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

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1 SECTION A CASE QUESTIONS (Total: 75 marks) Answer 1 Date: To: From: Subject: xx xx xx xxx Chief Financial Officer, Holdco xxx Accounting Manager, Holdco Accounting treatment of the acquisition of Entity X In respect of the acquisition of the 80% equity interest of Entity X by Holdco, Holdco obtains 80% voting rights in Entity X and is able to appoint the sole director in Entity X and affect the returns through its power over Entity X. Holdco has obtained control over Entity X and this represents an acquisition of business and thus a business combination under HKFRS 3 (Revised) Business Combinations. However, according to HKFRS 3 (Revised) para 2(c) and B1, HKFRS 3 (Revised) does not apply to a business combination of entities or businesses under common control. A business combination involving entities or businesses under common control is a business combination in which all of the combining entities or businesses are ultimately controlled by the same party or parties both before and after the business combination, and that control is not transitory. In this case, before the acquisition, Mr Lee held 65% and 80% shareholdings of Holdco and Entity X respectively and thus he was the controlling party of both entities. After the acquisition, Holdco owns an 80% equity interest in Entity X and obtained control over Entity X. As a result, Entity X and Holdco are ultimately controlled by Mr Lee and the acquisition of Entity X represents a business combination of entities under common control. Such an acquisition is scoped out from HKFRS 3 but there is currently no specific guidance under HKFRS on accounting for a business combination under common control. There is a policy choice for an entity to account for the transaction in accordance with HKFRS 3 (Revised) or Accounting Guideline ( AG ) 5. According to HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, however, merger accounting is considered an appropriate accounting policy. AG5 Merger Accounting for Common Control Combinations was issued by the HKICPA to set out the basic principles and procedures of merger accounting. If Merger Accounting is adopted In applying merger accounting, financial statement items of the Group and Entity X for the year 2014 and for the comparative period (i.e. the year 2013) are included in the consolidated financial statements of the combined entity as if the combination had occurred from the date when the Group and Entity X first came under the control of the controlling party, Mr Lee (which was 2011). The net assets of Entity X are consolidated using its existing carrying amounts from the controlling party s perspective. Final Examination (December 2015 Session) Paper II 1 of 13

2 No fair value accounting is required for the acquired assets, liabilities and contingent liabilities, accordingly, no corresponding deferred tax impact will arise from the fair value adjustment. No amount of goodwill or bargain purchase is recognised on merger accounting, instead any difference is recognised as a debit or credit to equity. The consolidated statement of profit or loss includes the results of the Group and Entity X from the earliest date presented or since the date when both the Group and Entity X first came under common control (which was 2011), where this is a shorter period, regardless of the date of the common control combination. IF HKFRS 3 is adopted If the acquisition method is chosen as the accounting policy for a business combination under common control, the requirements and guidance under HKFRS 3 (Revised) should be applied. At the acquisition date, the identifiable assets acquired and liabilities assumed are recognised at their fair values. Deferred tax should also be recognised in the fair value measurement where applicable. Goodwill is measured as the excess of the fair value of the cash consideration and the amount of non-controlling interests in Entity X over the net fair value of the identifiable assets acquired and liabilities assumed. Non-controlling interests that are present ownership interests and entitle their holders to a proportionate share of Entity X s net assets in the event of liquidation are measured at either fair value or at the non-controlling interests proportionate share in the recognised amounts of the Entity X s identifiable net assets, i.e. it should be the fair value of identifiable net assets at the date of completion of such an acquisition. Signed XXX Accounting Manager, Holdco Final Examination (December 2015 Session) Paper II 2 of 13

3 Answer 2(a) As an auditor, we should understand the internal controls exercised by the management on revenue recognition and evaluate whether they are effective and consider whether we can place reliance on the controls. The accounting clerk is responsible for managing all of the daily operations, authorised to sign the rental agreement with the tenants, maintaining the leasing record summary as well as recording the rental income and preparing the financial statements. There is no proper segregation of duties and thus it is unlikely that we can place reliance on controls. We therefore need to obtain audit evidence by performing substantive procedures. The substantive procedures include the following: Substantive procedures Obtain the leasing record summary and review the respective rental agreements to ensure they are properly signed between Entity X and the tenants. Assertions Occurrence Check the rental agreements against the deposits / rental income received from the tenants (i.e. the cheques records / bank statements) to ensure they are consistent with the terms as stated in the rental agreements. If there are any rental receivables outstanding, assess whether they have been settled subsequent to the year-end. If there is any irrecoverable rent written off during the year, discuss with the management and assess its reasonableness. Check the rental income received from the tenants (i.e. the cheques record / bank statement) against the rental agreements and the leasing record summary to ensure they are consistent with the terms as stated in the rental agreements. Perform reasonableness tests on the rental income according to the terms of the rental agreements and evaluate the differences identified. Calculate the effective rent that should be recognised based on the rent-free period as stated in the rental agreements. Assess the impact on the financial statements if the effective rent has not been taken into account by Entity X. Completeness Accuracy Cut-off Final Examination (December 2015 Session) Paper II 3 of 13

4 Answer 2(b) Issue: Lack of segregation of duties as the accounting clerk prepares all of the financial statement data and this will lead to higher opportunities for fraud. Suggested remediation: Management should implement compensating controls such as to enhance the review and approval controls before data processing if the daily operation continued to be only monitored by the accounting clerk. Issue: Lack of control over access to the notebook computer as Mr Lee, his business partner and the accounting clerk can access all of the information in the notebook using the same user name and password. Records inside the notebook can be amended easily. Suggested remediation: Different login user names and passwords should be used for different users along with different levels of access and actions. Issue: Lack of back-up files as this could lead to information loss in the case of any system breakdown. Suggested remediation: Back-up files should be prepared on a regular basis and saved in a secure location. Answer 3(a) The valuation of the factory unit requires specific knowledge including the making of assumptions with regard to future developments as well as the application of certain methodologies and techniques in order to compute the value. If ABC Audit Firm ( ABC ) performs the valuation of the factory unit for the purpose of the audit of the consolidated financial statements of Holdco, a self-review threat arises. The self-review threat cannot be reduced to an acceptable level by the application of any safeguard, as the valuation of the factory unit is material to Holdco s consolidated financial statements. As Holdco is listed on the Main Board of the Hong Kong Stock Exchange, it is a public interest entity according to the Code of Ethics. The valuation has a material effect, separately or in the aggregate, on the consolidated financial statements on which ABC will express an opinion, ABC should not provide the valuation services for Holdco for the factory unit. Answer 3(b) As an auditor, we should use our best endeavours to obtain sufficient, relevant and reliable audit evidence to enable us to express an unqualified opinion. Final Examination (December 2015 Session) Paper II 4 of 13

5 If the valuation report has not been received from an independent qualified professional valuer, we should consider alternative audit procedures. We should issue a modified opinion only when there are no alternative procedures or where such alternative procedures fail. In this case, the audit team can consider alternative procedures such as checking the market value of a similar factory unit within the same district for reference and should not issue a qualified opinion simply because of the absence of the valuation report. Answer 3(c)(i) According to HKSA 620 (Clarified) Using the work of an auditor s expert, we have to evaluate whether the auditor s expert has the necessary competence, capabilities and objectivity for the auditor s purposes. In the case of an auditor s external expert, the evaluation of objectivity shall include inquiries regarding interests and relationships that may create a threat to that expert s objectivity. Assess competence and capabilities: For example: (i) (ii) (iii) consider the professional qualifications and membership in professional bodies; license to practice; and the knowledge of related accounting and auditing requirements. Assess the objectivity: For example: (i) (ii) (iii) understand whether there are any other services provided by the valuer to Holdco; understand whether Holdco has any financial interest in the firm of the valuer; and understand whether there are any other personal or business relationships between Holdco and the valuer. Answer 3(c)(ii) In accordance with HKAS 12 Income Taxes, if a deferred tax liability or asset arises from an investment property that is measured using the fair value model in HKAS 40 Investment Property, there is a rebuttable presumption that the carrying amount of the investment property will be recovered through sale. If the presumption is rebutted, deferred tax assets and liabilities should be measured to reflect the tax consequences that would follow from the expected manner of recovery of the carrying amount of an asset. Final Examination (December 2015 Session) Paper II 5 of 13

6 Such a presumption is rebutted only when the investment property is depreciable and is held within a business model whose business objective is to consume substantially all of the economic benefits embodied in the investment property over time, rather than through sale. Although the investment property is depreciable, the way that Entity X manages the factory unit is that it expects to rent out the factory unit to earn rental income and then sell it to gain from capital appreciation at some point depending on the market conditions in the future. Accordingly, the presumption of recovery through sale is not rebutted. The deferred tax of the factory unit is calculated on the basis that the carrying amount of the unit will be recovered through sale. Answer 3(c)(iii) The deferred tax implications are determined on the basis of the tax consequences of sale of the factory unit. In Hong Kong, capital gain tax is not imposed on the sale of the investment property. However, the amount of tax allowances (i.e. the industrial building allowances or IBA ) previously claimed is taxable at profits tax rate as a consequence of sale of the factory unit of which is a claw-back tax treatment. In such case, the tax base under HKAS 12 Income Taxes is the carrying amount less future taxable amounts which may not be equal to the tax written down value to date. Carrying amount (fair value) = HK$27M Future taxable amounts = HK$10M x 4% x 3 years = HK$1.2M (i.e. IBA that would be clawed back on disposal also see Note below) Tax base = Carrying amount Future taxable amounts = HK$27M HK$1.2M = HK$25.8M Temporary difference = Carrying amount Tax base = HK$1.2M Deferred tax liability = HK$1.2 M x 16.5% = HK$198K where M stands for million and K stands for thousand. Note If initial allowance of 20% were granted and applied in addition to the annual allowance given in the question, the future taxable amounts would be HK$3.2M (HK$10M x 20% + HK$1.2M). Accordingly, temporary difference would be HK$3.2M and deferred tax liability would be HK$528K. Answer 4(a) In accordance with HKAS 28 (2011) Investment in Associates, an associate is an entity over which the investor has significant influence. Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control of those policies. Final Examination (December 2015 Session) Paper II 6 of 13

7 Holdco has significant influence over Entity D as it has 40% of the voting power of Entity D. Also, it has representation on the Board of Directors (2 out of 5) and participates in policymaking processes. Hence, Entity D is classified as the associate of Holdco. On the date of acquisition, any excess of the cost of the investment over the Group s share of the net fair value of the identifiable assets and liabilities of the investee (i.e. Entity D) is recognised as goodwill, which is included within the carrying amount of the investment. Any excess of the Group s share of the net fair value of the identifiable assets and liabilities over the cost of the investment, after reassessment, is recognised immediately in profit or loss in the period in which the investment is acquired. There is a goodwill of HK$8 million (HK$40 million - 40% x HK$80 million) which arose from such acquisition and is included as part of the interest in an associate in the Group s consolidated statement of financial position. Answer 4(b) After the acquisition of a further 35% interest in Entity D, Holdco possesses 75% of the voting rights in Entity D and appoints 4 out of 5 directors to the Board (including the Chairman and the Chief Executive Officer), which in return has power over the investee. Holdco has rights to variable returns and is able to affect those returns through power over Entity D (i.e. it has the ability to direct the dividend policy). As a result, it has obtained control of Entity D. The acquisition should be accounted for using the acquisition method. Holdco shall measure the identifiable assets acquired and the liabilities assumed at their fair values at the date of acquisition. According to HKFRS 3 Business Combinations, in a business combination achieved in stages, the acquirer shall re-measure its previously held equity interest in the acquiree at its acquisition-date fair value and recognise the resulting gain or loss, if any, in profit or loss. For the year ended 31 December 2014: Gain on disposal of associate: Fair value of previously held 40% interest Less: Carrying amount under HKAS 28 (HK$40M+5M+3M) Gain Goodwill recognised by Holdco: Fair value of consideration Non-controlling interests (fair value) Fair value of previously held interest Less: Fair value of identified net assets Goodwill HK$50M (HK$48M) HK$2M HK$55M HK$30M HK$50M HK$135M (HK$120M) HK$15M where M stands for million. Final Examination (December 2015 Session) Paper II 7 of 13

8 Answer 4(c) The revaluation gain of HK$3 million previously recognised in other comprehensive income is not reclassified to profit or loss because it would not be reclassified if the interest in Entity D were disposed of. According to HKAS 16 Property, Plant and Equipment, the revaluation surplus included in equity in respect of an item of property, plant and equipment may be transferred directly to retained earnings when the asset is derecognised. Transfers from the revaluation surplus to retained earnings are not made through profit or loss. Answer 5(a)(i) The return point (R*) using the Miller-Orr model is: R* = Lower limit + (3/4 transaction cost variance of cash flow / interest rate) 1/3 R* = HK$2,000,000 + [3/4 x HK$1,000 x (HK$50,000) 2 /0.0005] 1/3 R* = HK$2,155, The upper limit (U*) is: U* = HK$2,000, [3/4 x HK$1,000 x (HK$50,000) 2 /0.0005] 1/3 U* = HK$2,466, Answer 5(a)(ii) If the cash balance rises to the upper limit, buy HK$310, (HK$2,466, HK$2,155,361.63) in marketable securities. If the cash balance falls to the lower limit, sell HK$155, (HK$2,155, HK$2,000,000) of marketable securities for cash. Answer 5(b) Major reasons for a firm to hold cash are given below: (i) (ii) (iii) for regular transactions: To meet regular expenditure e.g. wages, account payable and so on; for precautionary motive: To keep a buffer of cash for unforeseen contingencies; and for speculation: To keep excess cash flow for speculation opportunities. The main cost is the opportunity cost of forgoing an investment return. Final Examination (December 2015 Session) Paper II 8 of 13

9 Answer 5(c) Yes, because Entity D should buy the machine when the NPV is positive. We would want to buy the machine when the NPV is at its highest. So, we need to calculate the NPV each year and we need to discount all of the NPVs up to today. So: Year 0 NPV 0 = HK$6,000,000 + HK$2,000,000 x (PVIFA10%,6) NPV 0 = HK$6,000,000 + HK$2,000,000 x NPV 0 = HK$2,710,600 where NPV0 stands for net present value today and PVIFA stands for present value discount factor Year 1: NPV 0 = [ HK$5,000,000 + HK$2,000,000(PVIFA10%,5)] / 1.1 NPV 0 = HK$2,346,909 Year 2: NPV 0 = [ HK$4,000,000 + HK$2,000,000(PVIFA10%,4)] / 1.21 NPV 0 = HK$1,933,719 Year 3: NPV 0 = [ HK$3,000,000 + HK$2,000,000(PVIFA10%,3)] / NPV 0 = HK$1,482,945 Year 4: NPV 0 = [ HK$2,000,000 + HK$2,000,000(PVIFA10%,2)] / NPV 0 = HK$1,004,713 Year 5: NPV 0 = [ HK$2,000,000 + HK$2,000,000(PVIFA10%,1)] / NPV 0 = HK$112,884 The company should purchase the machine today in order to attain the highest NPV. Answer 5(d) It is because diversification does not create value in and of itself. unsystematic risk. It can decrease In general, if a merger is done purely to diversify without any operating synergy, then the NPV of the merger is zero. If the NPV is zero, the stockholders must be worse off but bondholders are better off. Final Examination (December 2015 Session) Paper II 9 of 13

10 Answer 5(e) The statement is wrong because: Even though markets are efficient, the presence of synergy will make the value of the combined firm different from the sum of the values of the separate firms. Incremental cash flows will result in the positive NPV of the transaction, so bidders could pay premiums above market prices for target firms. * * * END OF SECTION A * * * Final Examination (December 2015 Session) Paper II 10 of 13

11 SECTION B ESSAY QUESTIONS (Total: 25 marks) Answer 6 Hong Kong profits tax exposure on the gain upon disposal of the 75% equity interest in Entity D: The gain on disposal of Entity D is only taxable in Hong Kong under s.14 of the IRO if: (i) (ii) The gain is sourced in Hong Kong; and The gain is not capital in nature. On (i), the source of disposal of unlisted shares (i.e. shares of Entity D) is governed by the places where the purchase and sale contracts of shares are effected according to Departmental Interpretation and Practice Note No. 21 Locality of profits ( DIPN No. 21 ). If either the purchase contract or sale contract is effected in Hong Kong, the IRD will draw the initial presumption that the profit is sourced in Hong Kong. The term effected does not merely mean legally executed, but encompasses all the relevant steps in generating the profits in question including solicitation, negotiation and conclusion of the contracts. Although the share purchase contracts in 2012 and 2014 were signed in Hong Kong, the negotiation and conclusion of these contracts were carried out outside Hong Kong. Accordingly, the purchase contracts may be regarded as effected outside Hong Kong. As for the share sale contract, it was negotiated, concluded and signed in Hong Kong, so the share sale contract was effected in Hong Kong. Although the share purchase contracts were effected outside Hong Kong, the share sale contract was effected in Hong Kong and the profits so earned would be regarded by the IRD as sourced in Hong Kong according to DIPN No. 21 from the Hong Kong profits tax perspective. The fact that the gain is regarded by the Chinese tax authorities as China sourced income (refer to suggested answers to Question 8) would not impact the view that the gain is regarded by the IRD as Hong Kong sourced income. On (ii), the gain on disposal of the shares in Entity D could be argued as capital in nature and non-taxable for the following reasons (supporting cases like Simmons (as liquidator of Lionel Simmons Properties Ltd) v CIR, All Best Wishes Limited v CIR, and the six badges of trade of the Royal Commission Report 1955): (i) (ii) (iii) the intention for the acquisition of the shares in Entity D was for strategic expansion in the security business for subsequent listing on the Shenzhen Stock Market. This supports the long-term holding intention of Entity D; the shares in Entity D were classified as non-current assets upon acquisition; since the acquisition is financed by Holdco s equity, no borrowing is required. This demonstrates Holdco s ability to hold the investments for long-term purposes; and Final Examination (December 2015 Session) Paper II 11 of 13

12 (iv) the disposal was due to an unsolicited attractive offer from a third party, Group X, which for Holdco was unexpected. Since the burden of proof rests with the taxpayer, it is important to maintain the relevant documents such as directors minutes and correspondence in connection with the acquisition and the disposal in substantiating that the gain is capital in nature and nontaxable. Answer 7 In order for an interest expense to be deductible, it has to satisfy the conditions under s.16(1)(a), and one of the conditions under s.16(2). Also, the restrictions under ss.16(2a), (2B) and (2C) do not apply; and the interest expense is not disallowed as a capital expenditure under s.17(1)(c) of the IRO. As Holdco acquired the equity interest in Entity D for long-term investment purposes, the income generated by the equity interest to Holdco are dividend income and capital gain on disposal of Entity D. Both of these incomes are non-taxable in Hong Kong, so the interest expense in financing the acquisition of the equity interest would not be incurred in generating the assessable profits of Holdco. Failing this condition would render the interest expense non-deductible under s.16(1)(a) of the IRO. There is no need to further consider the conditions under ss.16(2) or 16(2A), (2B) or (2C) or s.17(1)(c). Answer 8 Since Entity D is established in China, the gain on the disposal of the equity interest in Entity D is China-sourced income under the Enterprise Income Tax ( EIT ) Law. The fact that the gain is regarded by the Hong Kong tax authorities as Hong Kong sourced income (refer to suggested answers to Question 6) would not impact the view that the gain is regarded by the Chinese tax authorities as China sourced income. As Holdco is a non-tax resident without any establishment in China, the gain on the disposal of the equity interest (i.e. China sourced income) is subject to EIT at a rate of 10% according to EIT Law. Answer 9 Although Holdco is not incorporated in Hong Kong, Holdco is a Hong Kong tax resident under the Double Taxation Arrangement between mainland China and Hong Kong ( DTA ) as it is generally managed and controlled in Hong Kong. Final Examination (December 2015 Session) Paper II 12 of 13

13 The gain is subject to Enterprise Income Tax ( EIT ) because the shares sold represent more than 25% of the total shareholding in Entity D according to the Capital Gain Article 13 under the DTA. The EIT paid with respect to the profit could be used to offset the Hong Kong profits tax payable, if any, on the same gain under Article 21 under the DTA. Note: Whether the gain is taxable in Hong Kong depends on whether the gain is revenue or capital in nature from the Hong Kong profits tax perspective. However, this would not impact Holdco s application of Capital Gain Article because the Capital Gain under the DTA has a meaning different from domestic laws and comprises both revenue and capital gains. Answer 10 Stamp duty is only imposed upon the transfer of Hong Kong stock which is defined under s.2 of the Stamp Duty Ordinance ( SDO ) as stock the transfer of which is required to be registered in Hong Kong. Although Holdco is not incorporated in Hong Kong, it is still regarded as a Hong Kong stock because it is listed in Hong Kong and the transfer of its shares are required to be registered in Hong Kong. There is, however, no transfer involved when shares are newly issued. Accordingly, there is no Hong Kong stamp duty payable. Transfer of Hong Kong stock in satisfaction of a debt is subject to stamp duty under s.24(1) and (2) of the SDO. The dutiable amount is the value of the shares or the amount of the debt whichever is the lesser. * * * END OF EXAMINATION PAPER * * * Final Examination (December 2015 Session) Paper II 13 of 13