SECTION A CASE QUESTIONS (Total: 75 marks) Answer 1(a)

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1 SECTION A CASE QUESTIONS (Total: 75 marks) Answer 1(a) The required return of a stock ( Rs ) consists of two components, the capital gains yield and the dividend yield based on the constant dividend growth model: Rs = D1/P0 + g Where: D1 is the dividend per share in Year 1 P0 is the current stock price g is the expected annual growth in dividend payments Dividend per share (D0) = (Net income Payout ratio) / Shares outstanding Dividend per share (D0) = (HK$100,000, ) / 12,500,000 Dividend per share (D0) = HK$2.00 So: Rs = D1/P0 + g Rs = 2 x ( )/ Rs = or 13.95% Answer 1(b) The cost of debt is 5%. Market value of equity or MV(S) = 38 x 12.5M = HK$475M Market value of debt or MV(B) = HK$50M Market value of debt and equity or MV(Assets) = HK$525M WACC = 475/525 x 13.95% + 50/525 x 5% x (1-16.5%) WACC = 12.62% + 0.4% WACC = 13.02% Where M stands for million. Final Examination (December 2015 Session) Paper I 1 of 13

2 Answer 1(c) Working: Year 1 Year 2 Year 3 Year 4 sale quantity 2,000 2,200 2,420 2,662 selling price $2,500 $2,500 $2,500 $2,500 fixed cost per unit $800 $800 $800 $800 capital spending/ recoup $(6,000,000) $1,000,000 warehouse cost $(2,000,000) $2,000,000 revenue $5,000,000 $5,500,000 $6,050,000 $6,655,000 variable cost $1,600,000 $1,760,000 $1,936,000 $2,129,600 fixed cost $2,000,000 $2,000,000 $2,000,000 $2,000,000 depreciation $1,250,000 $1,250,000 $1,250,000 $1,250,000 earnings before tax $150,000 $490,000 $864,000 $1,275,400 tax $24,750 $80,850 $142,560 $210,441 earnings after tax $125,250 $409,150 $721,440 $1,064,959 operating cash flow $1,375,250 $1,659,150 $1,971,440 $2,314,959 Incremental cash flow $(8,000,000) $1,375,250 $1,659,150 $1,971,440 $5,314,959 Remark: Capital spending at Year 4 (After-tax salvage value of the machine at end of Year 4) = market value (book value residual value) x tax rate = HK$1,000,000 - (HK$1,000,000 - HK$1,000,000) x 16.5% = HK$1,000,000 Final Examination (December 2015 Session) Paper I 2 of 13

3 Answer 1(d) Discount rate = WACC + risk adjustment on discount rate for the project = 13.02%(WACC) % = 15.27% NPV = (HK$1,260,606.63) so it should not accept the project. Incremental cash flow (Year 0 to Year 4) $(8,000,000) $1,375,250 $1,659,150 $1,971,440 $5,314,959 Answer 1(e) The statement is incorrect. If a firm has debt, it is advantageous to shareholders of the firm to undertake risky projects, even if those have negative net present values because some of the risk of project failure is borne by bondholders. So, the value is transferred from the bondholders to the shareholders by undertaking risky projects, even though the projects have negative NPVs. This incentive is stronger for the shareholders when the probability and costs of bankruptcy are high. Answer 2 Date: xx xx xx To: xxx Directors, Kinetic From: xxx Financial Controller, Kinetic Subject: Accounting treatment and financial impact on equity investments In accordance to HKFRS 9 Financial Instruments ( HKFRS 9 ), the equity investment shall be measured initially and subsequently at fair value as it is not a financial asset with contractual terms which give rise on specific dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Our Company has the option to make an irrevocable election under HKFRS 9 at the initial recognition to measure the equity investment at fair value through other comprehensive income. If so, the gain or loss arising from fair value of the equity investment shall be in other comprehensive income. Final Examination (December 2015 Session) Paper I 3 of 13

4 We propose not to opt for the election in view of the size of investment relative to our annual profit of nearly HK$100 million (case information). Without such election, the gain or loss arising from the fair value change of the equity investment of HK$400,000 shall be recognised in profit or loss for the year ended 31 December Since the equity investment had been measured at fair value, no further impairment review should be performed as at 31 December Answer 2 Alternative Answers Date: xx xx xx To: xxx Directors, Kinetic From: xxx Financial Controller, Kinetic Subject: Accounting treatment and financial impact on AFS equity investments HKAS 39 Financial Instruments: Recognition and Measurement, A significant or prolonged decline in the fair value of an investment in an equity instrument below its cost is also objective evidence of impairment. The meanings of significant or prolonged are interpreted as below: (iii) either a significant or prolonged decline is sufficient to require the recognition of an impairment loss. the fact that the decline in the value of an investment is in line with the overall level of decline in the relevant market does not mean that an entity can conclude the investment is not impaired. the existence of a significant or prolonged decline cannot be overcome by forecasts of an expected recovery of market values, regardless of their expected timing. Consequently, an anticipated market recovery is not relevant to the assessment of significant or prolonged. Based on the background information, it is not sufficient to conclude whether the sustained decline in fair value is prolonged or not. However, there is a 70% decline in the original cost in this case. This is considered as a significant decline in the fair value so that it is the objective evidence of impairment. The cumulative loss of HK$350,000 (HK$400,000 HK$50,000) that had been recognised in other comprehensive income shall be reclassified from equity to profit or loss. Remark: The determination of what constitutes a significant or prolonged decline is a matter of judgment that requires the application of judgment rather than an accounting policy choice. Hence we should disclose the judgment made in determining the objective evidence of impairment. Final Examination (December 2015 Session) Paper I 4 of 13

5 Answer 3(a) In order to test for impairment of goodwill, it is required to make a formal estimate of the recoverable amount of the cash-generating units for which goodwill has been allocated. The cash-generating units ( CGU ) to which the goodwill is allocated, from the acquisition date, should represent the lowest level within the entity at which the goodwill is monitored for internal management purposes and not be larger than an operating segment as defined by HKFRS 8 Operating Segments. Since Kinetic s management monitors the operation and performance of the Group by its operating segments, goodwill of HK$5 million arising from the acquisition of Sub A should be allocated to the two segments (i.e. the electronics segment and entertainment segment) acquired in Impairment testing is required at each reporting date for the CGU to which goodwill has been allocated when there is an indication of possible impairment and when goodwill is tested for impairment in the annual mandatory impairment testing. The recurring loss from the electronics segment may be an indicator of impairment. Hence, the management should compare the carrying amount of the unit (which is the electronics segment), including the goodwill, with the recoverable amount of the unit. If the carrying amount of the unit exceeds the recoverable amount of the unit, the management shall recognise the impairment loss. For the goodwill which has arisen from the acquisition of HK Co, goodwill should, from the acquisition date, be allocated to Kinetic s cash-generating unit that is expected to benefit from the synergies of the combination, irrespective of whether other assets or liabilities of the acquiree are assigned to that unit. As a result of the development of the smart glasses product, the management will unify the product development teams of Sub A and HK Co and these constitute one single CGU thereafter. The HK$2.85 million goodwill which arose from the acquisition of HK Co should be combined with the goodwill which arose from the acquisition of the electronics segment for impairment assessment. Although HK Co did not generate any profits as at the date of acquisition, the management of Kinetic Group should prepare the estimated future cash flow expected to be derived from the CGU in the electronics segment on a consolidated basis so as to determine the recoverable amount based on a value in use calculation. The cash flow projections should be based on the most recent financial budgets/forecasts approved by the management and cover a maximum of 5 years. As a result, before concluding whether there is any impairment of goodwill, the Group should review the estimated future cash flows to assess the feasibility of the forecast as well as the reasonableness of those assumptions adopted in the forecast. Final Examination (December 2015 Session) Paper I 5 of 13

6 Answer 3(b) Impairment should be tested by comparing the carrying amount of the cash generating unit ( CGU ), including the goodwill, with the recoverable amount of the unit. In accordance with HKAS 36 Impairment of Assets, if the non-controlling interest is measured at its proportionate interest in the net identifiable assets of a subsidiary at the acquisition date, rather than at fair value, the carrying amount of goodwill allocated to the CGUs should be grossed up to include the goodwill attributable to the non-controlling interest. As per the background information, the non-controlling interest is measured at its proportionate interest in the net identifiable assets of a subsidiary at the acquisition date, as a result, the goodwill is grossed up by HK$350,000. The adjusted amount of goodwill should be HK$3.2 million (HK$2.85 million / 90%), aggregated in the carrying value of the CGU and compared against the recoverable amount of the CGU. Answer 3(c) Since there is no historical track record for the revenue of HK Co, the projection of cash flows used in the forecast is merely based on the management s best estimate. We have to evaluate the management s estimates based on external evidence. For example: Whether the price set for the smart glasses is within the price range set by its competitors. Compare the market price of the warehouse with reference to the sale transaction prices of similar properties. Consider whether there is any existing sales order to support the sales forecast. Discuss with the management to assess whether the production capacity is sufficient to support the demand from sales. Compare the discount rates and re-perform the discount rate calculation. Answer 4(a) For internally generated intangible assets, we should distinguish between two phases, namely the research phase and the development phase. Capitalisation of development costs is only permitted during the development phase if the entity is able to demonstrate all six conditions as set out in HKAS 38 Intangible Assets. If it is not possible to distinguish the research phase from the development phase, the expenditure on the project is treated as relating only to the research phase and should be recognised in profit or loss. Final Examination (December 2015 Session) Paper I 6 of 13

7 Hence, we should understand the nature of the labour cost of HK$100,000 to justify which phases they are referring to. Based on the information provided, as the smart glass project is still in the research phase since different alternatives of materials used in the new smart glasses product are still under consideration, the labour cost of HK$100,000 was incurred for the preliminary stage of product development and not attributable to the development phase. Future economic benefits may not be generated directly by this labour cost. Also, such expenditure did not arise from any contractual right. As a result, the labour cost should not be recognised as an asset of HK Co. Instead, it should be expensed in the period in which it was incurred (i.e. in the 2014 financial statement) in accordance with HKAS 19 Employee Benefits. Answer 4(b) Nature We need to understand the nature of the items capitalised and determine whether they should be capitalised according to the accounting framework. Control versus substantive We need to understand whether the management has any control in approving the research and development activities and ensure they have been properly recognised. Based on the evaluation of the effectiveness of the controls, we need to decide the level of substantive procedures that we have to perform to address the relevant assertions. Disclosure requirements The capitalisation of research and development costs as intangible assets may have to be disclosed in the notes to the financial statements according to the accounting framework. Audit procedures have to be designed to address the assertions of presentation and disclosure for the research and development costs. Answer 5(a) It is unlikely to be appropriate for Kinetic to aggregate these two operating segments into a single reportable segment because the aggregation criteria in HKFRS 8 Accounting Policies, Changes in Accounting Estimates and Errors are not fully satisfied. The aggregation criteria require similar economic characteristics, similar products and a similar type or class of customer. As the management report and the chairman s report described different economic characteristics, product types and customer demographics, and stressed some important distinctions between these two segments, accordingly HKFRS 8 may not be fully satisfied. Final Examination (December 2015 Session) Paper I 7 of 13

8 Answer 5(b) HKSA 501 (Clarified) Audit Evidence Specific Considerations for Selected Items requires the auditor to obtain sufficient appropriate audit evidence regarding the presentation and disclosure of segment information in accordance with the applicable financial reporting framework. Audit procedures include: (iii) obtain an understanding of the methods used by management in determining segment information; evaluate whether such methods are likely to result in disclosure in accordance with HKFRS and where appropriate, test the application of such methods; and perform analytical procedures or other audit procedures, such as checking to underlying supporting documents. Answer 6 Under the new Hong Kong Companies Ordinance, the directors are required to include a business review in the directors report in order to provide additional information for members and to help them to assess how the directors have performed their duties. The business review will include a review of the company s business during the fiscal year, the principal risks and uncertainties the company is facing, significant events after the reporting period and the likely future development of the company s business. Specific exemptions to include in a business review in the directors report: (iii) companies falling within the reporting exemption as per s.359 of Part 9 Reporting Exemption for the financial year; companies that are wholly-owned subsidiaries of another body corporate; and private companies whose shareholders passed a special resolution not to prepare the business review. In this case, if HK Co is not a company falling within the reporting exemption, an exemption can be obtained by a special resolution to be passed by members with at least 75% of the vote, and at least 6 months before the end of the financial year (i.e. 30 June 2015). Final Examination (December 2015 Session) Paper I 8 of 13

9 Answer 7(a) HKSA 320 (Clarified) Materiality in Planning and Performing an Audit requires an auditor to determine at least two types of materiality in planning an audit: materiality for the financial statements as a whole to establish the overall audit strategy; and performance materiality to assess the risks of material misstatement and to determine the nature, timing and extent of further audit procedures. Answer 7(b) A proposed materiality based on professional judgment for the financial statements as a whole for HK Co could be as follows: Benchmarks % Justifications Total expenses 0.5%-2% The company is in the initial start-up stage and the business has not yet commenced for the year under audit and only expenses have been incurred. The users will be concerned as to whether the expenses have been properly approved and recognised and thus it is used as a benchmark to determine materiality. Net assets 0.5%-2% The company is engaged in research and development. There is significant investment in fixed assets and capitalisation of the development cost. Funding of the company is mainly coming from bank loans. Investors may focus on its net assets. Thus it is a suitable benchmark that can be used to determine the materiality. Answer 7(c) HKSA 600 (Clarified) Special Considerations Audits of Group Financial Statements states that to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in the group financial statements exceeds materiality for the group financial statements as a whole, component materiality shall be lower than materiality for the group financial statements as a whole. Thus, the materiality of HK Co must be lower than the one used for the audit of the consolidated financial statements of Kinetic Group. The determination of materiality is based on an auditor s professional judgment. Final Examination (December 2015 Session) Paper I 9 of 13

10 Since Kinetic is a profit-oriented entity, it is likely that 5% of profit before tax will be used to determine materiality for the audit of its consolidated financial statements. A proposed approach for the materiality of the financial statements could be as follows: Materiality of Kinetic Group = HK$110 million x 5% = HK$5,500,000 Materiality of HK Co (based on total expenses) = HK$6 million x 2% = HK$120,000 Materiality of HK Co (based on net assets) = HK$0.5 million x 2% = HK$10,000 As the materiality calculated for the audit of the financial statements of HK Co is lower than that of Kinetic Group as a whole, the materiality of HK Co is acceptable in the context of the audit of Kinetic s consolidated financial statements. * * * END OF SECTION A * * * Final Examination (December 2015 Session) Paper I 10 of 13

11 SECTION B ESSAY QUESTIONS (Total: 25 marks) Answer 8 The gain on disposal of Hong Kong securities of SIP is taxable under s.14(1) of the IRO provided: (iii) SIP carries on a business in Hong Kong; The gain from the disposal is arising in or derived from Hong Kong; and The gain is not capital in nature. For condition, SIP is considered to be carrying on a business in Hong Kong because SIP bought and sold Hong Kong securities frequently through Best Price Limited as its agent in Hong Kong. When the listed securities are bought and sold on the Hong Kong Stock Exchange, Best Price Limited would execute the transactions on behalf of SIP so Best Price Limited is regarded as an agent of SIP. Accordingly, no matter how minimal the activities Mr Hui performed in Hong Kong, SIP would still be considered to be carrying on a business in Hong Kong. For condition, the definition of arising in or derived from Hong Kong under s.2 of the IRO includes all profits from business transacted in Hong Kong whether directly or through an agent. Under DIPN 21 Locality of Profits, the source of gains from the disposal of listed securities is where the stock exchange of the securities are traded. Accordingly, the source of the gains in question is Hong Kong as the Hong Kong Stock Exchange is where the listed securities are traded. For condition (iii), the gain in question will very likely be regarded as revenue in nature for the following reasons: The incorporation document of SIP states that the objective is to realise a profit from the rolling over of the investment portfolio, implying that the firm would not hold shares for long-term investment purposes. The incorporation document of SIP states that no single share would be held for more than 2 years, i.e. a short period of ownership. Accordingly, provided no specific tax exemption applies, SIP s gain on disposal of listed securities is taxable in Hong Kong under s.14(1) of the IRO as all three conditions stated above are satisfied. Final Examination (December 2015 Session) Paper I 11 of 13

12 Answer 9 S.20AC exempts SIP from Hong Kong profits tax provided the following conditions are satisfied: (iii) SIP is a non-resident in Hong Kong; the transaction is a specified transaction in Schedule 16; and the transaction has been carried out by a specified person, i.e. a corporation licensed or a financial institute registered under the Securities and Futures Ordinance. For, since the board of directors meetings of SIP are generally held in Singapore, SIP is not a resident in Hong Kong. For, trading of listed securities in Hong Kong is generally a specified transaction in Schedule 16. For (iii), Best Price Limited, a licensed broker, is generally recognised as a specified person for the purpose of s.20ac. Accordingly, s.20ac should generally operate to exempt the disposal gain of SIP from Hong Kong profits tax. Answer 10 For HK Co, the share based payment in relation to share options is deductible under s.16(1) as the following conditions are satisfied: (iii) the amount was incurred as HK Co has an obligation to pay Kinetic; the amount is a staff benefit to HK Co for the production of future assessable profits. It does not matter that HK Co may not have any income in the first year for the amount to be deductible; and the share based payment is not capital in nature under s.17(1)(c) as there is no enduring benefit created upon the payment. For Kinetic, the share based payment is not deductible. Regardless of whether the equity instruments granted vest immediately or not, the expense recognised for accounting purposes in an equity-settled share based payment transaction is not an outgoing or expense incurred for the purpose of s.16 of the IRO. According to Lowry v Consolidated African Selection Trust Ltd. [1940] 23 TC 259, when an entity fulfils its obligations by issuing its own new shares, the share issue merely involves a movement in the entity s equity reserve account, and not an outgoing or expense for the purpose of s.16(1) of the IRO. Final Examination (December 2015 Session) Paper I 12 of 13

13 Answer 11 Since Mr Hui fulfilled his director s duties in Hong Kong, his income came from an office as opposed to an employment. Under McMillan v Guest (1942) 24 TC 190, it was held that the office of director is located at the place where the central management and control of the company is located. This is usually the place where the board of directors meetings are held. Since SIP s board of directors meetings were held in Singapore, the source of income from the office of Mr Hui was outside of Hong Kong. There is, however, an argument that the source of a director s fee is where the employer s real business is carried on as opposed to where the meetings of directors are held according to Board of Review case no. D21/13. As SIP trades HK listed shares, it may be argued to have a business in Hong Kong. This is not a strong argument as SIP only trades through a brokerage firm in Hong Kong. There is no provision under the IRO allowing an apportionment of the income from an office. Although s.9(1)(d) deems the gain realised by the exercise of share options to be income from an office, such income to Mr Hui is sourced outside Hong Kong and is not taxable because the source of the income is outside of Hong Kong. * * * END OF EXAMINATION PAPER * * * Final Examination (December 2015 Session) Paper I 13 of 13