CASE. Background and principal activities

Transcription

1 CASE Background and principal activities My Beloved Jewellery Holding Company Limited ( MBJ Holding or the Company ) was incorporated in Hong Kong and its subsidiaries (collectively the Group ) are controlled and 75% owned by the Chan Family. The Group has a financial reporting date of 30 June and planned to list on the Hong Kong Stock Exchange. The Group has been engaging in selling jewellery for more than 20 years. It is the leader in the Hong Kong jewellery retail market and is two to three times larger than any of its competitors in Hong Kong. It enjoys the economic benefits of a large organisation with the competitive advantage of brand name and retail network. It is equipped with an efficient direct fulfilment operation and supply chain infrastructure as well as e-commerce sales channels. Adam Chan is the founder of the Group. He retired in 2014 and retains only the title of Chairman of the Board. The Board also consists of three other non-executive directors, two of whom are Adam s brothers. James and Amber are the children of Adam and his first wife. Sofia is another daughter of Adam and his second wife. James is the Chief Executive Officer ( CEO ) and Amber is the Chief Financial Officer ( CFO ) of the Group. James has expanded the Group s business into mainland China. He wants to develop the brand of My Beloved Jewellery as a well-known luxury jewellery and specialty retailer in the Asian market. Under James s development plan, the ultimate goal of the Group is to provide prominent value to its customers through the range and quality of its brands, with competitive prices and high standards of products. Auditor of the Group As CFO of the Group, Amber is responsible for treasury and accounting. She is a graduate from a top business school with a double major in accounting and finance. She worked in Lau & Co, a reputable CPA firm, for more than eight years and joined the Group as CFO in 2013, a year before Adam retired. Wong Lam & Co ( Wong Lam ), another reputable CPA firm, has been the auditor of the Group for three years and it has a good relationship with the Chan Family. However, Amber is not satisfied with the services provided by Wong Lam and has given a significant push back on its proposed audit fee for the year ended 30 June 2015 by arguing that it should be reduced by 15%. If the audit fee is not reduced, the Group will engage Lau & Co to be the auditor of the Group instead. Market competition and opportunities The Group s leading position in Hong Kong has been eroded by other competitors and its opportunities for further expansion by acquisition are limited. It also faces rising shopping venue rental in Hong Kong and is exposed to the economic slowdown in the China market. James is also exploring opportunities to develop the Group s business in other Asian countries and regions such as Taiwan and Singapore. However, the Group sells products internationally without self-owned retail outlets in the overseas markets. Final Examination (June 2016 Session) Paper II 1 of 9

2 The key element for the Group to pursue further expansion is the emerging convergence of technologies, such as the internet and digital television. The Internet has increased the opportunities for the Group to communicate with its customers and to create new channels to market many of its products. This will help the Group to maintain a competitive edge. In addition, James is planning for the Group s listing on the Hong Kong Stock Exchange in two or three years time. Funding plan MBJ Holding plans to raise funding to expand its business in mainland China from the following sources: Debt Preference share Common share 100,000 bonds with a face value of HK$1,000 and coupon rate of 5% - compounded annually - 20 years term to maturity - yield to maturity ( YTM ) is 5% - current price quote is ,000 zero coupon bonds with a face value of HK$1, years term to maturity - YTM is 5.8% - current price quote is ,000 shares of 5% preferred stock - issued at HK$100 for each share - current price is HK$77 2,500,000 shares of common stock - current price is HK$63 - market beta of the share is 1.22 The corporate tax rate is 16%. Currently, the market risk premium is 6% and the risk-free interest rate is 2%. Engagement of celebrity endorser In 2015, a significant amount of expenses was incurred for the design and renovation of the new retail shops in Shanghai and Beijing, as well as the recruitment and training of sales persons, and the engagement of Mei Mei Li, a famous actress in mainland China, to be the celebrity endorser of the Group for advertising purposes. Mei Mei Li uses a British Virgin Islands ( BVI ) incorporated company, Li BVI Ltd ( Li BVI ), a non-hong Kong tax resident, to sign the services contract with MBJ Holding for her performance in the opening ceremonies for two shops in Hong Kong at a consideration of HK$3 million. Final Examination (June 2016 Session) Paper II 2 of 9

3 Sales offer of discount coupon The Group has no past practice of routinely granting customer discounts or similar awards on any purchases. To celebrate the grand openings of the Group s new retail shops in Shanghai and Beijing in 2015, a discount coupon of HK$500 which is redeemable on the next purchase with a value over HK$10,000 at the same shop would be given to a customer for purchases with a value over HK$10,000 in a single transaction, with a validity of two years from the issue date. This discount coupon is only available to customers who had made the qualified purchases and it is not anticipated that the Group would breach its obligation when the customers present the valid discount coupons on the next purchase. As at 30 June 2015, 1,000 discount coupons of HK$500 each had been issued to customers and 30 of such discount coupons had been redeemed during the year. According to historical experience, 20% of the coupons issued are expected to be redeemed by the expiry date. Executive share option plan On 1 July 2014, MBJ Holding granted 1,000 executive share options to each of the 50 eligible employees of the Group, on the condition that they remain in the employment of the Group throughout the vesting period. Each share option provides the holder with the right to purchase one share of MBJ Holding at HK$25. The executive share options shall be vested in three tranches as follows: (I) up to 30% of the share options shall be vested on 30 June 2015; (II) up to 30% of the share options shall be vested on 30 June 2016; and (III) up to 40% of the share options shall be vested on 30 June In addition, if the Group were to be successfully listed on the Hong Kong Stock Exchange between 1 July 2014 and 30 June 2017, the employees under this share option plan who are still in service at that time will become unconditionally entitled to receive all of their remaining unvested options. If the listing does not occur between 1 July 2014 and 30 June 2017, the employees leaving the Group are not required to surrender the vested share options. The fair value of each share option for tranches (I), (II) and (III) has been determined as HK$10, HK$12 and HK$15 respectively as of 1 July 2014, with the management s estimation that the listing could be achieved in three years time. As at 30 November 2015, the management concluded that the Group s listing on the Main Board of the Hong Kong Stock Exchange was probable and expected that it would occur by as early as 31 December It was anticipated that no employees under the share option scheme would leave during the required service period. Trendy Club s internet sales platform Sofia, the second daughter of Adam, does not involve herself in the family business. She is a fashion designer and she set up Trendy Club in 2015, with its registered office in a factory unit in Lai Chi Kok owned by Adam. She travels to Europe frequently to source fashioned clothes and shoes and sells them through Trendy Club s website. Final Examination (June 2016 Session) Paper II 3 of 9

4 Wong Lam is also the auditor of Trendy Club and Amber always asks about the details of Trendy Club by chatting with the audit team members. (i) Membership and purchase Trendy Club s customers have to register as a member of the club and place their orders directly for the items displayed for sale on the website. Full payments have to be deposited to one of the Trendy Club s designated bank accounts within three days after the order is confirmed by Trendy Club through , otherwise the order will be cancelled automatically. (ii) Delivery and returns Trendy Club arranges the delivery of goods from its factory unit to the customers solely through Speedy Delivery Ltd ( Speedy Delivery ), and the customers are charged with the costs of such delivery services based on the weight of goods. Upon delivery, the customers sign on the delivery notes to acknowledge the receipt of goods and Speedy Delivery will return the signed delivery notes to Trendy Club to update the record in the website as completed orders. At the same time, an will be sent to the customer automatically as a confirmation of delivery and the sales will be automatically posted to the accounting system. Trendy Club settles the delivery service cost with Speedy Delivery and the delivery cost is based on 30% of Trendy Club s monthly gross revenue. Goods return/exchange is allowed within seven days after the goods delivery only if there is qualify issue with the goods sold and a refund will only be made by cheque to the customer. However, goods return/exchange cases are not common. (iii) European purchase and delivery In addition, Trendy Club provides purchasing services for customers who would like to buy a specific item of fashioned clothes or shoes from European retail online shops. The customers can place the purchase order through Trendy Club s website to specify the product details, the website address linked to the product, the listed retail price, the quantity and the method of international shipment/delivery. Trendy Club then purchases such goods from the European retail online shops for on-sale to the customers. Trendy Club then calculates the total payment amount which includes the sales price with 10% mark-up and the international delivery charges as determined by the suppliers. A customer has to deposit the full payment into one of the Trendy Club s designated bank accounts within three days after the order is confirmed by Trendy Club through , otherwise the order will be cancelled automatically. However, Trendy Club does not warrant that the items ordered by customers will be available for purchase and delivery. An order will also be cancelled automatically if the goods ordered are reported as out of stock or available at a higher price at the time of purchase. In the case of a cancelled order, any advance payments made will be fully refunded to the customer. When the product order has been successfully placed online, the product is delivered to the customers through Speedy Delivery under which the actual delivery charges are borne by the customer on physical receipt. No return services are available. Final Examination (June 2016 Session) Paper II 4 of 9

5 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 (5 marks approximately 9 minutes) Identify the corporate governance issues of the Group and advise on how they could be enhanced in view of the listing plan. (5 marks) Question 2 (6 marks approximately 11 minutes) Identify from the case the potential ethical issues and independent threats to the auditor, Wong Lam & Co ( Wong Lam ). Propose safeguards or ways to mitigate the threats you have identified. (6 marks) Question 3 (9 marks approximately 16 minutes) Determine the typical information technology general controls and specific application controls you would expect to be present in Trendy Club s internet sales platform. (9 marks) Question 4 (13 marks approximately 24 minutes) (a) You are the audit engagement manager-in-charge of the Trendy Club for the year ended 30 June For the two sales arrangements through the website of Trendy Club, analyse whether the revenue should be reported as gross or net in the financial statements of Trendy Club. (8 marks) (b) Based on the case relating to the transactions of Trendy Club, identify the transactions that may indicate possible undisclosed related party transaction and propose the audit procedures to address this audit risk. (5 marks) Final Examination (June 2016 Session) Paper II 5 of 9

6 Question 5 (8 marks approximately 15 minutes) (a) Outline the vision and mission of My Beloved Jewellery Holding Company Limited ( MBJ Holding ). (2 marks) (b) Apply briefly a SWOT analysis of MBJ Holding and identify at least one item under each category within the analysis. (6 marks) Question 6 (17 marks approximately 30 minutes) (a) According to the Funding plan, compute: (i) the theoretical market value of MBJ Holding; and (ii) the weighted average cost of capital ( WACC ) for MBJ Holding. Note: For your computation, the market value of preference share is assumed at HK$15.4 million. (8 marks) (b) Identify two possible limitations when performing financial due diligence for mergers and acquisitions. Propose administrative or operating procedures to address the issues. (4 marks) (c) Explain why dividend payout decisions can be used by the management to signal the prospects of the related entity. (5 marks) Final Examination (June 2016 Session) Paper II 6 of 9

7 Question 7 (17 marks approximately 30 minutes) You are Peter Lam, the audit engagement manager-in-charge of the My Beloved Jewellery Group audit. You started the audit planning and met Amber, the CFO, to obtain the latest information similar to that provided in the case. Prepare the following to facilitate your audit team to start the audit on the financial statements for the year ended 30 June Required: (a) State the relevant accounting principles in accounting for expenditures incurred (whether expensed or capitalised) and propose the accounting treatment for each of the following expenditures: (i) design and renovation of the new retail shops in Shanghai and Beijing; (ii) recruitment and training of sales persons; and (iii) engagement of Mei Mei Li at the shop opening ceremony as celebrity endorser for the Group. (5 marks) (b) Explain the accounting treatment for the discount coupons including the financial impact on the financial statements. Note: Assume My Beloved Jewellery uses the residual method to allocate the consideration. (4 marks) (c) Explain the accounting treatment for the share option scheme adopted by the Group. Calculate the share-based payment cost to be recognised in the year ended 30 June 2015 and prepare the required accounting entry(ies). (8 marks) * * * * * * * * Final Examination (June 2016 Session) Paper II 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. Question 8 (8 marks approximately 15 minutes) Explain whether Li BVI is liable to Hong Kong profits tax. If yes, advise the tax obligations and the specific action(s) required by Li BVI. Also, advise as to the tax implication and the specific actions required by MBJ Holding in relation to the HK$3 million payment to Mei Mei Li. Apply specific tax case(s) and tax provision(s) to support your advice, if any. (8 marks) Question 9 (17 marks approximately 30 minutes) You are the tax advisor to Sofia and she wants to lodge an offshore profits claim in Hong Kong whilst keeping the server machine holding the website sales platform of Trendy Club in Hong Kong. Prepare an advice letter to Sofia with regard to the following: Required: (a) Explain the rules governing the source of income in Hong Kong and analyse whether her idea of keeping the server machine in Hong Kong is feasible for offshore claims purposes. (9 marks) (b) Advise as to how the different activities should then be carried out in places both in and outside of Hong Kong to strengthen the offshore claim. (4 marks) (c) Advise on how the Inland Revenue Department ( IRD ) deal with the offshore claim and what Trendy Club could do if the IRD raises a tax assessment disallowing the offshore claim? (4 marks) * * * END OF EXAMINATION PAPER * * * Final Examination (June 2016 Session) Paper II 9 of 9