HKFRS 3 further defines a business combination as a transaction or other event in which an acquirer obtains control of one or more businesses.

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1 SECTION A CASE QUESTIONS (Total: 75 marks) Answer 1(a) Under HKFRS 3, a business combination requires that the assets acquired and liabilities assumed constitute a business. If the assets acquired are not a business, the reporting entity shall account for the transaction or other event as an asset acquisition. HKFRS 3 further defines a business combination as a transaction or other event in which an acquirer obtains control of one or more businesses. Although the customer base and trade receivables have not been acquired by the Group, Dim Sum is operating the food factory, it represents an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividend, lower costs or other economic benefits directly to owners, accordingly the food factory itself constitutes a business while Yummy Holdings is able to control it upon acquisition. Hence, the acquisition of Dim Sum is considered as a business combination. Answer 1(b)(i) Business combination is accounted for using the acquisition method. As of 30 September 2014, the Group shall recognise, separately from goodwill, the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree. The identifiable assets acquired and liabilities assumed should be measured at fair value at the acquisition date. The Group shall recognise and measure a deferred tax asset or liability arising from the assets acquired and liabilities assumed in a business combination in accordance with HKAS 12 Income Taxes. The difference between the carrying amount of a revalued asset and its tax base is a temporary difference and gives rise to a deferred tax liability or asset. A temporary difference may arise on initial recognition of an asset or liability, if part or all of the cost of an asset will not be deductible for tax purposes. Consequently, those deferred tax assets and deferred tax liabilities affect the amount of goodwill or the bargain purchase gain the Group recognises. However, an entity does not recognise deferred tax liabilities arising from the initial recognition of goodwill. Final Examination (June 2015 Session) Paper I 1 of 16

2 The consideration transferred in a business combination is measured at fair value, which is calculated as the sum of the acquisition-date fair values of the assets transferred by the Group, liabilities incurred by the Group to the former owners of the acquiree and the equity interests issued by the Group. Goodwill is measured as the excess of the sum of the consideration transferred, the amount of any non-controlling interests in the acquiree and the fair value of the acquirer s previously held equity interest in the acquiree (if any) over the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed. If the net of the acquisition-date amounts of the identifiable assets acquired and liabilities assumed exceeds the sum of the consideration transferred, the amount of any non-controlling interests in the acquiree and the fair value of the acquirer s previously held interest in the acquiree (if any), the excess is recognised as gain on bargain purchase in profit or loss on the acquisition date. Goodwill arising on an acquisition of a business is carried at cost at the date of acquisition of the business less accumulated impairment losses, if any. According to HKAS 36, for the purposes of impairment testing, goodwill is allocated to each of the Group s cash-generating units. The management should assess any impairment on the goodwill as at 30 September A cash-generating unit to which goodwill has been allocated shall be tested for impairment annually, and whenever there is an indication that the unit may be impaired, by comparing the carrying amount of the unit, including the goodwill, with the recoverable amount of the unit. If the recoverable amount of the unit exceeds the carrying amount of the unit, the unit and the goodwill allocated to that unit shall be regarded as not impaired. If the carrying amount of the unit exceeds the recoverable amount of the unit, the entity shall recognise the impairment loss in profit or loss. The acquisition-related costs should be expensed as they are incurred. Final Examination (June 2015 Session) Paper I 2 of 16

3 Calculation: At 30 September 2014: Consideration transferred: HK$ 000 Cash 15,000 Ordinary shares [5 million 6,500 Convertible bonds 10,000 31,500 Assets acquired and liabilities recognised at the date of acquisition are as follows: HK$ 000 Property, plant and equipment 11,670 Intangible assets 3,250 Inventories 724 Other receivables 2,190 Bank balances and cash 6,637 Trade and other payable (2,483) Deferred tax liabilities [Note] (1,398) 20,590 [Note] [(HK$11,670k-HK$9,329k)+HK$3,250k]*25% = HK$1,398k or HK$1,397,750 Goodwill arising on acquisition: HK$ 000 Consideration transferred 31,500 Less: Net assets acquired (20,590) Goodwill arising on acquisition [Or HK$10,909,750] 10,910 Answer 1(b)(ii) The management should perform impairment testing on the cash-generating unit of which the goodwill is allocated pursuant to HKAS 36 even if the business combination is completed during 31 December The Group should compare the carrying amount of the food factory, including the goodwill, with the recoverable amount and consider if any impairment is necessary. The management of Yummy Holdings may perform the annual impairment test at any time during an annual period, provided the test is performed at the same time every year. Different cash-generating units may be tested for impairment at different times, however, the test must be carried out before the end of the current annual period (i.e. 31 December 2014). Final Examination (June 2015 Session) Paper I 3 of 16

4 Answer 1(b)(iii) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - extract On 30 September 2014, the Group acquired the entire registered capital of Dim Sum Manufacturing Company Limited ( DSM ) from an independent third party for a total consideration of approximately HK$31.5 million. The total consideration has been settled by cash of HK$15 million, the issue of 5 million ordinary shares 1 and the issue of convertible bonds of the Company with a principal amount of HK$10 million. The acquisition has been accounted for using the purchase method. DSM operates a food factory in Dongguan in the People s Republic of China (the PRC ) producing mainly dim sum products. DSM was acquired so as to maintain a stable supply of dim sum products to the restaurants operated by the Group and to continue the expansion of restaurants in Southern China in the near future. Acquisition-related costs amounting to HK$1.28 million have been recognised during the year 2. The carrying values of the assets acquired and liabilities recognised at the date of acquisition approximate to their fair value. 3 Included in the revenue and profit for the year of the Group were approximately HK$8,260,000 and HK$549,000 respectively, which represent the revenue and profit of DSM generated from the date of acquisition to 31 December The goodwill carried in the consolidated statement of financial position solely arose from the acquisition of DSM which is engaged in manufacturing dim sum products in the PRC. The goodwill is attributable to the acquisition of DSM 5. The business of DSM is integrated into the Group s food manufacturing and restaurant operations and accordingly the cash generating unit ( CGU ) for the purpose of impairment testing of goodwill. During the year ended 31 December 2014, the management of the Group has determined that there is no impairment on the goodwill arising from the acquisition of DSM as the recoverable amount of DSM (being the CGU to which the goodwill has been allocated) is in excess of the aggregate carrying amounts of the CGU. 6 Comments: (1) HKFRS 3 where equity interests of the acquirer are issued as part of the consideration, we should disclose the number of instruments or interests issued or issuable and the method of determining and measuring the fair value of those instruments or interests. (2) HKFRS 3 for the acquisition-related costs, we should disclose separately the amount of those costs recognised as an expense and the line item or items in the statement of comprehensive income in which those expenses are recognised. Final Examination (June 2015 Session) Paper I 4 of 16

5 (3) HKFRS 3 The acquirer shall measure the identifiable assets acquired and the liabilities assumed at their acquisition-date fair values. HKFRS 3 for other receivables, the following items should be disclosed: (i) (ii) (iii) the fair value of the receivables; the gross contractual amounts receivable; and the best estimate at the acquisition date of the contractual cash flows not expected to be collected. (4) HKFRS 3 we should disclose the revenue and profit or loss of the combined entity for the current reporting period as though the acquisition date for all business combinations that occurred during the year had been as of the beginning of the annual reporting period. If disclosure of any of the information required by this subparagraph is impracticable, the acquirer shall disclose that fact and explain why the disclosure is impracticable. (5) HKFRS 3 we should disclose a qualitative description of the factors that make up the goodwill recognised, such as the anticipated profitability of the business acquired and the anticipated future operating synergies after the Group s acquisition of DSM. (6) HKAS 36 the basis on which the recoverable amount of DSM has been determined should be disclosed HKAS 36 if the recoverable amount is based on value in use, the following items should be disclosed: (i) (ii) (iii) (iv) each key assumption on which the management has based its cash follow projections; a description of the management s approach to determining the values assigned to each key assumption; the period over which the management has projected cash flows and an explanation of why a period greater than 5 years is justified; and the growth rate used to extrapolate cash flow projections. HKAS 36 if the recoverable amount is based on fair value less costs of disposal, the valuation techniques used are to measure fair value less costs of disposal. Final Examination (June 2015 Session) Paper I 5 of 16

6 Answer 2(a) Immediately effective on 3 March 2014: abolition of par value of shares; transfer of share premium, capital redemption reserve to share capital; and abolition of the requirement for authorised share capital. Answer 2(b) (i) (ii) Entire amount from insurance of ordinary share should be wholly credited to the share capital account. The fair value of the convertible bond and the 3-month interest elements up to 31 December 2014 should be wholly credited to the share capital account. Answer 3 Financial reporting considerations should include both the accounting treatment and classification of the disposal into the Group s consolidated financial statements. 1. An entity shall classify a non-current asset (or disposal group) as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use. 2. The asset (or disposal group) must be available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such assets (or disposal groups) and its sale must be highly probable. 3. The appropriate level of management must be committed to a plan to sell the asset (or disposal group), and an active programme to locate a buyer and complete the plan must have been initiated. 4. In addition, the sale should be expected to qualify for recognition as a completed sale within one year from the date of classification. 5. The probability of shareholders approval (if required in the jurisdiction) should be considered as part of the assessment of whether the sale is highly probable. Final Examination (June 2015 Session) Paper I 6 of 16

7 Since Ms. Ho is regarded as a connected person, approval of the independent shareholders at an EGM (where Ms. Ho is not eligible to vote) must be obtained before carrying out the transaction. Considerations include the probability of voting for and against the transaction with reference to the recommendations of independent financial advisor and/or independent board of directors. If the consideration approximates the net asset value of Deluxe Furniture, the independent shareholders will probably vote for the transaction in view of the continuous loss-making situation. 6. On the other hand, if the management assesses that the resolution will probably be objected to based on the historical meeting track record, the sale will be considered as not highly probable. The assets and liabilities of Deluxe Furniture should not be classified as held for sale and the sale plan will only be disclosed as an event after the reporting period. 7. Assuming the sale is highly probable and Deluxe Furniture is classified as held for sale: (i) (ii) Deluxe Furniture should be presented as a discontinued operation as it represents a separate major line of business. A single amount in the statement of profit or loss and other comprehensive income should be disclosed comprising the total of: the post-tax profit or loss of discontinued operations; and the post-tax gain or loss recognised on the measurement to fair value less costs to sell. (iii) (iv) (v) The assets of Deluxe Furniture are classified as held for sale separately from other assets in the statement of financial position. The liabilities of Deluxe Furniture classified as held for sale shall be presented separately from other liabilities in the statement of financial position. Those assets and liabilities shall not be offset and presented as a single amount. To disclose in the note to financial statements: description of the transaction; the major classes of assets and liabilities classified as held for sale; revenue, expenses and pre-tax profit or loss of discontinued operations; the related income tax expense; and the gain or loss recognised on the measurement to fair value less costs to sell. Final Examination (June 2015 Session) Paper I 7 of 16

8 (vi) To disclose in the note of event after the reporting period: result of the EGM; and any other relevant information about the transaction before the issue of financial statements. Answer 4(a) The base-case, best-case, and worst-case values are shown below. During the bestcase, unit sales increase but costs decrease. However, in the worst-case, unit sales decrease and costs increase. Scenario Unit sales Variable cost (HK$) Fixed costs (HK$) Base 900, ,000,000 Best 990, ,100,000 Worst 810, ,900,000 Using the tax shield approach, the operating cash flow ( OCF ) and net present value ( NPV ) for the base case estimate are: OCF base = [(HK$36 15)(900,000) HK$9,000,000](0.835) (HK$20,000,000/4) OCF base = HK$8,266,500 + HK$825,000 OCF base = HK$9,091,500 NPV base = HK$20,000,000 + HK$9,091,500 (PVIFA 15%,4 ) NPV base = HK$20,000,000 + HK$25,956,036 NPV base = HK$5,956,036 (PVIFA - Present Value Interest Factor Of Annuity) The OCF and NPV for the worst case estimate are: OCF worst = [(HK$ )(810,000) HK$9,900,000] (0.835) (HK$20,000,000/4) OCF worst = HK$4,922, ,000 OCF worst = HK$5,747,325 NPV worst = HK$20,000,000 +HK$5,747,325 (PVIFA 15%,4 ) NPV worst = HK$3,591,511 Final Examination (June 2015 Session) Paper I 8 of 16

9 And the OCF and NPV for the best case estimate are: OCF best = [(HK$ )(990,000) HK$8,100,000] (0.835) (HK$20,000,000/4) OCF best = HK$11,836,125+ HK$825,000 OCF best = HK$12,661,125 NPV best = HK$20,000,000 + HK$12,661,125(PVIFA 15%,4 ) NPV best = HK$20,000, ,147,238 NPV best = HK$16,147,238 Answer 4(b) To calculate the sensitivity of the NPV to changes in fixed costs, we choose another level of fixed costs. We will use fixed costs of HK$10 million. The OCF using this level of fixed costs and the other base case values with the tax shield approach, is as follows: OCF = [(HK$36 15)(900,000) $10,000,000] (0.835) (HK$20,000,000/4) OCF = HK$ ,000 OCF = HK$8,256,500 NPV = HK$20,000,000 + HK$8,256,500 (PVIFA 15%,4 ) NPV = HK$20,000,000 + HK$23,572,129 NPV = HK$3,572,129 The sensitivity of NPV in response to changes in fixed costs is: NPV/FC = (HK$5,956,036 HK$3,572,129)/(HK$9,000,000 10,000,000) NPV/FC = (HK$2,383,907 / 1,000,000) NPV/FC = HK$2.384 If the fixed cost increases by HK$1, NPV will drop by HK$ Answer 4(c)(i) Sensitivity analysis is used to investigate the sensitivity of the outcome i.e. NPV in response to changes of input variables. It allows for one variable to change at a time. Scenario analysis is a variant of sensitivity analysis. It is usually used to estimate the changes of the NPV under various scenarios like worst scenario and best scenario. It allows for multiple variables to change under different scenarios. It can overcome the limitations of sensitivity analysis. The results of scenario analysis can provide management with a picture of potential outcomes under various scenarios. It is used to evaluate the possible outcomes for project failure. Final Examination (June 2015 Session) Paper I 9 of 16

10 Answer 4(c)(ii) No, scenario analysis is not an investment decision rule but NPV is. This is because scenario analysis provides a basis upon which management can apply their experience and knowledge to decide whether to accept or reject the projects. However, the final decision does require management s (i.e. human) judgment. Answer 4(d) The method requires that changes in each variable are isolated. However management is more interested in the combination of the effects of changes in two or more key variables. Looking at factors in isolation is unrealistic since they are often interdependent. Sensitivity analysis does not examine the probability that any particular variation in costs or revenue might occur. Critical factors may be those over which managers have no control. In itself it does not provide a decision rule. Parameters defining acceptability must be laid down by managers. Answer 5(a) The engagement team must avoid any self-interest threat and ensure they are independent. The engagement team should decline any offers which may be seen to be intended to influence the judgment of a professional accountant. Since the total value of the vouchers is not trivial and inconsequential, the engagement team should not accept the gift. Answer 5(b) In respect of the sales of vouchers, the engagement team should: discuss with the management of Super Wasa to understand the accounting policy adopted for the recognition of revenue generated from the sales of vouchers and evaluate whether the accounting policy adopted is appropriate; assess the risk of material misstatement in the sales of vouchers; understand, evaluate and validate (if the management rely on control) the management s control implemented to address the risk of material misstatement in the sales of vouchers; Final Examination (June 2015 Session) Paper I 10 of 16

11 develop a substantive test to ensure sufficient audit evidence is obtained to address all of the assertions; and quantify and assess the materiality of misstatement to the financial statements if the deferred revenue is not recognised in respect of the sales of vouchers. Since this is an initial audit engagement, additional audit procedures have to be performed. According to HKSA 510 (Clarified) Initial Audit Engagement Opening Balances, the engagement team have to obtain sufficient appropriate audit evidence about whether: opening balances contain misstatements that materially affect the current period s financial statements ; and appropriate accounting policies reflected in the opening balances have been consistently applied in the current period s financial statements, or changes thereto are appropriately accounted for and adequately presented and disclosed in accordance with the applicable financial reporting framework. As such, the following additional procedures should be performed: evaluate whether the audit procedures performed in the current period provide evidence relevant to the opening balances of deferred revenue; contact the predecessor auditor to understand the audit work performed on the sales of vouchers and review their work papers where permissible; assess whether the opening balances contain misstatements that materially affect the current period s financial statements if deferred revenue is not recognised; and consider the reporting implication if the effect of the misstatement is that the deferred revenue is not recognised or not adequately presented or disclosed. Answer 5(c)(i) What kind of inventory is J-Food selling? Are there any conditions giving rise to obsolescence? Are there any specific risks of material misstatement identified for the inventory based on the nature of the inventory items? Except for the supermarkets, is the inventory kept in other third-party warehouses? Are there any goods-in-transit? Will all of the locations be covered for the inventory observation? What are the internal controls exercised by the management and are they effective? Has the management prepared any inventory observation instructions? Are the count team made up of appropriate members? Final Examination (June 2015 Session) Paper I 11 of 16

12 Answer 5(c)(ii) If the nature of fresh food items is such that its existence and condition cannot be verified by an inventory observation, then the engagement team may consider the evidence obtained from other audit procedures performed and determine whether this evidence can be used to support the existence and condition of fresh food items. The engagement team can: validate the internal controls exercised by the management; check the expiry date of fresh food items; leverage the audit work performed in the purchase test to validate the existence of fresh food items; inspect the documentation of the subsequent sales (as well as the respective cash receipts) of fresh food items after the inventory observation; or compare the current activity between 15 September 2014 and 30 September 2014 to the activity of the same period in the last year and investigate unusual fluctuations. Answer 5(d)(i) According to HKSA 550 (Clarified) Related Parties, Related party A party that is either: 1. A related party as defined in the applicable financial reporting framework; or 2. Where the applicable financial reporting framework establishes minimal or no related party requirements: (a) (b) (c) A person or other entity that has control or significant influence, directly or indirectly through one or more intermediaries, over the reporting entity; Another entity over which the reporting entity has control or significant influence, directly or indirectly through one or more intermediaries; or Another entity that is under common control with the reporting entity through having: (i) Common controlling ownership; (ii) Owners who are close family members; or (iii) Common key management. Since Yuki is the Director of the Yummy Group, she and her husband are related parties to the Yummy Group. Also, since Yuki s husband is the owner of Super Wasa, the rental arrangement between J-Food and Super Wasa should be disclosed in the related party transactions. Final Examination (June 2015 Session) Paper I 12 of 16

13 Since the rental arrangement is not disclosed as required, the engagement team should discuss with the accounting manager the Group s controls over the related party relationships and transactions and the reason for failure in disclosure. Also, they need to consider the impact on the audit from a fraud risk perspective. Answer 5(d)(ii) According to HKSA 550 (Clarified) Related Parties, if the management has made an assertion in the financial statements to the effect that a related party transaction was conducted on terms equivalent to those prevailing in an arm s length transaction, the auditor shall obtain sufficient appropriate audit evidence about the assertion. Thus, the accounting manager has to provide evidence to support this assertion, for example: compare the terms and conditions of the rental arrangement between J-Food and Super Wasa to other rental arrangements with counterparties who are not related parties; and compare the terms and conditions of the rental arrangement between J-Food and Super Wasa to known market terms for similar arrangements in an open market. Remind the accounting manager that the terms and conditions include not only the monthly rental paid to Super Wasa but lots of other aspects such as credit terms, specific charges and contingencies. * * * END OF SECTION A * * * Final Examination (June 2015 Session) Paper I 13 of 16

14 SECTION B ESSAY QUESTIONS (Total: 25 marks) Answer 6(a)(i) To the Board of Directors of Delicious Food Limited We list below the respective problems and recommendations: The intangibles involved are (i) goodwill; (ii) production management and cooking methodology; and (iii) trademark. For (i) goodwill, it is capital in nature under s.17(1)(c) and is not deductible. For (ii) production management and cooking methodology, they are techniques used to assist in the manufacture or processing of food, so they are rights on know-how, if not patent rights under s.16e(4). Under s.16e, expenditure on rights on know-how and patent rights are fully deductible. On should note that the rights on know-how and patent rights do not require any registration in Hong Kong or elsewhere for their costs of acquisition to be deductible. For (iii) trademark, under s.16ea, expenditure on registered trademark is deductible in 5 years provided it is registered in Hong Kong or elsewhere. However, the trademark All Happy has not been registered in Hong Kong or elsewhere (s.16ea(11) refers), its cost of acquisition is not deductible under s.16ea. Since it is a capital expenditure, it is disallowed under s.17(1)(c). Answer 6(a)(ii) Problems: Below are two potential problems: (A) (B) Given that AHL s net assets value is just HK$55 million but the total consideration of HK$100 million, a large portion of value will be allocable to the abovementioned intangible assets. Under s.16e(7), the IRD is empowered to allocate a consideration for the purchase of the rights on know-how and patent rights if they are sold with other assets for one consideration. There is a risk that a significant amount of consideration is allocated to goodwill which is not tax deductible. If the Commissioner of Inland Revenue ( CIR ) considers that the consideration on the acquisition of the rights on know-how and design does not represent its true market value, the CIR could determine the true market value according to s.16e(8). Final Examination (June 2015 Session) Paper I 14 of 16

15 Recommendations: To address problem (A), it is important to allocate a specific consideration to AHL s unique method of production management and cooking methodology under the business transfer agreement, such that the consideration is tax deductible. To address problem (B), an independent valuation report is recommended to strengthen the consideration allocated to AHL s unique method of production management and cooking methodology representing their true market value. In addition, AHL could register the trademark before the business transfer such that the consideration attributable to the trademark could also become tax deductible to Delicious Food. Answer 6(a)(iii) Tax implications (and problem) on trade receivables After the acquisition of the trade receivables from AHL, any provision of bad debts made at the level of Delicious Food would not be deductible because, under s.16(1)(d)(i), the trading receipts with respect to the provision made have not been included as the trading receipts of Delicious Food. Recommendation Delicious Food should make sure that the provision of bad debts has been adequately made by AHL before the debts are transferred. In other words, Delicious Food would then acquire the debts as well as the provision for bad debts. Yours faithfully Tax Advisor Answer 6(b) To the Board of Directors of All Happy Limited We list below the problems and recommendations for the disposal of plant and machinery: Tax implications (and problems) for the plant and machinery Given that the plant and machinery s net book value represents 80% of its cost whereas its tax written down value should be around 32% (assuming an annual allowance of 20%), if the plant and machinery is sold at their net book value, there will be a big balancing charge to AHL under s.39d. In addition, if the plant and machinery is sold altogether with other assets for one consideration, the CIR is empowered to allocate a purchase price to each individual asset under s.38a. Final Examination (June 2015 Session) Paper I 15 of 16

16 Recommendation Since the value of these plant and machinery to Delicious Food is not high due to the additional modification requirement, AHL may agree with Delicious Food to allocate a relatively lower consideration for the plant and machinery and specify the same under the business transfer agreement provided such allocation could be supported by an independent valuation report. A relatively higher consideration may be allocated to goodwill as the goodwill to AHL (i.e. gain on disposal of the business) is capital in nature and generally non-taxable according to the tax case of Barr Crombie & Co Ltd v CIR (1945) 26 TC 406. Yours faithfully Tax Advisor Answer 7(a) The three most important factors in determining the source of employment income are: (i) The place where the employer contract is negotiated, concluded and enforceable; (ii) The residence of the employer; and (iii) The place where the employee s remuneration is paid. Answer 7(b) S.45 is applicable to the transfer of (i) immovable property and (ii) Hong Kong stock between associated corporations. At the time of transfer, s.45 will only apply when the transferor and the transferee are associated body corporate. That means: (i) one is the beneficial owner of not less than 90% of the issued share capital of the other; or (ii) a third such body is the beneficial owner of not less than 90% of the issued share capital of each. * * * END OF EXAMINATION PAPER * * * Final Examination (June 2015 Session) Paper I 16 of 16