Group structure of Wai Lung and its subsidiaries as of 31 December Wai Lung Corporation Ltd

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1 CASE Wai Lung Corporation Ltd ( Wai Lung or the Company ), is a Hong Kong incorporated manufacturer of high-quality sporting goods including golf, tennis and badminton with headquarters in Hong Kong. Wai Lung and its subsidiaries ( the Group ) have around 200 employees. It engages in product development and manufacturing, raw materials buying or sourcing, vendor compliance and distribution. It has manufacturing facilities in Hong Kong and Vietnam. Wai Lung has a financial year end of 31 December. Group structure of Wai Lung and its subsidiaries as of 31 December 2014 Wai Lung Corporation Ltd 90% 100% 100% 100% Good Point Company Ltd Good Resources Company Ltd WL Property Ltd Other Overseas Companies 100% Vietnamese subsidiary Notes: Good Point Company Ltd ( Good Point ) does not undertake any key operating activities on its own while it holds a Vietnamese subsidiary, which operates the manufacturing facility for Wai Lung. Good Resources Company Ltd ( Good Resources ) was set up in November 2014 with no significant operation as at 31 December WL Property Ltd merely held a self-owned property for administrative use in Hong Kong and did not involve itself in the Group s principal activities. Other overseas companies engage in vendor compliance and distribution for Wai Lung. Final Examination (December 2016 Session) Paper II 1 of 11

2 Functional currency of Wai Lung In the past, Wai Lung regarded the Hong Kong Dollar ( HK$ ) as its functional currency because it has an active local sales market which accounted for over half of the Company s turnover, although there were also significant amounts of exports. However, during the first quarter of the financial year ended 31 December 2015, a significant change in trading operations and circumstances occurred when Wai Lung entered into several licence contracts with brands in the United States (US). As a result, Wai Lung s business transactions have increasingly placed greater reliance on the US economy. The turnover contributed by export sales in the US is expected to account for 80% of the Company s total revenues under which the sales contracts will be denominated in US$. The payments can be made in either US$ or in HK$ but it is likely that the US customers will settle them in US$. In the past, 55% of the Company s cash expenses arising from management of the manufacturing facilities, insurance and staff costs were incurred and settled in HK$, and 35% of the Company s cash costs were imports of some raw materials denominated in US$, and the remaining were denominated in other foreign currencies. Following the increasing reliance placed on the US market, the principal operating costs denominated in US$ are expected to increase. The investing and financing activities have remained unchanged so that most of the Company s cash balances are deposits in HK$ and US$ with major global financial institutions, and it does not have significant debt obligations. In preparing the consolidated financial statements for the year ended 31 December 2015, Mr Peter Wong, Chief Financial Officer ( CFO ) of Wai Lung decided to change the functional and presentation currencies of the Company from HK$ to US$, effective from 1 January Brand licences and distribution rights In 2015, Wai Lung entered into several licence contracts with various brand-owners in fashion, consumer and entertainment markets in the US. Wai Lung partners with these brand owners or licensors to develop their brands into exciting new product categories and expand into new markets. In one example of a brand licence contract, the brand-owner, who specialised in kids toys under a long established brand registered in the US, granted a five-year licence to Wai Lung in exchange for a non-refundable upfront cash payment of US$20 million and the annual guaranteed royalty payments, which are payable regardless of the ultimate volume of sales to end users. In addition, the brand-owner agreed to sell its products to Wai Lung at a 20% discount of the usual retail prices during the licence period. However, the brand owner does not provide any services associated with the products. After the expiry of the licence contract, Wai Lung can apply for renewal but there is no guarantee that it will be renewed. Final Examination (December 2016 Session) Paper II 2 of 11

3 Wai Lung s markets in Europe Apart from the US market, Wai Lung also had some exports to Europe. Due to the currency peg with the United States Dollar ( US$ ), the Hong Kong Dollar ( HK$ ) is strong against the Euro ( or EUR ) and in recent times this has hurt the sales and business of Wai Lung in Europe. In the European market, Wai Lung also faces competition from French and Spanish sellers, whose operating currencies are the Euro. Wai Lung s Sales Director, Mr Johnson Leung, has just signed a contract to sell golf gear and the relevant accessories to a German firm, Latice Corporation ( Latice ). Latice will be billed in EUR for the contract amount of 3 million, all of which is payable in one year. The current spot exchange rate is HK$10.05/ and the one-year forward rate is HK$11.10/. The relevant annual interest rates for the currencies are 6.0% in Hong Kong and 5.0% in Germany respectively. Mr Peter Wong, the CFO of Wai Lung, is concerned about the fluctuations in the exchange rate between the Hong Kong Dollar and Euro and would like to hedge the exchange exposure. There are two hedging alternatives for Wai Lung to consider: (1) sell the Euro receivable with a forward contract; or (2) borrow Euros from a bank in Hong Kong against the Euro receivable. In order to fulfil the order, Wai Lung s purchase department needs to order raw materials for production from a Switzerland supplier. The total cost is Swiss Franc ( CHF ) 500,000 and it will be payable in three months. As of today, the spot exchange rate for CHF1 is HK$4.88 and the three-month forward rate is HK$5.04. Peter Wong is concerned about the HK$ cost of this accounts payable. He has the option of buying a three-month call option on CHF with an exercise rate of HK$5.12 for CHF1 for an option premium of HK$0.4 for each CHF. The three-month interest rate is 6% per annum in Hong Kong and 4% per annum in Switzerland. Wai Lung is also considering investing in a new purchasing system. The new system is expected to generate incremental sales of 9 million units of T-shirts per year at HK$1 net cash flow per unit for the coming 10 years. Hence, the new system will raise Wai Lung s annual operating cash flow by HK$9,000,000 per year for the next 10 years. The required return rate is 15% and the initial investment cost of the system is HK$20,000,000. Partial disposal of a foreign operation in Vietnam Wai Lung acquired 90% of Good Point Company Ltd ( Good Point ) that includes a whollyowned foreign operation in Vietnam some years ago. In 2015, Wai Lung sold 60% of its investment in Good Point for US$8 million and lost control of Good Point. On the date of disposal, the retained 30% interest in Good Point had a fair value of US$4 million, and Good Point had consolidated net assets of US$9 million and a foreign currency translation reserve of credit of US$2 million. Final Examination (December 2016 Session) Paper II 3 of 11

4 Human Resources Arrangement in Hong Kong Starting from 1 April 2015, Wai Lung has engaged Good Resources Company Ltd ( Good Resources ) to handle human resource related matters for staff in Hong Kong. The services provided by Good Resources include staff recruitment, maintenance of staff records, and payroll calculation. Good Resources has developed a tailor-made system where authorised personnel of different departments in Wai Lung can submit staff recruitment requests, payroll adjustments in relation to overtime, resignations, bonuses, salary reviews, etc, whenever necessary. Good Resources will process all of the transactions and update the information in the database once they are approved by the respective Department Heads of Wai Lung through the system. For staff recruitment, Good Resources will identify the appropriate candidates for Wai Lung to interview and Wai Lung will make the final decision on whether or not to accept the candidates. The monthly payroll is calculated by Good Resources based on the information in the database and a payroll report will be sent to Wai Lung for review and approval of payment. A monthly service fee is charged by Good Resources based on the headcount of Wai Lung. A Type II Report on the suitability of design and operating effectiveness of controls of Good Resources will be provided by XYZ CPA ( XYZ ), a local CPA firm. Property Deal Wai Lung has a subsidiary, WL Property Ltd ( WL Property ). WL Property plans to borrow from Investa Company Ltd ( Investa ) a sum of HK$10 million by pledging as security its selfowned property ( Property P ) currently used as an office. The proposed arrangement for this plan is as follows: Step 1: WL Property sells to Investa Property P at HK$10 million on Day 1. Step 2: Investa leases Property P back to WL Property at a yearly rental of HK$1 million. Step 3: After 3 years from Day 1, Investa sells the Property P at HK$10 million back to WL Property. Auditing matters A&E CPA ( A&E ), an international CPA firm, offers both audit and tax services to Wai Lung. In the audit for the year ended 31 December 2015, bank confirmation requests were arranged by A&E and issues were noted in 2 requests. No response from TT Bank was received from the request to confirm the bank balances of a subsidiary in Taiwan. The accounting manager in Taiwan said that a fire incident had severely damaged the premises of TT Bank recently and it was unlikely that it would resume business shortly. The bank balances maintained in TT bank were material to Wai Lung. Another request to Alpha Bank to confirm the bank balances of a subsidiary in Hong Kong has a significant difference between the balances confirmed and that recorded in the management accounts. The accounting manager explained that it was due to a timing difference in the recording funds transfer from overseas subsidiaries at year-end in the ledger and in the bank statement. Final Examination (December 2016 Session) Paper II 4 of 11

5 SECTION A CASE QUESTIONS (Total: 75 marks) Answer ALL of the following questions. Marks will be awarded for logical argumentation / calculation and appropriate presentation of the answers. Question 1 (21 marks approximately 38 minutes) (a) Regarding the 3 million receivable from the sale to Latice, there are the two hedging alternatives for Wai Lung to consider: (1) sell the Euro receivable with a forward contract; or (2) borrow Euros from a bank in Hong Kong against the Euro receivable. Required: Explain with reasons which alternative Mr Peter Wong should recommend. (b) Compute the expected HK$ cost of buying CHF 500,000 if Wai Lung chooses to hedge the accounts payable with a call option. Note: Assume the expected future spot exchange rate is the same as the forward rate. (c) Compute the future HK$ cost of meeting the CHF accounts payable obligation if Wai Lung decides to hedge with a forward contract instead. (d) Determine what the future spot exchange rate would be when this is no difference in the exposure of Wai Lung between the forward and the option market hedges. (e) Explain with reasons whether exchange rate changes between the Hong Kong dollar and the Euro are good or bad for Wai Lung s exports. Final Examination (December 2016 Session) Paper II 5 of 11

6 (f) The accounting manager of Wai Lung has prepared the following disclosure notes regarding the financial risk management arising from foreign currency risk in Wai Lung s consolidated financial statements as at 31 December Identify any inaccurate or missing disclosures in the extract of the relevant foreign currency risk disclosure notes below (assuming that the US Dollar is used as the functional currency of Wai Lung with effect from 1 January 2015): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - extract Foreign currency risk The Group operates globally with a large volume of sales and purchases traded in foreign currencies, mostly in US Dollar ( US$ ). The HK$ is pegged to the US$ in a narrow range and the foreign exchange exposure between US$ and HK$ is therefore limited. The Group is also exposed to foreign exchange risk arising from various currency exposures as a result of transactions in European markets, mainly to the extent of its receivables and payables in currencies other than the US$, such as the Euro dollar and CHF. Foreign exchange risk arising from sales and purchases transacted in different currencies are managed through the use of foreign exchange forward contracts. Question 2 (6 marks approximately 11 minutes) (a) Compute the NPV of investing in a new purchasing system. (b) Assuming Wai Lung invested in the new purchasing system and the actual incremental sales in the first year were far below the original expected incremental sales. It has an option to sell the new system for HK$15,000,000 in the second year. Compute the minimum level of expected incremental sales per year which Wai Lung would justify selling the new system in the second year. (c) Explain why the HK$15,000,000 abandonment value can be seen as the opportunity cost of keeping the new system after one year. Final Examination (December 2016 Session) Paper II 6 of 11

7 Question 3 (25 marks approximately 45 minutes) During the audit of the 2015 consolidated financial statements of Wai Lung and its subsidiaries, the engagement partner raised some issues to you as the audit manager. Analyse the issues raised as follows: (a) The accounting treatment for the brand licences of Wai Lung. (4 marks) (b) In respect of the partial disposal of Good Point in 2015, explain the accounting treatment of the foreign currency translation reserve, and calculate the gain or loss from the disposal in the books of Wai Lung, if any. (c) Determine (i) whether it is appropriate for Wai Lung to change the functional currency and presentation currency from HK$ to US$ (ii) the accounting and presentation impact on the preparation of the consolidated financial statements for the year ended 31 December 2015 assuming Wai Lung confirmed to change the functional currency and presentation currency on 1 January (9 marks) (d) Propose the specific follow up audit procedures that should be performed to address the issues identified in the bank confirmation requests and explain how the results of the procedures would impact the audit opinion. (7 marks) Question 4 (5 marks approximately 9 minutes) The directors of Wai Lung are concerned as to whether Wai Lung is required to comply with the new requirements on the contents of a directors report under the new Hong Kong Companies Ordinance, in particular, whether the names of the directors of its subsidiaries need to be disclosed in the directors report. Required: As the CFO of Wai Lung, explain to the directors the new/additional disclosures on the contents of a directors report of Wai Lung under the new Hong Kong Companies Ordinance for the year ended 31 December Final Examination (December 2016 Session) Paper II 7 of 11

8 Question 5 (18 marks approximately 32 minutes) You are the audit manager of A&E. Required: (a) A&E is planning to rely on the Type II report provided by XYZ. differences between the Type I and Type II reports. Explain the (b) State the definition of service organization and user entity according to the relevant auditing standard as well as with reference to the case. Propose, with explanation, how A&E should plan the test of controls of Wai Lung s payroll cycle in view of its arrangement with Good Resources as stated in the case. (10 marks) (c) List the information technology general controls and application controls you would expect in the operation of the tailor-made system used by Wai Lung. (6 marks) * * * * * * * * Final Examination (December 2016 Session) Paper II 8 of 11

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10 SECTION B ESSAY QUESTIONS (Total: 25 marks) Answer ALL of the following questions. Marks will be awarded for logical argumentation / calculation and appropriate presentation of the answers. Refer to the Case information. Question 6 (15 marks approximately 27 minutes) You are the tax advisor to Wai Lung and are requested to review Wai Lung s operations (currently no offshore claim is lodged) in order to explore whether it is possible to set up a new Hong Kong company to house certain operations of the Group such that the relevant operations would enjoy an offshore profits claim. The director has identified those operations under which the group buys from some 1,000 overseas suppliers and sells their products (without the need of any additional input or processing) to customers outside Hong Kong through overseas group companies. In other words, Wai Lung buys from independent overseas suppliers and sells to overseas group companies. Then, the overseas group companies on-sell to ultimate customers. The director does not expect a significant shift of employees outside Hong Kong, but the existing contracts with the overseas group companies through which the customers are found could be restructured. Required: By reviewing Wai Lung s operations, you as the tax advisor write a memo to: (a) (b) Propose, with reasons supported by appropriate tax cases, the set up or rearrangement of operations to be adopted by Wai Lung so that Wai Lung s existing onshore trading profits could be transformed into offshore commission income. (10 marks) State any possible challenge by the Inland Revenue Department ( IRD ) using supporting tax cases or provisions of the Inland Revenue Ordinance ( IRO ), including anti-avoidance provisions; and the possible lines of defence. [Marks to be awarded for proper memo format with logical presentation] Final Examination (December 2016 Session) Paper II 10 of 11

11 Question 7 (5 marks approximately 9 minutes) Wai Lung has recorded the following exchange differences. taxability/deductibility with reference to tax cases, if needed: Consider their (i) (ii) (iii) Exchange gain of HK$10 million arising from the forward contracts used to hedge the trading transactions; Exchange gain of HK$5 million arising from translation of debtors in foreign currency; and Exchange loss of HK$2 million arising from the translation of year end foreign currency. Question 8 (5 marks approximately 9 minutes) (i) (ii) Identify the single most significant factor that distinguishes a traditional financing arrangement from alternative bond schemes as defined under Schedule 17A of the IRO; Explain with reasons whether the property deal conducted by WL Property would be exempt under Schedule 17A of the IRO; and (iii) Explain in terms of implications for Hong Kong profits tax, property tax and stamp duty the statement that the Hong Kong Government wants to achieve tax neutrality with respect to Islamic Finance. * * * END OF EXAMINATION PAPER * * * Final Examination (December 2016 Session) Paper II 11 of 11