THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS

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1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination HONG KONG FINANCIAL ACCOUNTING PILOT PAPER Time allowed 3 hours Section A Compulsory questions Section B 5 long questions (attempt any 3) DO NOT OPEN THIS PAPER UNTIL INSTRUCTED TO DO SO BY THE INVIGILATOR Important Note: Candidates are allowed 15 minutes reading time to read through the question paper before the commencement of the examination between 2:15pm- 2:30pm. During the reading time, all candidates must be silent and must not write or mark anything on their question papers or answer books. Candidates must close all their reference books, notes or other unauthorised materials and put these under their chairs. If any candidates write or make any marks during the reading time, or if they speak or in any other way communicate with anyone either in or outside the examination hall during this period or read any unauthorised materials, they will be disqualified from continuing this examination paper. Once candidates have opened the question paper, they are not allowed to leave the examination hall until 3:00pm. Page 1 of 14

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3 SUBJECT NO 15M HONG KONG FINANCIAL ACCOUNTING PILOT PAPER The examination paper is divided into TWO Sections. Section A is compulsory and carries 40 marks. Candidates should attempt THREE questions from Section B, all of which carry 20 marks each. You should allow yourself approximately 70 minutes in total to answer the questions in Section A, and 35 minutes for each of the questions attempted in Section B. Unless otherwise stated, $ denotes Hong Kong dollars. Saturday afternoon 13 December 2008 Time allowed: 3 hours SECTION A (Compulsory answer ALL parts of this question) Question 1 You are Charmaine Yuen, the company secretary and corporate accountant of International Computer Sales Limited (ICS). ICS is a company incorporated in Hong Kong and is principally engaged in the manufacturing and sales of computing equipment. The management of ICS has determined that the amortisation rate on its patents is unacceptably low due to current advances in technology. For the year ended 31 March 2008, they have decided to increase the amortisation rate on all existing patents from 10% to 20%. Patents purchased for $2,250,000 on 1 April 2002 had a carrying amount of $1,125,000 on 1 April On 31 March 2007, ICS acquired 30% of the issued share capital of Bell Limited, a retail chain store incorporated in Hong Kong. The cost of the investment was $3,500,000. This 30% shareholding enables ICS to exercise significant influence on Bell. On 31 March 2007, the fair value of Bell s identifiable net assets was equal to their carrying amount, i.e. $10,000,000. The issued share capital and retained earnings of Bell on 31 March 2007 were $6,000,000 and $4,000,000 respectively. During the year ended 31 March 2008, Bell reported a profit of $3,600,000 but did not pay any dividends. On 31 March 2008, ICS acquired a further 45% of the issued share capital of Bell for $15,000,000, thereby obtaining control in the company. ICS started to prepare consolidated financial statements for the year ended 31 March Page 3 of 14

4 The consideration transferred to acquire this additional equity interest represents the fair value of the additional equity interest, and the fair value of the previously held equity interest is in proportion to the fair value of the additional equity interest purchased. In addition, ICS will measure any non-controlling interest in Bell at the non-controlling interest s proportionate share of Bell s identifiable net assets. The following shows the balance sheet (statement of financial position) of Bell at 31 March Carrying amounts Fair values $ 000 $ 000 Property, plant and equipment (net) 4,900 10,000 Investment in a subsidiary - - Net current assets 8,700 8,700 13,600 18,700 Issued equity: Ordinary shares 6,000 Retained earnings 7,600 13,600 On 1 December 2007, ICS signed an agreement to lease premises for its sales outlets for five years. According to the lease agreement, ICS is responsible for restoring the premises to their original condition at the expiry of the lease term. As at 31 March 2008, ICS had already incurred $5,000,000 expenses in renovating and decorating the sales outlets. ICS estimates that it will incur an additional $750,000 to restore the premises to their original condition. You have drafted consolidated financial statements for ICS for the year ended 31 March After sending them to ICS s directors for review, one of the directors sends you an e- mail as follows: To: Charmaine YUEN, Company Secretary and Corporate Accountant, ICS From: Monica LEE (Director of ICS) c.c.: Danielle TSANG, Christopher WONG, Carmen HO (Directors of ICS) Date: 18 May 2008 Consolidated financial statements of ICS as at 31 March 2008 Could you please clarify the following points relating to ICS s draft consolidated balance sheet (statement of financial position) which I have just reviewed. (A) I cannot understand the reason for the different accounting treatment of changes to the preparation of the financial statements. I note from your memo that the change in amortisation rate was reflected only in the current period and will be reflected in future periods but not past periods. However, the change from FIFO to average cost is not. Why not? Page 4 of 14

5 (B) (C) (D) (E) In last year s financial statements, I see an item investment in an associate in the balance sheet (statement of financial position). This item disappeared from the current year s consolidated balance sheet (statement of financial position) as at 31 March However, I still find an item share of profit of an associate in the consolidated income statement for the current year. Is there something wrong with the financial statements? What is goodwill? We paid $18,500,000 to acquire Bell and the fair value of Bell is $18,700,000. Therefore we gained $200,000, right? Is this the goodwill that you refer to? I note that you have included the $750,000 for restoring the premises to the original condition as a liability. However, it is to be incurred only upon the end of the lease term and thus it must be a future obligation. I recall that future obligations are in fact not liabilities. Why do we treat it as a liability in our accounts? I am considering alternatives in obtaining external funds. I have received a proposal suggesting that ICS can issue a financial instrument for a principal amount of $10,000,000. The interest rate would be 18% per annum for eight years payable in arrears and zero per cent in subsequent periods. ICS would have no obligation to repay the principal amount. As we don t have to repay the principal amount, the initial amount to be recorded can be zero, right? I would appreciate your clarification in time for the upcoming board meeting. Best regards, Monica Required: Prepare a memorandum in response to the issues raised. In your memorandum: (a) Discuss how the change in amortisation rate and the change from FIFO to average cost should be reported and explain their impact on the financial statements for the year ended 31 March 2008 and in future periods. (9 marks) (b) Discuss how ICS should account for its investment in Bell as at 31 March 2007 and 31 March For this purpose, explain the accounting treatments of the 30% interest in Bell in ICS s balance sheet (statement of financial position) at 31 March 2007, and the effect of the further 45% interest acquired at 31 March (9 marks) (c) Discuss and calculate the amount of goodwill to be recognised in ICS s consolidated balance sheet (statement of financial position) as at 31 March (10 marks) Page 5 of 14

6 (d) Determine whether a provision to restore the premises to their original condition should be made and the amount of the provision, if any, in ICS s consolidated balance sheet (statement of financial position) as at 31 March (6 marks) (e) Discuss how ICS should account for the proposed financial instrument. (6 marks) (Total: 40 marks) Page 6 of 14

7 SECTION B (Answer THREE questions from this section) Question 2 On 1 April 2007, Parent Limited paid $1,100,000 to acquire 70% of the shares in Subsidiary Limited, when the retained profits of Subsidiary were $800,000. Subsidiary has not issued any additional shares since the acquisition by Parent. At the date of acquisition, the book value of net assets of Subsidiary approximated to the fair value, except for the plant and equipment. The excess of fair value over the book value of Subsidiary s plant and equipment, with a remaining useful life of five years at the date of acquisition, was $80,000. Goodwill arising on consolidation is not impaired. The individual financial statements of Parent and Subsidiary as at 31 March 2008 are as follows: Parent Subsidiary Balance Sheets (Statement of Financial Position) $000 $000 Assets Plant and equipment 4,800 1,200 Accumulated depreciation (800) (400) Investment in Subsidiary 1,100 - Inventory 2,400 1,600 Receivables ,300 2,560 Liabilities Payables (120) (40) 8,180 2,520 Equity Share capital 4, Retained earnings 2,980 1,880 Profit for the year 1, ,180 2,520 Income Statements Revenue 8,000 1,600 Cost of goods sold (6,000) (1,200) Other expenses (800) (160) 1, During the year, Parent sold goods to Subsidiary at a profit margin of 15% on selling price, totalling $400,000 at invoice value. One-quarter of these goods remained in Subsidiary s closing inventory as at 31 March In addition, Subsidiary owed Parent $8,000 as at 31 March Required: Prepare the consolidated balance sheet (statement of financial position) for Parent Group as at 31 March 2008 and the consolidated income statement for Parent Group for the year ended 31 March Ignore taxation. (Total: 20 marks) Page 7 of 14

8 Question 3 (a) Discuss why accounting standard setters are proposing bringing operating leases onto the balance sheet (statement of financial position) of companies. (5 marks) (b) Lessor Company is an equipment dealer that sometimes uses leasing as a means to facilitate its sale of products. On 1 April 2007, Lessor leased a piece of equipment to Lessee Limited. The lease term was four years, with annual lease payments of $2,000,000 to be paid on each 31 March. The estimated useful life of the equipment is four years. The equipment has an estimated zero residual value at end of the lease term. The equipment was carried in Lessor s accounts as inventory at a carrying amount of $6,000,000. The implicit interest rate on the lease was 10% of the selling price ($6,339,800). Both companies use the straight-line basis for depreciation purposes. You may find the following present value table useful: PV PVA Year Year Year Year where PV = Present value of $1 paid in arrears discounted at 10% PVA = Present value of an annuity of $1 paid in arrears discounted at 10% Required: Compute the trading profit or loss for Lessor (dealer/lessor). For both parties, prepare the relevant journal entries at the date of inception of the lease (1 April 2007) and at the end of the first year (31 March 2008). (15 marks) (Total: 20 marks) Page 8 of 14

9 Question 4 Orlando Limited is a publicly listed company that assembles domestic electrical goods which it then sells to both wholesale and retail customers. Orlando s management were disappointed in the company s results for the year ended 31 March Orlando s summarised financial statements for the year ended 31 March 2008 are set out below: Income statement $000 Revenue (all credit sales) 40,000 Cost of sales (34,500) Gross profit 5,500 Operating expenses (3,700) 1,800 Gain on disposal of plant (note 1) 400 Finance charges (200) Profit before tax 2,000 Income tax expense ( 500) Profit for the period 1,500 Balance sheet (statement of financial position) $000 $000 Non-current assets Property, plant and equipment (note 1) 5,500 Current assets Inventory 2,500 Trade receivables 3,600 Bank nil 6,100 Total assets 11,600 Equity and liabilities Equity shares of 25 cents each 1,000 Retained earnings 3,750 4,750 Non-current liabilities 8% loan notes 2,000 Current liabilities Trade payables 4,300 Current tax payable 400 Bank overdraft 150 4,850 Total equity and liabilities 11,600 Page 9 of 14

10 Below are ratios calculated for the year ended 31 March (i) Return on year end capital employed [(profit before interest and tax) over (total assets less current liabilities)] 29.00% (ii) Total asset turnover 2.70 times (iii) Gross profit margin 18.00% (iv) Net profit (before tax) margin 7.20% (v) Current ratio 1.70 (vi) Closing inventory holding period days (vii) Trade receivables collection period days (viii) Trade payables payment period days Notes: 1. Orlando Limited received $1,200,000 from the disposal of plant that had a carrying amount of $800,000 at the date of its disposal. 2. The total purchase of inventory for the year ended 31 March 2008 is $33,000,000. Required: (a) Calculate ratios for the year ended 31 March 2008 (showing your workings) for Orlando, equivalent to those provided above. Show your ratios up to two decimal places. (12 marks) (b) Analyse the financial performance and position of Orlando Limited for the year ended 31 March 2008 compared with the previous year. (8 marks) (Total: 20 marks) Page 10 of 14

11 Question 5 You have been given the following information relating to Cash Limited. The company is preparing its statement of cash flows for the year ended 31 March Cash Limited Income statement for the year ended 31 March 2008 $000 Revenue 13,645 Cost of sales ( 6,782) Gross profit 6,863 Distribution costs ( 2,287) Administrative expenses ( 1,442) Profit from operations 3,134 Finance cost ( 412) Profit before tax 2,722 Taxation ( 642) Profit for the period 2,080 Balance sheet (statement of financial position) as at 31 March Assets $000 $000 Non-current assets Cost 30,150 29,556 Accumulated depreciation ( 7,745) ( 6,408) 22,405 23,148 Current assets Inventory 6,588 7,342 Trade receivables 3,353 4,112 Bank ,680 12,213 Total assets 33,085 35,361 Equity and liabilities Equity Ordinary share capital 5,894 5,270 Share premium 2,996 2,562 Retained earnings 14,633 13,478 23,523 21,310 Non-current liabilities 7% debentures 1,436 5,658 Current liabilities Trade payables 5,883 5,951 Taxation Accrued interest Bank overdraft 1,717 1,960 8,126 8,393 Total equity and liabilities 33,085 35,361 Page 11 of 14

12 Additional Information (i) During the year, dividends paid were $925,000. (ii) The profit from operations is stated after charging depreciation of $1,696,000. (iii) During the year, the company disposed of equipment for $1,417,000 realising a gain of $452,000. This equipment had never been revalued, and there were no other disposals of non-current assets during the year. Required: Discuss the importance of the statement of cash flows and prepare a statement of cash flows for Cash Limited for the year ended 31 March 2008, using the indirect method. (Total: 20 marks) Page 12 of 14

13 Question 6 At 31 March 2007, CSA Company had 510,000 shares of ordinary shares outstanding. CSA sold 60,000 shares on 1 February The company s profit for the year ended 31 March 2008 was $2,477,000; the income tax rate was 15%. In addition, CSA had the following debt and equity securities on its books on 31 March 2008: (i) (ii) (iii) (iv) (v) 17,000 of 13% preference shares at $100 par. 28,000 of 10% convertible preference shares at $100 par, sold for $110. Each preference share is convertible into two ordinary shares. $2,000,000 of 9% bonds sold at par. 7% convertible bonds with a principal amount of $3,000,000 (at $1,000 par) were sold for cash to yield 8% (i.e. the effective interest rate is 8%). Each $1,000 bond is convertible into 20 ordinary shares. Options to purchase 100,000 ordinary shares were issued on 1 July The exercise price is $30 per share; the market value at date of option was $29; the average market value between I July 2007 and 31 March 2008 was $40. Required: (a) Compute the basic earnings per share (EPS) for the year ended 31 March (b) Compute the fully diluted EPS for the year ended 31 March (c) Explain why EPS is considered so important by both managers and investors. (4 marks) (8 marks) (4 marks) (d) Why would management want to increase EPS, and how would it be possible to manipulate such an increase? (4 marks) (Total 20 marks) Page 13 of 14

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