CASE. Background of the company

Transcription

1 CASE Background of the company Kinetic Enterprise Corporation Ltd. ( Kinetic or the Company ) is the holding company of a conglomerate (the Kinetic Group ) incorporated in the Cayman Islands and listed on the Hong Kong Stock Exchange. Its diversified business is primarily focusing on electronics, gaming and entertainment. The Company is also one of the leading manufacturers of electronic products such as smart phones and minicomputers for the consumer and professional markets. It is well-known for its innovative electronic products in the global market. The Chief Executive Officer (the CEO ) of Kinetic, Mr Peter Pang, is leading a product development team to develop a new type of smart glasses and the Company has spent a lot of financial resources on market research and product testing. Kinetic has a 31 December financial year end and the financial statements are prepared in accordance with the Hong Kong Financial Reporting Standards. Segment information Kinetic is principally engaged in the following segments: (c) (d) (e) Electronics segment research, development, manufacturing and selling of traditional or new electronic products Gaming segment design and selling of games Entertainment segment hotel and restaurant operations Investment holding segment investment in available-for-sale equity investment ( AFS ) Securities trading segment trading of listed equity securities The management s report published with the financial statements provides the results of the operations of these five segments separately by describing different customer demographics, products offered and sales and profit margin trends. The chairman s report also stressed important distinctions between these five segments. The electronics and entertainment segments refer to a wholly owned subsidiary of Kinetic ( Sub A ) acquired in 2012, in which a goodwill of HK$5 million arose in the acquisition. The electronics segment has been continuously incurring losses while the entertainment segment has been generating profits after acquisition. The product development team in Sub A has started to develop a new type of electronic product, smart glasses, since Financial performance of the Company On 1 March 2015, Kinetic announced that it earned HK$100 million for the fiscal year ended 31 December 2014 and it also proposed to declare to pay out 25% of its earnings as dividends. Kinetic s management expects that it will continue to pay out 25% of its earnings annually as dividends in future years. The remaining 75% of earnings will be retained for future business development. The Company has issued 12.5 million shares of common stock. The current stock price is HK$38 per share. The historical return on equity of 11% is expected to continue in the future. The Company projects a growth rate in dividend of 8.25% per annum. The Company is also subject to Hong Kong profits tax at 16.5%. Final Examination (December 2015 Session) Paper I 1 of 9

2 Acquisition of HK Co Kinetic acquires 90% of the issued share capital of a Hong Kong private limited company ( HK Co ) at a cash consideration of HK$3 million during the year ended 31 December The 10% non-controlling interest at the time of acquisition is initially measured at the noncontrolling interest s proportionate share of the recognised amount of the HK Co s net identifiable assets excluding goodwill. Goodwill of HK$2.85 million arose in the acquisition of HK Co by Kinetic. HK Co is principally engaged in the research and development, manufacturing and selling of smart glasses. Mr Ricky Auyeung is the Chief Financial Officer ( CFO ) of HK Co. Certain share options of Kinetic were granted to Mr Auyeung in relation to the services he rendered for HK Co and the related cost was recharged from Kinetic to HK Co. As at the date of acquisition and 31 December 2014, HK Co has a research and development team of around 10 people developing the smart glasses, which are still in the research phase. As at 31 December 2014, HK Co has unaudited net assets of HK$0.5 million. The assets of HK Co comprised mainly its office and research centre, facilities and equipment, and capitalised development costs. Its liabilities comprised mainly bank loans. No revenue has been generated. The unaudited total expenses for the year ended 31 December 2014 of HK Co amounted to HK$6 million. The CEO, Mr Pang, has concerns regarding the impairment assessment of the goodwill as at the date of acquisition. New smart glasses product Upon the completion of the acquisition, Mr Pang plans to combine the production development teams in Sub A and HK Co in order to develop and launch the smart glasses product in In 2014, HK Co invested HK$5 million to conduct market research and product testing related to the smart glasses project. HK Co prepared its 4-year sales forecast for the smart glasses project and the details with assumptions are as follows: the marketing department forecasts the sales to be 2,000 units for the first year; the sales will grow by 10% each year in the following 3 years; the selling price is expected to be HK$2,500 per unit; the smart glasses project needs to make a HK$6 million initial investment to acquire the relevant machine for production; the machine depreciates to its residual or market value over 4 years under the straightline method; the market value of the machine at the end of year 4 will be HK$1 million; the project fixed cost for each year is estimated at HK$2 million; the variable cost is HK$800 per unit in each of the project years; a warehouse, which is vacant, would be acquired from an associated company of HK Co for production use; the associated company would receive from the project HK$2 million for the warehouse transferred and the warehouse would be sold at cost for HK$2 million at the end of project; and Mr Auyeung, the CFO of HK Co, estimated that the project is riskier than the current business and so he judgmentally raised the discount rate for the project by 2.25%. Final Examination (December 2015 Session) Paper I 2 of 9

3 Securities investment business Kinetic established a 100% owned subsidiary, Singapore Investment Pte ( SIP ), in Singapore to carry out the investment in listed securities in the Asia market; and another 100% owned subsidiary, Singapore Management Pte ( SMP ), in Singapore to manage the investment portfolio of SIP. The board of directors of SIP comprised seven directors including one Hong Kong resident, Mr Hui. Mr Hui performs his duties as a director in Hong Kong but he would not be involved in SIP's day-to-day investment business. SIP's board of directors usually meet in Singapore where the business direction and strategies are determined, and SIP only maintains a registered office in Hong Kong. Under the incorporation document of SIP, it was stated that: the objective is to realise a profit from the rolling over of the investment portfolio; and no single share under the investment portfolio would be held for more than 2 years. For the listed securities in Hong Kong, SIP would buy and sell frequently through an independent licensed broking firm in Hong Kong, Best Price Limited, under the instructions of SMP from Singapore. Share options to Mr Hui Mr Hui spent most of his time in Hong Kong (300 days out of 365 days) during the year of assessment 2013/14. He was granted 10 million share options of Kinetic with his payment of HK$0.1 for each share option on 1 January The exercise price of the share options is HK$2 per share. The share price of Kinetic on 28 February 2014 and 31 March 2014 was HK$5 per share and HK$8 per share respectively. Mr Hui exercised half of the share options (i.e. 5 million shares) on 28 February 2014 when he was in Singapore and had 5 million share options on hand on 31 December The related share option cost of Kinetic was not recharged to SIP but was treated as an expense in the books of Kinetic. Final Examination (December 2015 Session) Paper I 3 of 9

4 SECTION A CASE QUESTIONS (Total: 75 marks) Answer ALL of the following questions. Marks will be awarded for logical argumentation / calculation and appropriate presentation of the answers. Question 1 (25 marks approximately 45 minutes) What is the required rate of return on Kinetic s stock at 1 March 2015? Kinetic plans to issue HK$50 million worth of perpetual bonds to fund the smart glasses project. The bonds will have a 5% annual coupon payment and be issued at par. What is the cost of debt and the weighted average cost of capital ( WACC ) for Kinetic? (6 marks) (c) What is the incremental cash flow in each of the smart glasses project years? Note: Assume all values are the same for the accounting and taxation perspectives. (7 marks) (d) (e) What is the discount rate for the smart glasses project and its net present value ( NPV )? Should Kinetic accept the project? (5 marks) It is argued that a firm s stockholders will never want the firm to invest in projects with a negative NPV. Do you agree or disagree? Why? (3 marks) Final Examination (December 2015 Session) Paper I 4 of 9

5 Question 2 (7 marks approximately 13 minutes) Kinetic acquired an Available-For-Sale ( AFS ) equity investment during the year ended 31 December As at the date of acquisition, the investment cost was HK$500,000. The fair value movement after the acquisition is summarised as follows: Fair value (in HK$) As at the date of acquisition 500,000 Nil As at 31 December , ,000 As at 31 December , ,000 As at report date (i.e. 30 March 2015) Fair value changes (in HK$) 520, ,000 In the opinion of Kinetic s directors, the decline in the fair value as at the year end date of 31 December 2014 is in line with the overall level of decline in the market and the market value is expected to increase after the year end date. Hence no impairment should be provided for the AFS equity investment as at 31 December As the financial controller of Kinetic, write a memo to the directors to propose the appropriate accounting treatment and explain its financial impact on the consolidated financial statements of Kinetic for the year ended 31 December Note: Ignore any tax effect in this question. (7 marks) Question 3 (12 marks approximately 22 minutes) Discuss how and when the impairment assessment of Kinetic Group s goodwill (including the goodwill which arose from the acquisitions of Sub A and HK Co) should be performed. (6 marks) For impairment testing purposes, the accounting manager of Kinetic compares the carrying amount of goodwill for HK Co, HK$2.85 million (based on the 2014 audited consolidated financial statements of Kinetic Group), with the recoverable amount of the cash generating unit ( CGU ) to determine whether the goodwill is impaired. (c) Comment on the correctness of the accounting manager s assessment in respect of the impairment of goodwill. (2 marks) As the engagement audit manager of Kinetic Group, discuss with examples how you can assess the reasonableness of the 4-year sales forecast prepared by HK Co if the forecast is used by the management to assess the impairment of goodwill. Final Examination (December 2015 Session) Paper I 5 of 9

6 Question 4 (6 marks approximately 11 minutes) HK Co capitalised a labour cost of HK$100,000 as an intangible asset as at 31 December 2014 on the ground that it was incurred to conduct technical feasibility studies for alternatives of using different materials for the new smart glasses product and the product is expected to be launched in the market in Assume you are the engagement audit manager of Kinetic Group. Explain to your audit team how to account for the above labour cost and comment on the appropriateness of HK Co s accounting treatment. (3 marks) Except for the labour cost, HK Co s intangible assets include other research and development costs. List three considerations when you plan for the audit of HK Co s intangible assets. (3 marks) Question 5 (6 marks approximately 11 minutes) During the year ended 31 December 2014, Kinetic wanted to aggregate its two operating segments the Gaming and Entertainment segments into a single reporting segment for the purposes of reporting under HKFRS 8 Operating Segments. Assume you are the engagement audit manager of Kinetic Group. Assess whether the aggregation of the two operating segments is appropriate under HKFRS 8. (2 marks) List the audit procedures that have to be performed for the audit of the segment information with reference to the relevant auditing standard. Question 6 (5 marks approximately 8 minutes) The accounting manager is going to prepare the annual report of HK Co for the year ending 31 December As the engagement audit manager of HK Co, advise the accounting manager with regard to the new requirements regarding the business review section in the directors report under the new Hong Kong Companies Ordinance (Cap. 622) and the respective exemptions, if any. (5 marks) Final Examination (December 2015 Session) Paper I 6 of 9

7 Question 7 (14 marks approximately 25 minutes) Assume you are the engagement audit manager of Kinetic Group. (c) State the two types of materiality that should be determined during the audit planning stage and explain the different purposes of these two types of materiality. Based on the information available in the Case, propose with reasoning two benchmarks (including the percentage to be used) that could be used to determine the materiality of the financial statements as a whole for HK Co. (6 marks) Assume the profit before tax of Kinetic Group for the year ended 31 December 2014 is HK$110 million. Calculate the materiality for the audit of Kinetic Group s consolidated financial statements as a whole using an appropriate benchmark and calculate the materiality for the audit of the financial statements of HK Co based on the two benchmarks proposed in Question 7. Discuss the appropriateness of the materiality of HK Co you calculated above in the context of the audit of Kinetic Group s consolidated financial statements according to the relevant auditing standard. * * * * * * * * Final Examination (December 2015 Session) Paper I 7 of 9

8 End of Section A

9 SECTION B ESSAY QUESTIONS (Total: 25 marks) Answer ALL of the following questions. Marks will be awarded for logical argumentation / calculation and appropriate presentation of the answers. Refer to the Case information. Assume you are the Tax Manager of Kinetic Group. Question 8 (7 marks approximately 13 minutes) Analyse whether Singapore Investment Pte s ( SIP ) gain from the disposal of Hong Kong listed securities is taxable in Hong Kong under Section 14 of the Inland Revenue Ordinance ( IRO ). Note: Assume tax exemption under other specific provision(s) of the IRO is/are not applicable. (7 marks) Question 9 (7 marks approximately 13 minutes) State the specific provision under the IRO (other than Section 14) that would exempt the disposal gain of listed securities of SIP from Hong Kong profits tax and specify the required conditions for the exemption. (7 marks) Question 10 (5 marks approximately 8 minutes) Comment on the Hong Kong profits tax deductibility of the cost of share options incurred by: (i) (ii) HK Co with respect to the share options granted to Mr Auyeung; and Kinetic with respect to the share options granted to Mr Hui. (5 marks) Question 11 (6 marks approximately 11 minutes) Analyse Mr Hui's Hong Kong salaries tax exposure for the year of assessment 2013/2014 with supporting tax case(s), if any. (6 marks) * * * END OF EXAMINATION PAPER * * * Final Examination (December 2015 Session) Paper I 9 of 9