THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES. Suggested Answers

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THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES Suggested Answers Level : Professional Subject : Hong Kong Financial Accounting Diet : December 2007 The Suggested answers are published for the

1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES Suggested Answers Level : Professional Subject : Hong Kong Financial Accounting Diet : December 2007 The Suggested answers are published for the purpose of assisting students in their understanding of what may be expected from a good candidate in the time allowed for each paper. They are in no way exhaustive nor model answer to the questions. They do not reflect the opinion of HKICS. 1

2 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES HONG KONG FINANCIAL ACCOUNTING DECEMBER 2007 Suggested Answer SECTION A 1. (a) The IASB adopts the view that most business combinations are an exchange of equal amounts. Therefore, the existence of an excess on acquisition is expected to be unusual or rare. HKFRS 3 requires that if an excess arises, the acquirer should: (i) (ii) reassess the identification and measurement of the acquiree s identifiable assets, liabilities and contingent liabilities, and the measurement of the cost of the combination; and recognize immediately in profit or loss any excess remaining after reassessment. 1. (b) The pledged bank deposits should not be included as cash equivalents as they do not meet the definition of cash or cash equivalents in HKAS 7 Cash Flow Statements. These deposits could not be withdrawn on demand or within three months (i.e. they are not liquid cash). Moreover, the reason for keeping the pledged bank deposits is not for cash management purposes. Hence, in the cash flow statement, the movement of these pledged bank deposits should be disclosed as financing or investing activities according to the nature and intention of the underlying transaction and not as part of cash and cash equivalents. 1. (c) Income is an increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants. Expenses are decreases in economic benefits during the accounting period in the form of outflows or the depletion of assets or incurring of liabilities that result in decreases in equity, except when they relate to distribution to equity participants. 1. (d) Surpluses on revaluation of property, plant and equipment are taken to equity under the heading of revaluation surplus, unless and to the extent that they reverse a previous loss on the same asset that has been charged to the income statement; in this case they should be recognised as income. Deficits on revaluation of property, plant and equipment should normally be charged to the income statement. However, where they relate to an asset that has previously been revalued upwards, then to the extent that the losses do not exceed the amount standing to the credit of the asset in the revaluation surplus, they should be charged directly to that reserve. 1. (e) Under the percentage of completion method, profit is recognised as the contract activity progresses. Under the completed contract method, profit is recognised only when the contract is completed. If the total profit is recognised only on completion of the contract, it will bear no relationship to the operating activity in respect of the contract over the years in which it has been in progress. Hence, the recognition of attributable profit during the period of a long-term construction contract has been recommended, despite the fact that this contradicts the prudence concept. 2

3 1 (f) (i) Yes, there is control. HKAS 27 Consolidated and Separate Financial Statements requires that when assessing whether an entity has the power to govern another entity, the existence and effect of potential voting rights currently exercisable or convertible should be considered. The debentures are currently convertible and will give H Ltd voting power. (ii) (iii) (iv) No, there is no control. The debentures are not currently convertible. Yes, there is control. The debentures are currently convertible. When assessing the potential voting rights of en entity, all facts and circumstances should be examined, except management s intention and financial ability to exercise or convert. No, there is no control. The debentures are not convertible until the occurrence of a future event. 1 (g) The main advantages of historical cost are readily available measurement, objectivity and verifiability. Examples of circumstances under which historical cost is combined with realisable value and fair value: (i) Inventories and work in progress are usually carried at the lower of cost and net realisable value. (ii) Marketable securities may be carried at market value. (iii) Investment properties are carried at fair value. 1 (h) (i) Disposal of subsidiary The disposal occurred after the balance sheet date. This is a non-adjusting event, requiring no adjustments to the financial statements. It is also the requirement of HKAS 27 Consolidated and Separate Financial Statements to include results and assets of a subsidiary in the consolidated financial statements until the date of disposal when the parent ceases to have control of the subsidiary. (ii) Plans to close down a major division As XY Ltd only announced its plans post year-end, this is a non-adjusting event. It is also the requirement of HKAS 37 Provisions, Contingent Liabilities and Contingent Assets that no provision for closure cost should be made where no obligating event exists at the balance sheet date. However, it is necessary to include disclosures as required by HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations and XY Ltd may need to assess and recognise any impairment loss relating to the assets employed by the major division. 1 (i) (i) Decrease in inventory turnover The decrease in inventory turnover signals bad news especially if it also falls below the industrial average turnover ratio because it is taking the company longer to sell the inventory and consequently there is a greater chance of inventory obsolescence. (ii) Decrease in earnings per share The decrease in earnings per share might be bad news for the company because it could mean a decrease in net income. If there is an increase in shareholders investment (as a result of issuing additional shares) and a decrease in EPS, then this means that the 3

4 additional investment is earning a lower return (as compared to the return on shareholders equity before the additional investment). Generally, this is undesirable. (iii) Increase in price-earnings ratio The increase in price-earnings ratio is generally good news because it means that the market price per share has increased and investors are willing to pay that higher price for the shares. An increase in the P/E ratio is good news for investors who own the shares and don t want to buy any more. It is bad news for investors who want to buy (or buy more of) the shares. (iv) Increase in debt to total assets ratio The increase in debt to total assets ratio is generally good news if initially the company is close to a full equity firm because it signals a better utilisation of financing resources to increase the profitability of the company. However, it is bad news as the ratio gears up to a level of alert because it means that the company has increased its obligations to creditors and has lowered its equity buffer. 1 (j) Understating closing inventory in 2006 will overstate costs of sales and understate both gross profit and income on the 2006 income statement. On the 2006 balance sheet, both inventory and retained earnings will be understated. On the 2007 income statement, opening inventory will be understated, the cost of sales will be understated and both gross profit and income will be overstated. However, on the 2007 balance sheet, both inventory and retained earnings will be correct. The errors will balance themselves out by the end of

5 SECTION B 2. (a) Sun Ltd Group Consolidated income statement for the year ended 30 June 2007 $000 Revenue 269,100 Trading profit 40,500 Depreciation (4,920) Share of associate s profits 1,170 Profit before taxation 36,750 Income tax expense (15,150) Profit for the year (of which $18,384,000 is dealt with in the 21,600 accounts of Sun Ltd) Attributable to: Equity holders of the parent 20,322 Minority interest 1,278 21,600 Investment in associate $000 Group s share of net assets other than goodwill (4, ,100 1, , )*30% 2,475 Goodwill on acquisition 225 Net investment in associate 2,700 Goodwill on acquisition of associate $000 Cost of shares in Moon Ltd 2,160 Share of net assets (4,500 OS + 1,500 RE contingent asset)*30% (1,935) Goodwill on acquisition 225 5

6 Workings: Schedule of consolidated income statement Sun Earth 80% Adjustment Group Moon 30% $000 $000 $000 $000 Revenue 210,000 60,000 30,000 Intragroup sales (900) 269,100 Trading profit Sun 30,000 6,450 Earth (10, ) 10,530 Unrealised profit in inventory (180*20/120) (30) 40,500 Div from Earth (4,500*80% + 120*20%) 3,624 (3,624) Div from Moon (1,200*30%) 360 (360) Depreciation (3,600) (1,410) (900) Excess depreciation on plant (360*1/4) 90 (4,920) Profit before taxation 30,384 9,120 (3,924) 35,580 5,550 Share of associate s profits (3,900*30%) 1,170 1,170 Profit before taxation (2,754) 36,750 Income tax expense (12,000) (3,150) (15,150) (1,650) Profit after tax 18,384 5,970 (2,754) 21,600 3,900 Minority interests (W1) (1,278) (1,278) Group profit 18,384 5,970 (4,032) 20,322 Dividends paid (1,500) 1,500 Dividends declared (9,000) (3,120) 3,120 (9,000) (1,200) Retained earnings for the year 9,384 1, ,322 2,700 W1 = [(5, unrealised profit + 90 excess depreciation 120 preference dividend)*20%] + 120*80% = 1,278 6

7 3. (a) HKAS 23 Borrowing Costs deals with the accounting treatment for borrowing costs. Instead of focusing on capitalising borrowing costs as part of the carrying value of assets, the standard primarily requires the immediate expensing of borrowing costs. Under the benchmark treatment, borrowing costs should be treated as an expense in the period in which they are incurred. Under the allowed alternative treatment, borrowing costs are treated as an expense in the period in which they are incurred unless they meet the criteria for capitalisation. Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset should be capitalised as part of the cost of the asset. (b) Capitalisation of interest: Average borrowings = [(opening cumulative borrowings + closing cumulative borrowings)/2] Average borrowings for 2005 = $750,000 [($0 + $1,500,000)/2] Average borrowings for 2006 = $3,000,000 [($1,500,000 + $90,000) + ($1,590,000 + $2,820,000)]/2 Interest capitalised for 2005 = $750,000 x 12% = $90,000 Interest capitalised for 2006 = ($1,500,000 x 12%) + ($1,500,000 x 9.8%*) = $327,000 * $4,500,000 x 14% + $10,500,000 x 8% = 9.8% $15,000,000 $15,000,000 (c) Straight-line depreciation: Total costs = expenditure + capitalised interest = ($1,500,000 + $2,820,000) + ($90,000 + $327,000) = $4,737,000 Straight-line depreciation = cost estimated residual value estimated service life = ($4,737,000 - $0) / 25 = $189,480 7

8 (d) Effects of interest capitalisation on financial statements: Income statement 2005 Interest expense decreased by $90,000. Net income increased by $90, Interest expense decreased by $327,000. Net income increased by $327,000. Balance sheet 31 December 2005 Asset (construction in progress) increased by $90,000. Retained earnings increased by $90, December 2006 Asset (factory) increased by $327,000 to $417,000. Retained earnings increased by $327,000 to $417,000. 8

9 4. (a) Income statement for the year ended 31 December 2006 $000 $000 Continuing operations Revenue (3, ) 3,190 Cost of sales (2, ) (1,550) Gross profit 1,640 Other income 20 Selling costs (620) Administrative expenses (427) Other expenses (128) Finance costs ( ) (405) Profit before tax 80 Income tax expense (14) Profit for the year from continuing operations 66 Discontinued operations Revenue 750 Expenses (350) Profit before tax 400 Income tax expense (70) Profit for the year from discontinued operations* 330 Loss for the year 396 Statement of changes in equity for the year ended 31 December 2006 Share capital Retained earnings $000 $000 Balance at 31 December 2005 As previously reported 2,000 1,300 Changes in accounting policy for the capitalisation of interest (net of income tax of $21,000) (99) As restated 2,000 1,201 Profit for the year 396 Total income and expense for the year 1,597 Interim dividends (180) Balance at 31 December ,000 1,417 * The single post-tax amount is required to be further analysed into revenue, expenses, pre-tax profit or loss and income tax expense. This can be shown separately either on the face of the income statement or in the notes to the financial statements. (b) (i) Even though Morgan reports both businesses as one segment, the furniture retail business constitutes a separate major line of business which is distinguishable from other business activities and has been completely abandoned. Therefore the cessation is treated and disclosed as a discontinued operation. 9

10 (ii) The contingent liability (damages payable) is probable and can be estimated with reasonable accuracy. In accordance with HKAS 37 Provisions, Contingent Liabilities and Contingent Assets, the damages payable of $200,000 have to be accrued in the financial statements. (iii) In accordance with HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, the change in accounting policy should be accounted for retrospectively by applying the new policy as if that policy had always been applied. Adjustments should be made to the opening balance of retained earrings. (iv) The expenditure is a research cost. In accordance with HKAS 38 Intangible Assets, research costs should be recognised as an expense in the period in which they are incurred and should not be recognised as an asset. (v) Shipment of consignment goods to a consignee does not constitute a sale by the consignor but is merely a transfer of location of the goods concerned. The figures of $650,000 and $550,000 should be deducted from turnover and cost of sales respectively. 10

11 5. (a) (i) Close family members are those that may be expected to influence, or be influenced by the major shareholders and key management personnel in their dealings with the reporting entity; they include the spouse, parent, child, brother and sister and their spouses. The determination of close family members is based on the principle of substance over form. Emphasis should be on the ability to influence business dealings rather than on the immediacy of the family relationship. (ii) Examples of related party transactions that may lead to disclosure: purchase or sale of goods (finished or unfinished); purchase or sale of property and other assets; rendering or receiving of services; leases; transfers of research and development; transfers under licence agreements; transfers under finance agreements (including loans and equity contributions in cash or in kind); provision of guarantees and collateral; and settlement of liabilities on behalf of the entity or by the entity on behalf of another party. (b) All parties are related parties of the reporting entity because: Mr. X Mrs. X Mr. Y A Ltd B Ltd C Ltd D Ltd Director (key management personnel) of the reporting entity A close family member of Mr. X Direct interest in voting power giving him control over the reporting entity Under common control with the reporting entity by Mr. Y Direct significant influence by the reporting entity by virtue of shareholding Having its director in common with the reporting entity, assuming Mr. X is able to control or significantly influence the transactions between the reporting entity and D Ltd Assuming Mr. X is able to have significant influence over D Ltd through Mrs. X, who controls D Ltd 11

12 6. (a) (i) Accruals The accruals concept is that revenue and costs are recognised as they are earned or incurred, not as money is received or paid. It also means that expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of the related income (matching). Example: Rent due but not yet paid is recognised as an expense of the period to which it relates and is set off against revenue for the same period. (ii) Consistency The presentation and classification of items in the financial statements should be retained from one period to the next unless: (1) there is a significant change in the nature of the operations; (2) a change will result in a more appropriate presentation of events or transactions; or (3) a change is required by a new accounting standard. Example: Depreciation rates should remain the same from period to period unless there is clear evidence that changed circumstances require them to be changed. (iii) Substance over form When there is a difference between the real effect of a transaction (substance) and its legal form (form), the real effect should be recognised in the financial statements rather than the legal form provided this is legally possible. Example: An asset being acquired on hire purchase terms will be recognised as an asset with an associated liability despite the fact that the legal ownership of the asset does not pass until the last instalment due under the agreement is paid. (iv) Money measurement The money measurement concept is that financial accounts can only recognise items capable of being expressed in monetary terms. Example: Financial accounting can recognise a piece of plant or equipment but cannot recognise the expertise of the workforce of a business. (b) To be useful, information must be relevant to the decision-making needs of users. Information is relevant when it influences the economic decisions of users by helping them to evaluate past, present or future events, or confirms or corrects their past evaluations. (c) (i) Neutrality means that information in financial statements should be free from deliberate or systematic bias. 12

13 Prudence means that a degree of caution is needed in making estimates required under conditions of uncertainty, so that assets or income are not overstated and liabilities or expenses are not understated. Prudence also means that revenue and profits are not included in the income statement until their realisation is reasonably certain. (ii) The potential conflict between the two is that neutrality requires freedom from bias while the exercise of prudence is a potentially biased concept since judgement is required. In resolving the conflict, a balance should be found that neither overstates nor understates assets, income, liabilities and expenses. 13

NOTES TO THE FINANCIAL STATEMENTS For the year ended 31st December, 2013

NOTES TO THE FINANCIAL STATEMENTS For the year ended 31st December, 2013 1. GENERAL Cosmos Machinery Enterprises Limited (the Company ) is a public limited company domiciled and incorporated in Hong Kong and its shares are listed on The Stock Exchange of Hong Kong Limited (the