Module Preparation Seminar (Part I) for Module A on Financial Reporting. Speaker Mr. Walter Lau

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1 Module Preparation Seminar (Part I) for Module A on Financial Reporting Speaker Mr. Walter Lau 11 October 2012

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3 EXECUTIVE TRAINING COMPANY (INTERNATIONAL) LTD About the Lecturer Mr Walter Lau ETC Lecturer QP MD & ACCA F7 Financial Reporting BBA, FCCA, MSC Finance Extensive teaching experience in teaching top academic and professional programmes in the top universities and professional institutes in Hong Kong and responsible for teaching courses on Financial Accounting and Taxation Lecturer and external examiner in modules of Financial Reporting and Taxation courses and lecturer for postgradguate programme in Financial Management Big Four and listed company experience Professional exam marker Experienced notes writer 1

4 Module A Financial Reporting Module Preparation Seminar on Major or Difficult Syllabus Topics (Part I) Income taxes Share-based payment Module A Financial Reporting Income taxes 2

5 MA Income taxes Content 1. Introduction 2. Current Tax Introduction Definition General Principles Applications Conclusion Group Accounts Disclosure Requirement MA Income taxes Income Taxes Current Tax Deferred Tax 3

6 MA Income taxes 1. Introduction Taxation consists of two component: Current tax is the amount actually payable to the tax authorities in relation to the trading activities of the entity during the period. Deferred tax is an accounting measure, used to match the tax effects of transactions with their accounting impact and thereby produce less distorted results MA Income taxes 2. Current Tax = actually payable Accounting Profit Tax computation Taxable Profit (estimate) (audited) Return IRD Assessment (payable) 4

7 MA Income taxes 2. Current Tax = actually payable Accounting Profit + Taxable income - Exempted income Non-deductible expenses + - Deductible item (e.g. depreciation allowance) = Taxable profit x Tax rate gtax Payable MA Income taxes 2. Current Tax Current year entries Tax Expenses (Dr) Tax Expenses (Cr) Bank (Cr) Tax Payable Tax Refund (Dr) Bank / Tax Receivable (Cr) Tax Income 5

8 MA Income taxes 2. Current Tax Last year adjustments Estimated current year tax charges Under/over provision of prior year tax charges $ x (x) / x Income statement Tax charges (this year) x P/L Tax losses carried back to offset prior year profit tax (Not eligible under Hong Kong Tax) (Dr) Tax Receivable (Cr) Tax Payable (refund) x (SOFP) x (SOCI) MA Income taxes 2. Current Tax Presentation Tax related to trading P/L Tax related to comprehensive income OCI Tax related to equity (e.g. error) equity Offset net basis (tax asset VS tax liability) only when the entity has a legally enforceable right to set off the recognised amount the entity intends to settle the amounts on a net basis 6

9 MA Income taxes Introduction Unrelated to tax authority Simply accounting treatment GAAP Income Taxable Income The amount of tax expenses cannot reflect revenue generated (matching principle) Permanent difference OR Temporary difference MA Income taxes Introduction E.g. GAAP Income Taxable Income Analysis Example A/C IRD Permanent difference: - never the same Temporary difference: - same calculation - but different timing (recognition) - same in the long run Fine Depreciation Treated as expenses Straight line method Government s point of view: not an expenses item Pooled (different rate / period) Deferred tax calculated to reconcile timing difference 7

10 MA Income taxes Introduction Illustration Example of temporary difference Tax rate: 20% Asset: $600 at cost with straight line depreciation (2 years fully depreciated) while IRD treats $400 for first year and $200 for second year) MA Income taxes Introduction Illustrative Example (ANSWER) Income Statement Revenue Accounting Depreciation Yr 1 $1,000 $300 $700 Yr 2 $1,000 $300 $700 Asset Carrying Amount Accounting Profit Beginning Depreciation Year end Yr 1 $600 $300 $300 Yr 2 $300 $300 $0 Accounting base 8

11 MA Income taxes Introduction Illustrative Example (ANSWER) Asset IRD W/D Value Beginning Depreciation Year end Yr 1 $600 $400 $ Yr 2 $200 $300 $0 (20) Revenue DA Taxable Profit Deferred Tax Current Tax Tax base Deferred Tax Yr 1 $1,000 $400 $600 $120 $ Yr 2 $1,000 $200 $800 $160 ($20) 140 Tax Expenses MA Income taxes Introduction Illustrative Example (ANSWER) Yr 1 Yr 2 (Dr) Tax Expenses (P/L) (Cr) Tax Payable (Cr) Deferred Tax Liabilities (Dr) Tax Expenses (P/L) (Dr) Deferred Tax Liabilities (Cr) Tax Payable $140 $120 $20 $140 $20 $160 9

12 MA Income taxes Definition Tax base of an asset or liability is the amount attributed to that asset or liability for tax. Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of taxable temporary differences. Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of deductible temporary differences, carry forward of unused tax losses or credits. MA Income taxes Definition Temporary differences are difference between the carrying amount of an asset or liability in the statement of financial position and its tax base. Taxable temporary differences will result in (future) taxable amounts in determining taxable profit of future period when the carrying amount of the asset or liability is recovered or settled. Deductible temporary differences will result in amounts that are deductible in determining taxable profit of future periods when the carrying amount of the asset or liability is recovered or settled. 10

13 MA Income taxes General Principles a) Temporary Difference: carrying amount VS tax base Carrying Amount > Tax Base Taxable Temporary Difference (future) Deferred Tax Liability (DTL) Carrying Amount < Tax Base Deductible Temporary Difference (future) Deferred Tax Asset (DTA) MA Income taxes General Principles b) Calculate the Tax Base Permanent difference: NO timing difference, NO deferred tax Carrying Amount = Tax Base Example: Exempted income Non-deductible item (disallowed) 11

14 MA Income taxes General Principles b) Calculate the Tax Base Asset Interest receivable has a carrying amount of $1,000. The related interest revenue is not taxable. Trade receivables have a carrying amount of $10,000. The related revenue has already been included in taxable profit (tax loss) Loan receivable has a carrying amount of $1m. There are no tax consequences for repayment Carrying Amount Tax Base $1,000 $1,000 $10,000 $10,000 $1m $1m MA Income taxes General Principles b) Calculate the Tax Base Liability Current liabilities include accrued expenses with a carrying amount of $1,000. The related expense will be deducted for tax purposes on accrual basis Current liabilities include accrued fines and penalties with a carrying amount of $100. Fines and penalties are not deductible for tax purposes Loan payable has a carrying amount of $1m. There are no tax consequences for repayment Carrying Amount Tax Base $1,000 $1,000 $100 $100 $1m $1m 12

15 MA Income taxes General Principles c) Taxable Temporary Difference: Deferred tax liabilities arises from taxable temporary differences Examples: Depreciation of an asset Development costs (capitalized in B/S and amortized in P/L) Loan payable at proceeds received less transaction costs Fair value adjustments and revaluations (revalued PPE where the revaluation does not affect current taxable profits) MA Income taxes General Principles c) Taxable Temporary Difference: which do not result in deferred tax liabilities DTL arises from initial recognition of goodwill DTL arises from the initial recognition of an asset or liability in a transaction which: is not a business combination at the time of the transaction affects neither accounting profit nor taxable profit 13

16 MA Income taxes Deferred Tax Liability (DTL) Example Tax rate: 16.5% A/C base - Tax base = $13.2 ($80 x 16.5%) (Dr) Tax Expense $13.2 (Cr) DTL $13.2 A/C Tax IRD Tax Asset Cost $300 Cost $300 Less: Acc. Dep n $100 ($16.5) DA $180 ($29.7) TODAY $200 $120 Less: Acc. Dep n $200 ($33) DA $120 ($19.8) $0 ($49.5) $0 ($49.5) MA Income taxes General Principles d) Deductible Temporary Difference: Deferred tax assets arises from deductible temporary differences / HKAS 12 states that deferred tax assets can only be recognised when sufficient future taxable profits exist against which they can be utilised. Examples: Retirement benefit costs Net realisable value of inventory/ recoverable amount of asset (carrying amount < tax base) Research costs (a/c: expenses) / (IRD: non-deductible until further days) 14

17 MA Income taxes General Principles d) Deductible Temporary Difference (i) (ii) Recognition of DTA: HKAS 12 state that deferred tax asset can only be recognised to the extend that it is probable that taxable profit will be available against which it can be utilised. If an entity has a history of recent losses, then this is evidence that future taxable profit may not be available. Disclosure only DTA which do not result in deferred tax assets: Initial recognition of an asset or liability (not in a business combination) affects neither accounting nor taxable profit. MA Income taxes General Principles e) Tax Losses and Credit Carried Forward deferred tax asset HKAS 12 states that a deferred tax asset may be recognised by an entity which has unused tax losses or credits (i.e. which it can offset against future taxable profits) at the end of a period, to the extend that it is probable future taxable profits will be available to set off the unused tax losses/credit 15

18 MA Income taxes Deferred Tax Asset (DTA) Example Tax rate: 16.5% Revenue PBD Allowed Bad Debt Account Profit Taxable Profit Current Tax DTA Yr 1 $1,000 $200 $100 $800 $900 $148.5 ($16.5) 132 Yr 2 $1,000 $100 $1000 $900 $148.5 ($16.5) 165 Tax Exp Accounting base Tax base Year 1 (Dr) Tax Expense $132 (Dr) DTA $16.5 (Cr) Tax Payable $148.5 Year 2 (Dr) Tax Expense $165 (Cr) DTA $16.5 (Cr) Tax Payable $148.5 A/C base - Tax base = -$100 DTA $16.5 MA Income taxes Application: a) Full Provision Method: deferred tax is provided for on all temporary differences, irrespective of the future plans of an entity Assume tax rate is 10%: Asset Carrying Amount Tax Base Temp. Difference Deferred Tax DTA? DTL? A $1000 $800 $200 $20 DTL B $900 $1200 ($300) ($30) DTA b) Discounting: due to the complexity and difficulty involved, deferred tax assets and liabilities are NOT discounted. 16

19 MA Income taxes Application: c) Applicable tax rate/ base: use the tax rates which expected to apply in the period when the asset is realised or liability is settled, based on tax rates and laws enacted or substantially enacted at the end of the reporting period. Use average tax rates used where different tax rates apply to different levels of taxable income. When either the tax base or tax rate will differ depending on the way in which an entity recovers or settles the carrying amount of an asset or liability (e.g. different rates apply to ongoing use or disposal), the entity must consider the expected manner of recover or settlement and apply the appropriate tax rate & tax base. MA Income taxes Application: c) Applicable tax rate/ base: Investment Properties: HKAS 12 was amended in 2010 to include a rebuttable presumption that deferred tax on investment properties carried at fair value under HKAS 40 should be measured based on recovery through sale rather than use to avoid subjective assessment. As there is no capital gains tax in HK, the amendment will generally result in deferred tax liability on such investment properties being limited to the tax effect of any claw back on sale of any depreciation allowance previous given. i.e. NO deferred tax arises in respect of the excess of fair value over cost. (Para 51C, HKAS 12) 17

20 MA Income taxes Application: c) Applicable tax rate/ base: Investment Properties: Example (1) A company based in Hong Kong owns an investment property with a fair value carrying amount of $10m. The property cost $9m. The tax base of the property is $8m and the tax rate is 16.5%. Prior to the amendment to HKAS 12: DTL = $330,000 (16.5% x ($10m - $8m)) Amendment to HKAS 12: DTL = $165,000 (16.5% x ($9m - $8m)) MA Income taxes Application: c) Applicable tax rate/ base: Investment Properties: Example (2) A building has an original cost of $10m. In 20x1, the carrying value was $8m and the asset is revaluated to $15m. No adjustment was made for tax purpose. Total depreciation allowance for tax purposes is $3m and tax rate is 30%. If the asset is sold for more than cost, the total tax depreciation allowance of $3m will be included in taxable income but sale proceeds in excess of cost will not be taxable. Requirement: state the deferred tax consequences if the entity expects to recover the carrying value through use (Presumption rebutted) 18

21 MA Income taxes Application: c) Applicable tax rate/ base: Investment Properties: Example (2) Tax base = $7m ($10m - $3m) If the entity expects to recover the carrying amount by using the building, it must generate taxable income of $15m, but will only be able to deduct depreciation allowance of $7m. Therefore, DTL = ($15m - $7m) x 30% = $2.4m MA Income taxes Conclusion Carrying amount VS Tax base Difference? Yes No NO Deferred Tax 19

22 MA Income taxes Conclusion Yes Taxable temporary difference? Deferred tax asset (carrying amount > tax base) Deferred tax liability (carrying amount < tax base) Sufficient taxable profit in future? Yes book No disclosure Book with appropriate tax rate Offset when same authority and same tax (single payment) MA Income taxes Group Accounts a) Taxable temporary difference: identifiable assets and liabilities are recognised at fair value at acquisition but tax bases are not affected DTL b) Deductible temporary difference: a liability is recognised but the related costs are not deducted in determining taxable profits until a later period, a deductible temporary difference arises DTA c) Recognition criteria: NO deferred tax is recognised for goodwill 20

23 MA Income taxes Group Accounts a) Taxable temporary difference (Examples) Unrealised losses resulting from intragroup transactions are eliminated by inclusion in the carrying amount of inventory or property, plant and equipment. Retained earnings of subsidiaries, branches, associates and joint ventures are included in consolidated retained earnings, but income taxes will be payable if the profits are distributed to the reporting parent. MA Income taxes Group Accounts a) Taxable temporary difference Investments in foreign subsidiaries, branches or associates or interests in foreign joint ventures are affected by changes in foreign exchange rates. An entity accounts in its own currency for the cost of the non-monetary assets of a foreign operation that is integral to the reporting entity's operations but the taxable profit or tax loss of the foreign operation is determined in the foreign currency. 21

24 MA Income taxes Group Accounts b) Deductible temporary difference (Examples) Unrealised profits resulting from intragroup transactions are eliminated from the carrying amount of assets, such as inventory or property, plant or equipment, but no equivalent adjustment is made for tax purposes. Investments in foreign subsidiaries, branches or associates or interests in foreign joint ventures are affected by changes in foreign exchange rates. MA Income taxes Group Accounts b) Deductible temporary difference A foreign operation accounts for its non-monetary assets in its own (functional) currency. If its taxable profit or loss is determined in a different currency (under the presentation currency method) changes in the exchange rate result in temporary differences. The resulting deferred tax is charged or credited to profit or loss. 22

25 MA Income taxes Group Accounts c) Recognition criteria: deferred tax liability Entities should recognise a deferred tax liability for all taxable temporary differences associated with investments in subsidiaries, branches and associates, and interests in joint ventures, except to the extent that both of these conditions are satisfied: (a) The parent/investor/venturer is able to control the timing of the reversal of the temporary difference ; (b) It is probable that the temporary difference will not reverse in the foreseeable future. MA Income taxes Group Accounts c) Recognition criteria: deferred tax asset HKAS 12 requires that a deferred tax asset should be recognised for all deductible temporary differences arising from investments in subsidiaries, branches and associates, and interests in joint ventures, to the extent that both these are probable that: (a) the temporary difference will reverse in the foreseeable future ; (b) taxable profit will be available against which the temporary difference can be utilised (Consider the prudence principle) 23

26 MA Income taxes Group Accounts c) Recognition criteria: deferred tax asset Application: Undistributed profits Foreign exchange Associates Joint arrangements MA Income taxes Disclosure Requirement The major components of tax expense in profit or loss, including the following: Current tax expense Adjustments recognised in the period for the current tax of previous periods The amount of deferred tax expense (income) relating to the origination and reversal of temporary differences The amount of deferred tax expense (income) relating to changes in tax rates or the imposition of new taxes 24

27 MA Income taxes Disclosure Requirement The aggregate deferred tax relating to items that are charged or credited directly to equity. The amount of income tax (including deferred tax) relating to each component of other comprehensive income. MA Income taxes Disclosure Requirement An explanation of the relationship between tax expense and accounting profit in either or both of the following forms: A numerical reconciliation between tax expense and the product of accounting profit multiplied by the applicable tax rate(s), or A numerical reconciliation between the average effective tax rate and the applicable tax rate An explanation of changes in the applicable tax rate(s) compared to the previous accounting period. 25

28 MA Income taxes Disclosure Requirement The amount (and expiry date, if any) of deductible temporary differences, unused tax losses and unused tax credits for which no deferred tax asset is recognised in the statement of financial position. In respect of each type of temporary difference: The amount of deferred tax assets and liabilities recognised in the statement of financial position. The amount of deferred tax income or expense recognised in profit or loss. MA Income taxes Disclosure Requirement The amount of a deferred tax asset and the nature of evidence supporting its recognition when: the utilisation of the deferred tax asset is dependent on future taxable profits in excess of the profits arising from the reversal of existing taxable temporary differences, and the entity has suffered a loss in either the current or preceding period in the tax jurisdiction to which the deferred tax asset relates. 26

29 Module A Financial Reporting Share-based payment MA Share-based payment Content 1. What is Share-Based Payment? 2. Objectives and Scope of HKFRS 2 3. Recognition and Measurement Equity Settled Share-Based Payment Cash Settled Share-Based Payment Share-Based Payment with a choice of settlement 4. Group Cash-Settled Share-Based Payment 27

30 MA Share-based payment 1. What is Share-Based Payment? Share-Based Payment transactions are those transactions where an entity receives goods or services in return for: a) its own equity instruments (equity-settled) or b) an amount of cash related to the value of its equity instruments (cash-settled) MA Share-based payment 2. Objectives of HKFRS 2 The objective of HKFRS 2 is to specify the financial reporting by an entity when it undertakes a share-based payment transaction. In particular, it requires an entity to reflect in its profit or loss and financial position the effects of share-based payment transactions, including expenses associated with transactions in which share options are granted to employees. 28

31 MA Share-based payment 2. Objectives of HKFRS 2 HKFRS 2 applies to all share-based payments including: a) equity-settled share-based payment transactions b) cash-settled share-based payment transactions c) transactions in which the entity receives or acquires goods or services and the terms of the arrangement provide either the entity or the supplier of those goods or services with a choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments MA Share-based payment 3. Recognition and Measurement Basic recognition principle is to recognise goods or services received in a share-based payment when it obtains the goods or as the services are received. i.e. (Dr) Expenses or Assets (Cr) Depends on whether Equity Settled/ Cash Settled share based payment 29

32 MA Share-based payment 3. Recognition and Measurement Share Based Payment (Dr) Expense/ Asset (Cr) Equity / Liability Equity-Settled (Dr) Expense/ Asset (Cr) Equity Cash-Settled (Dr) Expense/ Asset (Cr) Liability Choice among Equity-Settled or Cash-Settled Parties other employees With employees With employees Entity can choose Counterparty can choose Recognise immediately Over the Vesting Period Over the Vesting Period Equity-settled OR Cash-settled Compound Instrument MA Share-based payment 3.1 Equity Settled share-based payment transactions with parties other than employees are measured at the fair value of the goods or services received and recognised in equity, normally immediately. (direct method) with employees are measured at the fair value on the grant date and recognised in equity over the vesting period. (indirect method) (Dr) Expenses or Assets (Cr) Equity 30

33 MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) The expense recognised in each year of the vesting period should be based on the best available estimate of the number or equity instruments expected to vest. The estimate should be revised subsequently when new information reveals a difference with pervious estimate. On the vesting date, the entity should revise the estimate to equal the number of equity instruments that actually vest. Grant Date: Fair value fixed Vesting Period Estimate no of equity issued Vesting Date: Estimate = Actual MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) [Basic] Example (1) Barber Co issues 100 share options to each of its 100 employees on 1 July 20X1. The fair value of share options is $8 on the grant date. The share options do not vest until 1 July 20x3, and this is conditional upon the individual employees remaining in employment with the company. It is not anticipated that any employees will leave before this date. This assumption is confirmed at 1 July 20X3 when all 1,000 employees remain in employment. When is the transaction recognised assuming a year end of 30 June? 31

34 MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) [Basic] Example (1) (ANSWER) The options do not vest until two years have passed, and they only vest for those employees who continue to work for Barber at this date. It is assumed that all employees will continue to work for Barber. Total value of options = $8 (grant date) x 1,000 employees x 100 options = $800,000 MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) [Basic] Example (1) (ANSWER) The $800,000 is spread over the two years ended 30 June 20x2 and 20x3 with $400,000 recognised as an expense and in equity in each year: 20x2 20x3 Remuneration expense in P/L $400,000 $400,000 Equity $400,000 $400,000 32

35 MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) [Change in estimate] Example (2) Whiston Co provides each of 200 managers with 500 share options on 1 Jan 20x1. Each option has a fair value of $8 at the grant date, $10 on 1 Jan 20x2, $13 on 1 Jan 20x3 and $12 on 31 Dec 20x3. a) Explain the measurement of the share options in each of the years 20x1, 20x2 and 20x3? MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) [Change in estimate] Example (2) Whiston Co b) The circumstances are the same but managers are expected to leave the company as follows: At 31 Dec 20x1, estimated 10% of managers will have left by end of 20x3. At 31 Dec 20x2, estimated 10% of managers will have left by end of 20x3. By the end of 20x3, 20% of the original managers awarded share options have actually left. Explain the treatment of the share options. 33

36 MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) [Change in estimate] Example (2a) (ANSWER) The total expense to be recognised over the three year vesting period is: 200 x 500 x $8 = $800,000, so an amount of $266,667 should be recognised for each of three years 20x1, 20x2 and 20x3. Note that changes in fair value after the grant date do not affect the charge to profit or loss. MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) [Change in estimate] Example (2b) (ANSWER) Total Expenses 20x1 200 managers x 90% x 500 x $8/3 $240,000 20x2 200 managers x 85% x 500 x $8 x 2/3-240,000 $218,667 20x3 200 managers x 80% x 500 x $8-240, ,667 $181,333 34

37 MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) [Multiple vesting dates] Example (3) On 1 Jan 20x0, Newsome Co granted 4,000 options to each of the four directors. Half of these vest on 31 Dec 20x1 and half on 31 Dec 20x2 on the condition that the directors continue to be employed on the relevant vesting date. It was expected that all of them would continue to be employed to 31 Dec 20x2. However, on 31 Mar 20x1, one director left the company. The departure did not alter the expectations about the remaining directors continuing in employment. On 1 Jan 20x0, the fair value of each option is $50. Show the accounting treatment in each of years ended in 20x0, 20x1 and 20x2. MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) [Multiple vesting dates] Example (3) (ANSWER) In case of multiple vesting dates, the options relating to each vesting date should be accounted for separately. Option vesting in 20x1 Charge to P/L 20x options x 4 x $50 / 2 $200,000 20x options x 3 x $50 - $200,000 $100,000 35

38 MA Share-based payment Equity Settled share-based payment transactions (Transactions with Employees during Vesting Period) [Multiple vesting dates] Example (3) (ANSWER) Option vesting in 20x2 Charge to P/L 20x options x 4 x $50 / 3 $133,333 20x options x 3 x $50 x 2/3 - $133,333 $66,667 20x options x 3 x $50-133,333-66,667 $100,000 MA Share-based payment 3.2 Cash Settled share-based payment transactions Cash-settled share-based payment transactions are recognised as a liability and measured at fair value of that liability. They are remeasured at the end of each reporting period Cash-settled share-based payment can be: Grant of share appreciation right to employees; or A right to shares that are redeemable. (Dr) Expenses or Assets (Cr) Liability 36

39 MA Share-based payment 3.2 Cash Settled share-based payment transactions (Measurement and Recognition) Measurement: The primary principle is that the fair value of the liability is used to measure the goods or services acquired and the liability incurred by the entity. The fair value of the liability should be reassessed at each reporting period till its settlement date. Any change in fair value are recorded as profit or loss for the period. Recognition: The services received from the employees, and a liability to pay for those services should be recognised as services are rendered. MA Share-based payment 3.2 Cash Settled share-based payment transactions (Measurement and Recognition) Example (4) Arthing Co has provided a share incentive scheme to a number of its employees on 1 Jan 20x1. This allows for a cash payment to be made to the individuals concerned equal to the share price at the end of three-year period subject to the following conditions: Vesting will be after three years. The share price must exceed $4 The employee must be with the company on 31 Dec 20x3. 37

40 MA Share-based payment 3.2 Cash Settled share-based payment transactions (Measurement and Recognition) Example (4) Arthing Co Each scheme issued will result in payment equal to the value of 10 shares at the end of the three-year period if the conditions are satisfied. The Chief Operating Officer has been issued 20 such schemes. Share prices over the next three years were $4.2 (20x1), $3.8 (20x2) and $4.4 (20x3). Show the journal entries. MA Share-based payment 3.2 Cash Settled share-based payment transactions (Measurement and Recognition) Example (4) (ANSWER) 20x1: (Dr) Remuneration Expense ($4.2 x 10 x 20/3) (Cr) Remuneration Liability 20x2: (Dr) Remuneration Liability (Cr) Remuneration Expense To reverse the 20x1 entry as condition did not satisfy 20x3: (Dr) Remuneration Expense ($4.4 x 10 x 20) (Cr) Remuneration Liability (Dr) Remuneration Liability (Cr) Cash $280 $280 $280 $280 $880 $880 $880 $880 38

41 MA Share-based payment 3.2 Cash Settled share-based payment transactions (Measurement and Recognition) Example (5) Circumstances are the same as Example (4), but assuming four other individuals were also granted the same right as the Chief Operating Officer and that on 1 Jan 20x2, two of those individuals left the company. Show the journal entries relating to the incentive scheme, for all the individuals including the Chief Operating Officer. MA Share-based payment 3.2 Cash Settled share-based payment transactions (Measurement and Recognition) Example (5) (ANSWER) 20x1: (Dr) Remuneration Expense ($4.2 x 10 x 20 x 5/3) (Cr) Remuneration Liability 20x2: (Dr) Remuneration Liability (Cr) Remuneration Expense To reverse the 20x1 entry as condition did not satisfy 20x3: (Dr) Remuneration Expense ($4.4 x 10 x 20 x 3) (Cr) Remuneration Liability (Dr) Remuneration Liability (Cr) Cash $1400 $1400 $1400 $1400 $2640 $2640 $2640 $

42 MA Share-based payment 3.3 Share-based payment with a choice of settlement Where the counterparty has a choice of settlement, the entity is deemed to have granted a compound instrument, and a liability component and an equity component are identified accounted for separately. Where the entity has a choice of settlement, the whole transaction is treated either, as cash-settled or as equity settled, depending on whether the entity has an obligation to settle in cash. MA Share-based payment 3.3 Share-based payment with a choice of settlement Example (6) On 1 Jan 20x7 an entity grants an employee a right under which he can, if he is still employed on 31 Dec 20x9, elect to receive either 10,000 shares or cash to the value, on that date, of 9,000 shares. The market price of the entity s shares is $310 at the date of grant, $370 at the end of 20x7, $430 at the end of $20x8 and $520 at the end of 20x9, at which time the employee elects to receive the shares. The entity estimates the fair value of the share route to be $290. Show the accounting treatment. 40

43 MA Share-based payment 3.3 Share-based payment with a choice of settlement Example (6) (ANSWER) The arrangement results in a compound financial instrument. The fair value of cash route: 9000 x 310 (grant date) = $2.79m The fair value of equity route: x 290 (estimate) = $2.90m The fair value of the equity component:2.9m 2.79m = 110,000 MA Share-based payment 3.3 Share-based payment with a choice of settlement Example (6) (ANSWER) Liability Equity Expense 20x7 1/3 x 9000 x ,000 x 1/3 20x8 2/3 x 9000 x ,000 x 2/3 20x x ,000 $1,110,000 $2,580,000 4,680,000 If the employee elects to receive shares, $4.68m is transferred to from liability to equity at the end of 20x9. The balance on equity is $4,790,000 $36,667 $73, ,000 $1,110,000 $36,667 $1,470,000 $36,667 $2,100,000 $36,666 41

44 MA Share-based payment 4. Group Cash-Settled Share-Based Payment An entity that receives goods or services in a share-based payment transaction must account for those goods or services no matter which entity in the group settles the transaction, and no matter whether the transaction is settled in shares or cash. Amendments to HKFRS 2 clarify how an individual subsidiary in a group should account for some share-based payment arrangements in its own financial statements. MA Share-based payment 4. Group Cash-Settled Share-Based Payment The entity receiving the goods or services will recognise the transaction as an equity settled share-based payment transaction only if: The awards granted are its own equity instruments It has no obligation to settle the transaction In all other circumstances, the entity will measure the transaction as a cash-settled share based payment. Subsequent remeasurement of equity-settled transaction will only be carried out for changes in non-market vesting conditions. 42

45 MA Share-based payment 4. Group Cash-Settled Share-Based Payment The entity responsible for settling the transaction will recognise it as an equity-settled share-based payment only if the transaction is settled in its own equity instruments. In all other circumstances, the transaction will be recognised by the entity that settles the award as a cash-settled share-based payment. MA Share-based payment 4. Group Cash-Settled Share-Based Payment Entity receiving goods and services Obligations to settle share-based payment transaction Subsidiary's individual financial statements Classification Consolidation financial statements How is it settled? Subsidiary Subsidiary Equity of the subsidiary Equity Equity Subsidiary Subsidiary Cash Cash Cash Subsidiary Subsidiary Equity of the parent Cash Equity Subsidiary Parent Equity of the parent Equity Equity Subsidiary Parent Cash Equity Cash 43

46 MA Share-based payment 4. Group Cash-Settled Share-Based Payment Example (7) On 1 Jan 20x1, Principal Co implemented a share incentive scheme for the five members of senior management at its subsidiary Sublime Co. Principal will make a cash payment on 31 Dec 20x2 based on the price of Sublime s shares at that date, provided that the managers remain in service. Ten share appreciation rights (SARs) are granted to each senior manager on 1 Jan 20x1, each with a fair value of $80. The fair value of each SAR at 31 Dec 20x1 is $70 and at 31 Dec 20x2 is $90. MA Share-based payment 4. Group Cash-Settled Share-Based Payment Example (7) Principal Co & Sublime Co. All five senior managers are expected to remain in employment until the settlement date. What entries are required in the individual companies and in the group? 44

47 MA Share-based payment 4. Group Cash-Settled Share-Based Payment Example (7) (ANSWER) Principal Co (Parent). Principal is responsible to settle the transaction. As the transaction will not be settled in Principal s own equity instruments it must be recognised as a cash-settled share based payment. Initial Recognition: Liability based on the fair value of the SARs at the grant date. Subsequent changes in fair value is recognised in P/L. MA Share-based payment 4. Group Cash-Settled Share-Based Payment Example (7) (ANSWER) 20x1: (Dr) Cost of Investment in Sublime (5 x 10 x 80/2) (Cr) Remuneration Liability (Dr) Liability [(80-70) x 5 x 10 /2]) (Cr) Cost of investment in Sublime 20x2: (Dr) Cost of Investment in Sublime (5 x 10 x ) (Cr) Liability (Dr) P/L (5 x 10 x ) (Cr) Liability $2,000 $2,000 $250 $250 $2,000 $2,000 $750 $750 45

48 MA Share-based payment 4. Group Cash-Settled Share-Based Payment Example (7) (ANSWER) Sublime Co (Subsidiary). Sublime received services of the senior managers. It has no obligation to settle the transaction itself and therefore it must be recognised as an equity-settled share-based payment transaction. 20x1: (Dr) Remuneration expense (5 x 10 x 80/2) (Cr) Equity (equity-based) 20x2: (Dr) Remuneration expense (5 x 10 x ) (Cr) Equity No remeasurement takes place as the transaction is treated as equity-settled $2,000 $2,000 $2,000 $2,000 MA Share-based payment 4. Group Cash-Settled Share-Based Payment Example (7) (ANSWER) Group (Consolidation). The Principal Group received services of the senior managers and has an obligation to settle the transaction in cash and therefore in the consolidation accounts the transaction is accounted for as cash-settled. 20x1: (Dr) Expense (5 x 10 x 70/2) (Cr) Liability 20x2: (Dr) Expense (5 x 10 x ) (Cr) Liability $1,750 $1,750 $2,750 $2,750 46

49 MA Share-based payment 4. Group Cash-Settled Share-Based Payment Example (7) (ANSWER) On consolidation the cost of investment in Principal must be cancelled against the equity and reserve in Sublime. As HKFRS 2 requires that the movement in equity in Sublime s accounts is based on the $80 fair value at the grant date, and not remeasured. If follows that the movement in the cost of investment must be based on the same amount. Therefore, any remeasurement must be put thru P/L Past Paper Practice Income taxes HKICPA MA Feb 2008 Q3 Share-based payment HKICPA MA Dec 2010 Q2 47

50 MA Feb 2008 Q3 Question Bestpoint Printing Limited ( BP ), established in the People s Republic of China ( PRC ), is a wholly-owned subsidiary of Glory Publishing Group ( GP ). BP is entitled to a two-year exemption from foreign enterprise income tax ( FEIT ) from its first profit-making year, as computed under PRC accounting standards ( PRC GAAP ) and tax regulations. For the following three years, it enjoyed a 50% reduction in the rate of FEIT was BP s first profit-making year. The standard tax rate for BP was 24% for the periods up to 31 December With the enactment of the new tax law during 2007, BP will be subject to FEIT at 25% for the year beginning 1 January GP is subject to Hong Kong Profits Tax at 17.5%. MA Feb 2008 Q3 Question BP acquired a printing machine on 1 July 2003 at a cost of HK$20 million. For the purpose of FEIT calculations, the machine is depreciated over 10 years with a residual value of 10% of the cost from the corresponding date of acquisition, which is the same for the preparation of BP s PRC GAAP financial statements. In the preparation of GP s consolidated financial statements, the machine is depreciated over 16 years with nil residual value. 48

51 MA Feb 2008 Q3 Question Required: a) Calculate the deferred tax asset or liability position in relation to the machine at 31 December 2007 accounted for in GP s consolidated financial statements. (5 marks) b) Prepare the journal entry(ies) to record the deferred income taxes at 31 December 2008 for GP's consolidated financial statements with calculation supporting the balances recorded. (5 marks) MA Feb 2008 Q3 Question Required: c) Assuming GP has a deferred tax asset of HK$500,000 in respect of its own plant and equipment at 31 December 2008, explain how the deferred taxes will appear on the consolidated statement of financial position at that date. (2 marks) 49

52 MA Feb 2008 Q3 Answer (a) Deferred tax position at 31 December 2007 accounted for in GP's consolidated financial statements: Carrying amount of the printing machine at 31 December 2007: HK$20,000,000 x [1 - (4.5 years / 16 years)] = HK$14,375,000 Tax base at 31 December 2007: HK$20,000,000 x [1 - (1-0.1) x (4.5 years / 10 years)] = HK$11,900,000 MA Feb 2008 Q3 Answer (a) Taxable temporary difference: Carrying amount - Tax base = HK$14,375,000 - HK$11,900,000 = HK$2,475,000 Deferred tax liability: HK$2,475,000 x 25% (1) = HK$618,750 50

53 MA Feb 2008 Q3 Answer (a) Deferred tax assets and liabilities shall be measured at the tax rates that are expected to apply to the period when the asset is realised or the liability is settled, based on tax rates (and tax laws) that have been enacted or substantively enacted by the reporting date is the first profit-making year for GP, the company will have full tax exemption for 2003 and 2004, and then be subject to 50% reduction for 2005 to 2007 (i.e. 12%). Afterward, the tax rate is 25%. As the taxable temporary difference will be reversed after 2007, the tax rate applied for deferred tax computation is 25%. MA Feb 2008 Q3 Answer (b) Journal entries to record the deferred income taxes at 31 December 2008 for GP's consolidated financial statements: (Dr) Deferred tax Income statement HK$137,500 (Cr) Deferred tax liability HK$ 137,500 Carrying amount of the printing machine at 31 December 2008: HK$20,000,000 x [1 - (5.5 years / 16 years)] = HK$13,125,000 Tax base at 31 December 2008: HK$20,000,000 x [1 - (1-0.1) x (5.5 years / 10 years)] = HK$10,100,000 51

54 MA Feb 2008 Q3 Answer (b) Taxable temporary difference: Carrying amount - Tax base = HK$13,125,000 - HK$10,100,000 = HK$3,025,000 Deferred tax liability: HK$3,025,000 x 25% = HK$756,250 Increase in deferred tax liability in 2008: = HK$756,250 - HK$618,750 =HK$137,500 MA Feb 2008 Q3 Answer (c) Amount of deferred taxes to be shown on GP s consolidated statement of financial position at 31 December 2008: Deferred tax asset Deferred tax liability HK$500,000 HK$756,250 GP s deferred tax asset cannot be offset against the deferred tax liability of BP as the two entities' income taxes are NOT levied by the same taxation authority. 52

55 MA Dec 2010 Q2 Question Modern Department Store (MDS) adopted a share option scheme which allows the board of director of the company to award share option to employees at nil consideration. On 1 April 2008, 2,000,000 share options were granted to the chief operating officer ("the COO"). Subject to the continued employment of the COO with the company, one-fourth of the awarded share options shall become vested at the end of each anniversary from the date of grant. MDS expects that all the awarded share option will vest. MA Dec 2010 Q2 Question On 1 April 2010, MDS entered into an agreement with the COO to cancel the unvested awarded share options at a consideration of HK$5,500,000. Fair value of the share options of MDS (assuming same for different vesting dates): 1 April 2008 HK$8 31 March 2009 HK$3 31 March 2010 HK$5 1 April 2010 HK$5 53

56 MA Dec 2010 Q2 Question Required: a) Calculate the amount of compensation expense in relation to the share options awarded by MDS for the years ended 31 March 2009 and 31 March 2010 respectively. (4 marks) b) Explain the accounting implication of and calculate the compensation expense upon the cancellation of the unvested awarded share options on 1 April 2010 to the financial statements of MDS for the year ending 31 March (7 marks) MA Dec 2010 Q2 Question Required: c) Assuming that the share options were awarded to the director of Bargain Store (BS), a subsidiary of MDS, instead of the COO of the company, without any intragroup charge for such share-based payment arrangement, explain the accounting implication for the financial statements of BS for the year ended 31 March (3 marks) 54

57 MA Dec 2010 Q2 Answer (a) Share-based compensation expenses for the year ended 31 March 2009: [(2,000,000/ 4 x HK$8)] + [(2,000,000 /4 x HK$8) /2] + [(2,000,000 /4 x HK$8) /3] + [(2,000,000 /4 x HK$8) /4] =$4,000,000 + $2,000,000 + $1,333,333 + $1,000,000 = HK$8,333,333 Share-based compensation expenses for the year ended 31 March 2010: [(2,000,000/ 4 x HK$8) /2] + [(2,000,000 /4 x HK$8) / 3] + [(2,000,000 /4 x HK$8) /4] = $2,000,000 + $1,333,333 + $1,000,000 = HK$4,333,333 MA Dec 2010 Q2 Answer (b) Accounting implication of cancellation of unvested awarded share options on 1 April 2010: According to HKFRS 2.28, if a grant of equity instruments is cancelled or settled during the vesting period (other than a grant cancelled by forfeiture when the vesting conditions are not satisfied): a) the entity shall account for the cancellation or settlement as an acceleration of vesting, and shall therefore recognise immediately the amount that otherwise would have been recognised for services received over the remainder of the vesting period. 55

58 MA Dec 2010 Q2 Answer (b) b) any payment made to the employee on the cancellation or settlement of the grant shall be accounted for as the repurchase of an equity interest, i.e. as a deduction from equity, except to the extent that the payment exceeds the fair value of the equity instruments granted, measured at the repurchase date. Any such excess shall be recognised as an expense. MA Dec 2010 Q2 Answer (b) Share-based compensation expense originally to be recognised from 1 April 2010 to 31 March 2012: [(2,000,000 / 4 x HK$8) / 3] + [(2,000,000 / 4 x HK$8) / 4 x 2 = HK$1,333,334 + HK$2,000,000 = HK$3,333,334 **OR** Accumulated compensation expense recognised up to 31 March 2010: HK$8,333,333 + HK$4,333,333 = HK$12,666,666 [(2,000,000 x HK$8) HK$12,666,666] = HK$3,333,334 56

59 MA Dec 2010 Q2 Answer (b) Payment exceeds the fair value of the share options granted and cancelled, measured at 1 April 2010: HK$5,500,000 [(2,000,000 / 4 x 2) x HK$5] = HK$500,000 Total compensation expense recognised upon cancellation unvested awarded share options on 1 April 2010: HK$3,333,334 + HK$500,000 = HK$3,833,334 MA Dec 2010 Q2 Answer (c) According to HK(IFRIC) Int 11 para. 8, provided that the share-based arrangement is accounted for as equity-settled in the consolidated financial statements of the parent, the subsidiary shall measure the services received from its employees in accordance with the requirements applicable to equity-settled share-based payment transactions, with a corresponding increase recognised in equity as a contribution from the parent. 57

60 MA Dec 2010 Q2 Answer (c) The journal entries to be recorded by BS for the year ended 31 March 2010 were: (Dr) Share compensation expense (Cr) Contribution from MDS HK$4,333,333 HK$4,333,333 At ETC, it is our aim to encourage you. Thank you! Website: 58