ratio has declined which indicates that there is no optimum utilisation of non-current assets in the year ended 31 March Purchases of furniture will have reduced the assets turnover as has the drop in sales. The net profit margin has been weakened by probably the heavy administrative expenses and the drop in turnover during the year ended 31 March Administrative expense is the same for both years, $490m, but in the year ended 31 March 2012 the company suffered an addition of finance costs. The lower net profit margin is also reflected in the return on capital employed which has shrunk to a low level. Return on capital employed has decreased considerably which indicates the under-utilisation of capital. The fall in the inventory level may indicate that the level of inventory has been checked to avoid unnecessary accumulation of inventory. The inventory to sales ratio has reduced from 37.4% (1,400/3,740) for 2011 to 33.3% (1,000/3,000) for 2012 which indicates a slight reduction in the accumulation of inventory. 18

19 5. Lung Shing Limited (LSL) is a manufacturer of balloons. In an effort to expand its production capacity, the company recently made several acquisitions of plant and equipment: Transaction 1 On 1 April 2011, LSL purchased equipment from Venus Limited. A $2,400,000 non-interest-bearing note was issued to Venus for the new equipment. LSL will pay off the note in 3 equal installments due at the end of each of the next 3 years. At the date of the transaction, the prevailing market rate of interest for obligations of this nature was 8%. In addition, freight costs of $85,000 and installation costs of $100,000 were incurred in completing this transaction. The factors for the time value of money at an 8% rate of interest are given below. Future value of $1 for 3 periods 1.26 Future value of an ordinary annuity for 3 periods 3.25 Present value of $1 for 3 periods 0.79 Present value of an ordinary annuity for 3 periods 2.58 Transaction 2 On 1 December 2011, LSL purchased several assets of a small balloon manufacturer whose owner was retiring. The purchase amounted to $4,200,000 and included the assets listed below. LSL has engaged the services of an independent appraiser to determine the fair market values of the assets which are also presented below. Book value Fair market value $ $ Inventory 1,200,000 1,000,000 Land 800,000 1,600,000 Building 1,400,000 2,400,000 3,400,000 5,000,000 During its year ended 31 March 2012, LSL incurred $160,000 for interest expense in connection with the financing of these assets. REQUIRED: 5. (a) For each of the two transactions described above, determine the value at which LSL should record the acquired assets. Support your calculations with an explanation of the underlying rationale. 19

20 Ans (a) Transaction 1 According to paragraph 23 of HKAS 16 Property, Plant and Equipment, the cost of an item of property, plant and equipment is the cash price equivalent at the recognition date. If payment is deferred beyond normal credit terms, the difference between the cash price equivalent and the total payment is recognised as interest over the period of credit unless such interest is recognised in the carrying amount of the item capitalised in accordance with HKAS 23 (Revised) Borrowing Costs. Therefore, to properly reflect the cash price, assets purchased on deferred payment contracts should be accounted for at the present value of the consideration exchanged between the contracting parties at the date of the consideration. In this case, since no interest rate is stated, interest should be imputed at a rate that approximates to the rate that would be negotiated in an arm s-length transaction (the prevailing market rate of interest). The cost of property, plant and equipment includes any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. Therefore, the freight costs and installation costs necessary to ready the asset for its intended use should be considered to be costs of the asset. Asset cost = Present value of the note + Freight + Installation = $2,400,000/3 x $85,000 + $100,000 = $2,064, ,000 = $2,249,000 Transaction 2 The lump-sum purchase of a group of assets should be accounted for by allocating the total cost among the various assets on the basis of their relative fair market values. However, the $160,000 of interest expense incurred for financing the purchase is only a period cost and it should not be included in determining the asset cost. Therefore the value of the inventory, land and building should be recorded as: Inventory $4,200,000 X (1,000,000/5,000,000) = $ 840,000 Land $4,200,000 X (1,600,000/5,000,000) = $ 1,344,000 Building $4,200,000 X (2,400,000/5,000,000) = $ 2,016,000 $ 4,200,000 20

21 5. (b) The books of LSL show the following additional transactions for the year ended 31 March 2012: 1. Purchase of a three-year insurance policy covering the plant and equipment. 2. Purchase of the rights for the exclusive use of a process used in the manufacture of balloons. For each of these transactions, analyse and identify whether the asset should be classified as a property, plant and equipment. If not, indicate the proper classification. Ans (b) Property, plant and equipment are defined in HKAS 16 as tangible items that: are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and are expected to be used during more than one period. Three-year insurance policy The three-year insurance policy covering plant equipment is not an item of property, plant and equipment as it is not long-term in nature and has no physical substance. This insurance policy is more appropriately classified as a current asset (prepaid insurance). Rights for the exclusive use of a process The rights for the exclusive use of a process used in the manufacture of balloons are not property, plant and equipment as they have no physical substance. The rights should be classified as an intangible asset. 21

22 6. In a board meeting of the Pineapple Limited (PAP), the financial controller and the sales director had a severe argument on the accounting treatment of a transaction. The financial controller insisted that in assessing whether an item meets the definition of an asset, liability or equity, attention needs to be given to its underlying substance and economic reality and not merely its legal form. The following information relates to the transaction in question: On 1 April 2011, PAP had an inventory of timber which was bought at a cost of $24 million on 1 April Due to shortages of this quality of timber, its value at 1 April 2011 had risen to $40 million. It will be a further three years before this timber is sold to a manufacturer of high-class furniture. On 1 April 2011, PAP entered into an arrangement selling the timber to Kowloon Bank for $30 million. In accordance with the arrangement, PAP has an option to buy back the timber at any time within the next three years at a cost of $30 million plus accumulated interest at 10% compounded per annum. This will be charged from the date of the original sale. PAP intends to buy back the timber on 31 March 2014 and sell it the same day for an expected price of $50 million. Assume that any storage costs and capitalisation of interest that may relate to inventory can be ignored. REQUIRED: 6. (a) Critically evaluate the requirement that attention needs to be given to the underlying substance and economic reality of an item and not merely its legal form. Illustrate with an example. Ans (a) Reflecting substance over legal form The Conceptual Framework for Financial Reporting 2011 specifies that in assessing whether an item meets the definition of an asset, liability or equity, attention needs to be given to its underlying substance and economic reality and not merely its legal form. The framework quotes as an example that, in the case of finance leases, the substance and economic reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of its useful life in return for entering into an obligation to pay for that right an amount approximating to the fair value of the asset and the related finance charge. Hence, the finance lease gives rise to items that satisfy the definition of an 22

23 asset and a liability and are recognised as such in the lessee s statement of financial position. For financial statements to be useful, they must faithfully represent PAP s underlying transactions. Faithful representation means that financial information represents the substance of an economic phenomenon rather than merely representing its legal form. Representing a legal form that differs from the economic substance of the underlying economic phenomenon does not result in a faithful representation. 6. (b) Assuming that the above transactions take place as expected, prepare extracts of the income statement of PAP for each of the three years to 31 March 2014: (i) to reflect the legal form of the transaction; and (ii) to reflect the substance of the transaction. Ans (b) Extracts from the income statements (i) To reflect the legal form: If the legal form is reported, sales take place in 2011 and the repurchase in Extracts from income statements for the year ended 31 March Total $000 $000 $000 $000 Sales 30,000 nil 50,000 80,000 Cost of sales (24,000) (nil) (39,930) (63,930) Gross profit 6,000 nil 10,070 16,070 (ii) To reflect the substance: If the substance is reported, both sales and the repurchase take place in Extracts from income statements for the year ended 31 March Total $000 $000 $000 $000 Sales nil nil 50,000 50,000 Cost of sales (nil) (nil) (24,000) (24,000) Gross profit nil nil 26,000 26,000 Interest 10% (3,000) (3,300) (3,630) (9,930) Net profit (3,000) (3,300) 22,370 16,070 23

24 6. (c) Analyse the impact of the two treatments on the income statements and the statements of financial position and the impact on the assessment of PAP s performance. Ans (c) It can be seen from the above that the two treatments have no effect on the total net profit reported in the income statements. However, the profit is reported in different periods and the classification of costs is different. If we reflect the substance, the company shows losses in the years ended 31 March 2012 and 2013 and a substantial profit in There is no element of profit smoothing. Interest is also charged to the income statement, and inventory and a loan appear on the statement of financial position. However, if we report only the legal form, this creates some element of profit smoothing and completely hides the financing cost. The effect on the statements of financial position is that recording the legal form of the transaction does not show the inventory, nor does it show the in-substance loan. Thus recording the legal form here is an example of off-balance sheet financing. Recording the legal form rather than the substance of the transaction, PAP s financial statements would show a higher interest cover and inventory turnover and a lower gearing ratio, which may be misinterpreted as showing a more favourable performance than is actually the case. END 24