Convergence to IFRS and SME-FRS 28 August 2006

Convergence to IFRS and SME-FRS 28 August 2006 Nelson Lam CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) ACA 2005-06 Nelson 1 Today s Agenda Overview of of SME-FRF and SME-FRS Real Cases and Examples Simple and Comprehensive Selected Major Changes Presentation & Disclosures Leases and Investment Property Effects of of Changes in in Foreign Exchange Rates Financial Instruments HKFRS/HKAS HKAS 1 & 8 HKAS 17 17 & 40 40 HKAS 21 21 HKAS 39 39 SME-FRS Section 1 & 2 Section 3 & 5 Section 15 15 Section 6 Other Major Changes in in SME-FRS Amendments effective for for the periods beginning on on or or after 1.1.2006 2005-06 Nelson 2 1

Several Pieces of News First. IASB announced on 24 July 2006 that: It will not require the application of new IFRSs under development or major amendments to existing standards before 1 January 2009 It will also be providing 4 years of stability in the IFRS platform of standards for those companies that adopted IFRSs in 2005 However, on 4 August 2006, it has issued its latest draft of ED on International Financial Reporting Standard for SME ED expected in Q4 of 2006 Final IFRS expected in Q4 of 2007 2005-06 Nelson 3 Brief Introduction: SME-FRF & FRS SME SME Financial Reporting Framework Sets out Conceptual Basis Qualifying Criteria (Qualifying Entity) Transitions and Effective Date SME Financial Reporting Standard Divided into Definitions Specific Requirements (in 17 sections) Transitions and Effective Date Appendices 2005-06 Nelson 4 2

Brief Introduction: SME-FRF & FRS Self-contained Historical Cost Convention Properly Present Only Not Applicable to Consol. No fallback to Main HKFRS (even if if no guidance in SME- FRS) No true and fair Only properly presented and/or true and correct Except for those Either not choose permitted or required SME-FRS, or under SME-FRS, incl. Apply to only PPE exchanged-in separate financial Finance lease statements Investment acquired by share or by asset exchange Revenue Foreign currency monetary items 2005-06 Nelson 5 SME Framework Users Objective Underlying Assumptions Qualitative Characteristics Elements Recognition Measurement Even SME-FRF is similar to the Framework of Main HKFRS 2 frameworks should be considered as independent framework. Conceptual Basis for the preparation of financial statements in accordance with the SME Financial Reporting Standard One of the major differences is: SME-FRF adopts Historical Cost Convention, but but further restricted that that assets: should should not not be be revalued nor nor should should future future cash cash flows flows be be discounted in in the the measurement of of assets assets and and liabilities Ruled out out Revaluation or or Fair Value Model? Value in in use? 2005-06 Nelson 6 3

SME Framework Qualifying Entity HK Incorporated Company Satisfies S.141D Adopted S.141D Can choose Must use No Choice Entity Non-HK Incorporated Entity Satisfies the requirements imposed by the law of the entity s place of incorporation and its constitution No Public Accountability All Owners Agreed Fulfilled Size Test Can choose SME-FRF SME-FRF and and SME-FRS SME-FRS 2005-06 Nelson 7 SME Framework Section 141D Satisfies S.141D In order to apply section 141D All the shareholders of a private company agree in writing that section 141D shall apply with respect to a financial year The shareholders shall not in any financial year enter into an agreement for the above purposes for more than one such financial year. But the following private companies are not allowed to apply section 141D a) a company has any subsidiary or is a subsidiary of another company formed and registered under the HK Companies Ordinance or an existing company; or b) a bank, a securities dealer, an insurance company, money lender, or a company owning and operating ships/aircraft engaged in the carriage of cargo into or out of HK All Owners Agreed in Writing Each Year Group companies under the HK Co. Ordinance Companies in Specific Industries 2005-06 Nelson 8 4

SME Framework Section 141D HK Incorporated Company In other word, all HK incorporated company has adopted section 141D, they must use SME-FRF and SME-FRS. Must use Adopted S.141D No Choice SME-FRF (para. 16) also clearly states that Compliance with the SME-FRF and SME-FRS is necessary in order for financial statements to give a true and correct view When a HK incorporated company prepares its financial statements in accordance with section 141D SME-FRF SME-FRF and and SME-FRS SME-FRS True and Correct = Compliance with SME-FRF and SME-FRS 2005-06 Nelson 9 Today s Agenda Selected Major Changes Presentation & Disclosures Leases and Investment Property Effects of of Changes in in Foreign Exchange Rates Financial Instruments HKFRS/HKAS HKAS 1 & 8 HKAS 17 17 & 40 40 HKAS 21 21 HKAS 39 39 SME-FRS Section 1 & 2 Section 3 & 5 Section 15 15 Section 6 2005-06 Nelson 10 5

Presentation and Disclosure (HKAS 1 and 8 vs. SME-FRS Section 1 and 2) Highlight Critical Amendments 2005-06 Nelson 11 Balance Sheet Minimum requirements on the face of the balance sheet As a minimum, the face of the balance sheet shall include line items that present the following amounts: a) property, plant and equipment; b) investment property; c) intangible assets The use of different measurement bases for different classes of assets suggests that their nature or function differs and, therefore, that they should be presented as separate line items. For example, different classes of property, plant and equipment can be carried at Cost, or Revalued amounts in accordance with HKAS 16 PPE. In In the the past, past, it it use use may may need need 2005-06 Nelson 12 6

Current Assets An asset shall be classified as current when it satisfies any of the following criteria: a) it is expected to be realised in, or is intended for sale or consumption in, the entity s normal operating cycle; b) it is held primarily for the purpose of being traded; c) it is expected to be realised within 12 months after the balance sheet date; or d) it is cash or a cash equivalent unless it is restricted from being exchanged or used to settle a liability for at least 12 months after the balance sheet date. New requirements All other assets shall be classified as non-current. Examples: Deposits pledged to bank (how long?) Fixed deposits over 1 year maturity 2005-06 Nelson 13 Reclassification of Non-Current Assets Current vs. non-current assets to observe HKFRS 5 as well No non-current assets can never be classified as current unless the criteria set out in HKFRS 5 are fulfilled Assets classified as as non-current in in accordance with with HKAS 1 shall shall not notbe be reclassified as as current assets until untilthey they meet meet the the criteria criteria to to be be classified as as held held for for sale sale in in accordance with with HKFRS 5 Assets of of a class that that an an entity would normally regard as as non-current that that are are acquired exclusively with with a view view to to resale shall shall not notbe be classified as as current unless unlessthey meet meet the the criteria criteria to to be be classified as as held held for for sale sale in in accordance with with HKFRS 5 2005-06 Nelson 14 7

Current Liabilities A liability shall be classified as current when it satisfies any of the following criteria: a) it is expected to be settled in the entity s normal operating cycle; b) it is held primarily for the purpose of being traded; c) it is due to be settled within 12 months after the balance sheet date; or d) the entity does not have an unconditional right to defer settlement of the liability for at least 12 months after the balance sheet date. New requirements All other liabilities shall be classified as non-current. Implication 2005-06 Nelson 15 Current Liabilities Revised rules on classifying a liability as current or non-current A liability held for traded current A financial liability due within 12 months after the B/S date current even if an agreement to refinance on a long-term basis is completed after the B/S date (only disclosed as non-adjusting event) If an entity has discretion to refinance If an entity without discretion to refinance non-current current A non-current financial liability is payable on demand with a breach on a condition of its loan agreement on or before the B/S date If the lender agreed not to demand payment after the B/S date current (only disclosed as non-adjusting event) by the B/S date non-current Implication 2005-06 Nelson 16 8

Current Assets and Liabilities Example Can the following be classified as current assets? 3-month fixed deposits pledged to a bank to secure a mortgage loan of 5 years 2-year fixed deposits with a bank Can the following be classified as non-current liabilities? 5-year term loan matured after year end but renewed for another 5 years after year end (before the issuance of the financial statements) 2-year term loan to be matured with 12 months and the entity has a right to renew for another 2 years 2005-06 Nelson 17 Income Statement Minimum requirements on the face of the income statement Requires the disclosure on the face of the income statement: Revenue (instead of turnover and other revenue) Finance costs Profit or loss for the period, and The allocation of that amount between a) Profit or loss attributable to minority interest, and b) Profit or loss attributable to equity holders of the parent A similar requirement has been added for the statement of changes in equity and such allocated amounts are not to be presented as items of income or expense Not require to disclose the results of operating activities as a line item on the face of the income statement An entity shall not present any items of income and expense as extraordinary items, either on the face of the income statements or in the notes Entities can t use it Entities can still show it 2005-06 Nelson 18 9

Notes New disclosures (an entity is required to disclose the following) Key sources of estimation uncertainty Information about the key assumptions concerning the future, and other key sources of estimation uncertainty at the balance sheet date, that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year In respect of those assets and liabilities, the notes shall include details of: a) their nature; and b) their carrying amount as at the balance sheet date Examples in in the absence of of recently observed market prices used to to measure the following assets and liabilities, future-oriented estimates are necessary to to measure: the recoverable amount of of classes of of PPE the effect of of technological obsolescence on inventories Estimates involve assumptions about such items as the risk adjustment to to cash flows or or discount rates used future changes in in salaries and in in prices affecting other costs. 2005-06 Nelson 19 Notes New disclosures (an entity is required to disclose the following) Disclosure of accounting policies The judgements, apart from those involving estimations, management has made in the process of applying the entity s accounting policies that have the most significant effect on the amounts recognised in the financial statements (in the summary of significant accounting policies or other notes) Examples Management makes judgements in in determining: a) a) whether financial assets are held-to-maturity investments; b) b) when substantially all the significant risks and rewards of of ownership of of financial assets and lease assets are transferred to to other entities; c) c) whether, in in substance, particular sales of of goods are financing arrangements and therefore do not give rise to to revenue; and d) d) whether the substance of of the relationship between the entity and a special purpose entity indicates that the special purpose entity is is controlled by the entity. 2005-06 Nelson 20 10

Notes New disclosures (an entity is required to disclose the following) Other disclosures An entity shall disclose the following, if not disclosed elsewhere in information published with the financial Any special? statements: a) the domicile and legal form of the entity, its country of incorporation and shall disclose now, the address of its registered office instead of of encouraged (or principal place of business, if different from the to to disclose registered office); b) a description of the nature of the entity s operations and its principal activities; and c) the name of the parent and the ultimate parent of the group. 2005-06 Nelson 21 Accounting Policies: Changes HKFRS issued but not yet effective HKAS 8 requires that, when an entity has not applied a new Standard or Interpretation that has been issued but is not yet effective, the entity shall disclose: a) this fact; and b) known or reasonably estimable information relevant to assessing the possible impact that application of the new Standard or Interpretation will have on the entity s financial statements in the period of initial application. 2005-06 Nelson 22 11

Accounting Policies: Changes Example Hong Kong Financial Reporting Standards issued but not yet effective for the year HKFRSs that have been issued but are not yet effective for the year include the following HKFRSs which may be relevant to the company s operations and financial statements: Effective for annual periods beginning on or after Amendments to HKAS 39 Financial instruments: recognition and measurement and HKFRS 4 Insurance contracts Financial guarantee contracts 1 January 2006 HKFRS 7 Financial instruments: disclosures 1 January 2007 Amendments to HKAS 1 Presentation of financial statements: capital disclosures 1 January 2007 Initial assessment has indicated that the adoption of these HKFRSs would not have a significant impact on the company s financial statements in the year of initial application. The company will be continuing with the assessment of the impact of these HKFRSs and other significant changes may be identified as a result. 2005-06 Nelson 23 How s Under SME-FRS? No requirement on cash flow statement Changes in equity can be disclosed in notes No specific disclosure required on critical accounting estimates and judgement No specific requirement as those in HKFRS 5 Definitions of current assets and current liabilities same as Main GAAP (as discussed) Domicile, legal form, place of incorporation, address of registered office are still required (as discussed) Undue cost or effort exemption criterion introduced on change in accounting policy 2005-06 Nelson 24 12

Leases and Investment Property (HKAS 17 and 40 vs. SME-FRS Section 3) 2005-06 Nelson 25 Leases Separate Measurement 1. Introducing several new paragraphs New requirements with significant impact, mainly Separate measurement (of (of the the land land and and buildings buildings elements) elements) at at the the inception inception of of the the lease lease Land and Building Land only Building only 2005-06 Nelson 26 13

Leases Separate Measurement If a lease contains land and buildings elements 2 elements are considered separately for lease classification If title of both elements is expected to pass to the lessee Both elements are classified as finance lease Lease of land and buildings Title passed to the lessee? No Yes If title of land or both elements is NOT expected to pass to the lessee The land element alone (as having indefinite life) is normally classified as an operating lease The building element is considered separately Land Operating Lease Building Finance Lease 2005-06 Nelson 27 Leases Separate Measurement Lease of land and buildings To classify and account for a lease of land and buildings the minimum lease payments (including any lump-sum upfront payments) are allocated between the land and the buildings elements Relative Fair Fair Value in proportion to the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception of the lease Land only Building only 2005-06 Nelson 28 14

Leases Separate Measurement Lease of land and buildings Minimum lease payment allocated in in proportion to to the the relative fair fair values of of land and and building elements Title passed to the lessee? No Can land and building be reliably separated? Yes Yes No Land Building Operating Lease Finance Lease 2005-06 Nelson 29 Leases Separate Measurement Lease of land and buildings If the lease payments cannot be allocated reliably between the 2 elements the entire lease is classified as a finance lease unless it is clear that both elements are operating leases, in which case the entire lease is classified as an operating lease For a lease of land and building if the land is immaterial The lease may be treated as a single unit and classified as finance or operating leases Land only Building only 2005-06 Nelson 30 15

Leases Separate Measurement Case Accounting policy on finance lease on properties (annual report 2005): On adoption of the deemed cost at the date of Merger (2001), the Group made reference to the independent property valuation conducted as at 31 Aug. 2001 for the purpose of the Merger, which did not split the values of the leasehold properties between the land and buildings elements. Any means of subsequent allocation of the valuation of the leasehold properties at the date of Merger between the land and buildings elements would be notional and therefore would not represent reliable information. It is determined that the values of the land and buildings elements of the Group s leasehold properties cannot be reliably split and the leasehold properties are treated as finance leases. The Group has also adopted the revaluation model under HKAS 16 by which assets held for own use arising under these finance leases are measured at fair value less any accumulated depreciation and impairment losses. 2005-06 Nelson 31 Leases Separate Measurement Can the lease of land and building be reliably separated? Cannot be reliably separated Reliably separated Land and Building Building Land Finance Lease Finance Lease Operating Lease Cost Cost Model Model Revaluation Revaluation Model Model Cost Cost Model Model Revaluation Revaluation Model Model At At Cost Cost 2005-06 Nelson 32 16

Leases Transition The adoption of HKAS 17 represents a change in accounting policy. HKAS 17 requires: An entity that has previously applied SSAP 14 (revised 2000) shall apply the amendments made by HKAS 17 retrospectively for all leases Retrospective Application as if that policy had always been applied restate opening balance of retained earnings restate comparative figures 2005-06 Nelson 33 Definitions of Investment Property Amended and clearer definition on an investment property SSAP 13 An investment property is an interest in land and/or buildings: a) in respect of which construction work and development have been completed; and b) which is held for its investment potential, any rental income being negotiated at arm s length HKAS 40 Investment property is property (land or a building or part of a building or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for: a) use in the production or supply of goods or services or for administrative purposes; or b) sale in the ordinary course of business 2005-06 Nelson 34 17

Definitions of Investment Property Example Amended and clearer definition on an investment property SSAP Examples 13 of investment property under HKAS 40 include: An Property investment leased property out under is an operating interest leases in land and/or buildings: Property a) in respect held for of long-term which construction capital appreciation work and development have been completed; and Property held for a currently undetermined future use b) which is held for its investment potential, any rental income Vacant being property negotiated to be leased at arm s out length under operating leases HKAS 40 Investment property is property (land or a building or part of a building or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for: a) use in the production or supply of goods or services or for administrative purposes; or b) sale in the ordinary course of business How s about property held by the lessee under an operating lease? 2005-06 Nelson 35 Definitions Extend to Operating Leases A property interest that is held by a lessee under an operating lease may be classified and accounted for as An entity has a choice investment property if, and only if the property would otherwise meet the definition of an investment property and the lessee uses the Fair Value Model This classification alternative is available on a property-by-property basis However, once this classification alternative is selected for one such property interest held under an operating lease, all properties classified as investment property shall be accounted for using the Fair Value Model Simple? How s about Let s property term this held classification by the lessee as under an operating Operating lease? Lease IP Alternative 2005-06 Nelson 36 18

Measurement after Recognition Introduce Cost Model and choose either and Fair Value Model Cost Model HKAS 40 implicitly implies that the choice can only be elected on the first-time adoption of HKAS 40 The model chosen should be applied to all investment properties, except for some identified exceptions. However, even Cost Model is adopted, HKAS 40 still requires all entities to determine the fair value of investment property For disclosure purpose, the fair value of the investment property has to be disclosed in notes to the financial statement! In determining the fair value of investment property for both cost model and fair value model an entity is only encouraged, but not required, to rely on a professional valuer s valuation 2005-06 Nelson 37 Measurement after Recognition After initial recognition, an entity that chooses shall measure all of its investment property at fair value, except in some limited cases. Fair Value Model When a property interest held by a lessee under an operating lease is classified as an investment property the fair value model must be applied for all investment properties A gain or loss arising from a change in the fair value of investment property shall be recognised in profit or loss for the period in which it arises The fair value of investment property shall reflect market conditions at the balance sheet date No depreciation required in HKAS 40 Depreciation? Not our concern this time! Tax Implication? But be careful, good & bad... 2005-06 Nelson 38 19

Transitional Arrangements Adopted Fair Value Model Opening balance of retained earnings shall be adjusted Comparative information Example: listed co. Entities previously disclosed the property s fair value encourage (but not require) to restate comparative information Entities NOT previously disclosed the property s fair value shall NOT restate comparative information Example: unlisted shall disclose this fact co., charities Included the charities taken Adopted Cost Model exemption of SSAP 13 before Deem the carrying amount of an investment property immediately before the applying HKAS 40 on its effective date (or earlier) as its cost Any adjustments shall be made to the opening balance of retained earnings for the period in which HKAS 40 is first applied Depreciation on deemed cost commences from the time at which HKAS 40 is first applied 2005-06 Nelson 39 Application of HKAS 17 & 40 in HK Any element held under lease? Can the lease of land and building be reliably separated? Whether the element can be reliably separated? Cannot be reliably separated Land and Building Building Reliably separated Land Choose the available options Finance Lease Cost Fair Value Model Model Finance Lease Cost Fair Value Model Model At Cost Operating Lease Fair Value Model Under HKAS 40 Under HKAS 17 Under HKAS 40 2005-06 Nelson 40 20

Application of HKAS 17 & 40 in HK Can Can PPE PPEor or Investment Property in in HK HK or or PRC be be carried at at cost cost model after after the the adoption of of HKAS 17 17 and and HKAS 40? 40? Example 2005-06 Nelson 41 Land and building Application of HKAS cannot 17 be reliably & 40 separated in HK Property for for own use Finance Lease Revaluation Model Cost Model Under HKAS 16 Investment property Finance Lease Fair Value Model Cost Model Under HKAS 40 2005-06 Nelson 42 21

Land and building Application of HKAS can be 17 reliably & separated 40 in HK More companies have argued Building Finance Lease Land Operating Lease Under HKAS 16 Property for for own use 1 st Choice 2 nd Choice 1 st Choice Cost Model Revaluation Model Under HKAS 40 Cost Model Cost Model Cost Model Cost Model Under HKAS 17 Investment property 2 nd Choice Fair Value Model Cost Model 3 rd Choice Fair Value Model Fair Value Model Under HKAS 40 2005-06 Nelson 43 Application of HKAS 17 & 40 in HK Example Can Can PPE PPEor or Investment Property in in HK HK or or PRC be be carried at at cost cost model after after the the adoption of of HKAS 17 17 and and HKAS 40? 40? PPE can be carried at cost model if either: The lease of land and building cannot be reliably allocated between land and building element The whole lease will be classified as finance lease (other than exception case) and then accounted for at cost model under HKAS 16; or The lease of land and building can be reliably allocated between land and building The land is carried at amortised cost under HKAS 17 The building is carried at cost model under HKAS 16 2005-06 Nelson 44 22

Application of HKAS 17 & 40 in HK Land and building cannot be reliably separated Property for for own use Finance Lease Cost Model Under HKAS 16 Land and building can be reliably separated Property for for own use Building Land Finance Lease Operating Lease Under HKAS 16 Under HKAS 17 Cost Cost Model Model 2005-06 Nelson 45 Application of HKAS 17 & 40 in HK Case Annual Report 2005 In the opinion of the directors, the lease payments of the Group cannot be allocated reliably between the land and building elements, therefore, the entire lease payments are included in the cost of land and building and are amortised over the shorter of the lease terms and useful lives. Annual Report 2005 As the Group s lease payments cannot be allocated reliably between the land and buildings elements, the entire lease payments are included in the cost of the land and buildings as a finance lease in property, plant and equipment. The adoption of HKAS 17 has not resulted in any change in the measurement of the Group s land and buildings. 2005-06 Nelson 46 23

Application of HKAS 17 & 40 in HK Example Can Can PPE PPEor or Investment Property in in HK HK or or PRC be be carried at at cost cost model after after the the adoption of of HKAS 17 17 and and HKAS 40? 40? Investment Property can be carried at cost model if either: The lease of land and building cannot be reliably allocated between land and building element The whole lease will be classified as finance lease (other than exception case) and then accounted for at cost model under HKAS 40; or The lease of land and building can be reliably allocated between land and building The land is carried at amortised cost under HKAS 17 The building is carried at cost model under HKAS 40 2005-06 Nelson 47 Application of HKAS 17 & Disclose 40 in fair HK Land and building cannot be reliably separated Disclose fair value on on which element? Investment property Finance Lease Cost Model Under HKAS 16 Land and building can be reliably separated Investment property Building Land Finance Lease Operating Lease Under HKAS 40 Under HKAS 17 Cost Cost Model Model 2005-06 Nelson 48 24

How s Under SME-FRS? Mainly fallback to the requirements of HK SSAP 17 Extended to investment property and leasehold interest in land Follow some simple approaches SME-FRS Section 3 HK SSAP 17 2005-06 Nelson 49 SME-FRS Section 3: PPE Definition Property, plant and equipment are tangible assets that: a) are held by an entity for use in the production or supply of goods or services, for rental to others, Assets held for investment for investment potential, or potential (including investment for administrative purposes; and property) are included b) are expected to be used during more than one period. 2005-06 Nelson 50 25

SME-FRS Section 3: PPE Recognition Recognition criteria for In SME-FRS In HKAS 16 Criteria not the same Same criteria Initial Cost Probable that future economic benefit of of the asset will flow to to the enterprise Cost measured reliably Subsequent Expenditure Probable that future economic benefits in in excess of of the originally assessed standard of of performance of of the existing asset will flow to to the entity Probable that future economic benefit of of the asset will flow to to the entity Cost measured reliably Same criteria applied to to both costs 2005-06 Nelson 51 SME-FRS Section 3: PPE Measurement after recognition No revaluation model can be used i.e. PPE should be carried at cost less any accumulated depreciation and any accumulated impairment losses Definitions of useful life and residual value are updated to the same definitions as in HKAS 16 Implies depreciation begins from available for use depreciation is still required even the asset is retired from active use Annual review is required on useful life but there is no such annual review requirement on residual value Consistent with Historical Cost Convention No revaluation is is allowed Useful life is is defined as: a) a) the period of of time over which an an asset is is expected to to be be available for for use by by an an entity; or or b) b) the no. of of production or or similar units expected to to be be obtained from the asset by by an an entity. 2005-06 Nelson 52 26

SME-FRS Section 3: PPE Application on leasehold interest in land Land and buildings are separable assets and are dealt with separately for accounting purposes. Leasehold interest in land from the HKSAR In In HKAS 17 Leases, such Government or elsewhere with similar features interest is is accounted for as an are also accounted for as PPE operating lease Leasehold land is to be depreciated over the lease term. Lease term defined as Buildings the same as HKAS 17 have a limited life and therefore, are depreciable assets. Separation or or Separate Measurement of of Land Land and and Building is is Can Can we we use use useful useful life, life, compulsorily required? instead of of lease lease term term in in amortisation? 2005-06 Nelson 53 Lease Term Defined in SME-FRS While HKAS 17 17 and and SME-FRS have the the same definition on on lease term, can can HK HK Interpretation 4 be be referred to to in in analysing the the implication? Lease Term is the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option. Lessee has the option At the inception 2005-06 Nelson 54 27

Leases HK Interpretation 4 HK-Int. 4 (applicable to HKFRS only) interprets that: For the purpose of applying the amortisation requirements under HKAS 16 and 17 the lease term of a HK land lease shall be determined by reference to the legal form and status of the lease renewal of a lease is assumed only when the lessee has a renewal option and it is reasonably certain at the inception of the lease that the lessee will exercise the option. Further Lessee has the option At the inception Options for extending the lease term that are not at at the discretion of of the lessee shall not be taken into account by the lessee in in determining the lease term. 2005-06 Nelson 55 Leases HK Interpretation 4 As a result (HK-Int. 4 also specifically stated) Lessees shall not assume that the lease term of a HK land lease will be extended for a further 50 years, or any other period while the HKSAR Government retains the sole discretion as to whether to renew Any general intention to renew certain types of property leases expressed by the HKSAR Government is not sufficient grounds for a lessee to include such Lessee has extensions in the determination of the lease term for the option amortisation At the inception Options for extending the lease term that are not at at the discretion of of the lessee shall not be taken into account by the lessee in in determining the lease term. 2005-06 Nelson 56 28

Leases HK Interpretation 4 Example Entity ABC has a property bought in 1980 and it is located in Cheung Sha Wan. According to the land search, the lease term with the HK SAR government should expire in 30 June 1997. Based on SSAP 14 and 17, the land and building had been depreciated over 50 years previously. Please discuss the implication under HKAS 17. Then, an an auditor issued a letter to to ABC ABC as as follows: Dear Dear Raymond, for for the the amortisation issue issue we we discussed, we we consider that that the the estimated useful useful life life of of the the land land should should be be 2047 2047 but but it it should should not not be be 1997. 1997. Therefore, the the land land cost cost should should be be amortised until until 2047. 2047. Our Our judgement is is based based on on the the HKSA s the the accounting guideline issued issued on on 1990s 1990s for for the the treatment of of land land title title in in the the new new Kowloon area. area. In In fact, fact, the the land land use use right right should should have have been been already already automatically extended to to 2047. 2047. Please comment. 2005-06 Nelson 57 Effects of Changes in Foreign Exchange Rates (HKAS 21 vs. SME-FRS Section 15) 2005-06 Nelson 58 29

Approach in HKAS 21 Determine Functional Currency Translate Foreign Currency Transactions Translate Foreign Operation or Whole Set 1. In preparing financial statements, each entity determines its functional currency. 2. The entity translates foreign currency items or transactions into its functional currency and reports the effects of such translation. 3. The results and financial position of any individual entity (say subsidiary, associate or branches) within the reporting entity (say parent) whose functional currency differs from the presentation currency of the reporting entity are translated. 4. If the entity s presentation currency differs from its functional currency, its results and financial position are also translated into the presentation currency. 2005-06 Nelson 59 What is Foreign Currency? Determine Functional Currency 1. In preparing financial statements, each entity determines its functional currency. Foreign currency is a currency other than the functional currency of the entity. Functional currency is the currency of the primary economic environment in which the entity operates. Presentation currency is the currency in which the financial statements are presented. 2005-06 Nelson 60 30

Indicators to Determine Functional currency is is the the currency of of the the primary economic environment in in which the the entity operates. Primary indicators a) the currency i) that mainly influences sales prices for goods and services, and ii) of the country whose competitive forces and regulations mainly determine the sales price of its goods and services. b) the currency that mainly influences labour, material and other costs of providing goods or service. Other indicators in determining functional currency a) the currency in which funds from financing activities (ie issuing debt and equity instruments) are generated. b) the currency in which receipts from operating activities are usually retained. 2005-06 Nelson 61 Indicators to Determine Functional currency is is the the currency of of the the primary economic environment in in which the the entity operates. When the above indicators are mixed and the functional currency is not obvious management uses its judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions. An entity s functional currency reflects the underlying transactions, events and conditions that are relevant to it once determined, the functional currency is not changed unless there is a change in those underlying transactions, events and conditions. If the functional currency is the currency of a hyperinflationary economy, the entity s financial statements are restated in accordance with HKAS 29 An entity cannot avoid restatement in accordance with HKAS 29 by, for example, adopting as its functional currency a currency other than the functional currency determined in accordance with HKAS 21 (such as the functional currency of its parent). 2005-06 Nelson 62 31

Indicators to Determine Example Functional currency is is the the currency of of the the primary economic environment in in which the the entity operates. If a PRC factory reports its financial statements in RMB. Its HK parent makes all the payments for the PRC factory in HK$. All the products of the PRC factory are delivered back to HK for selling in HK$. Which currency is the foreign currency of the PRC factory under HK SSAP 11 and HKAS 21? Under HK SSAP 11 The reporting currency is is RMB The foreign currency is is HK$ Under HKAS 21 The functional currency is is HK$ The foreign currency is is RMB Same as SME-FRS now What is is the the implication on on the the books of of PRC factory? 2005-06 Nelson 63 Indicators to Determine Case In its 2005 Interim Report, full set of HKFRS was adopted: The functional currency of each of the consolidated entities has been re-evaluated based on the guidance to the revised HKAS 21. Accounting policy on functional and presentation currency: Items included in the financial statements of each of the Group entities are measured using the currency of the primary economic environment in which the entity operates ( the functional currency ). The consolidated financial statements are presented in HK dollars, which is the Company s functional and presentation currency. 2005-06 Nelson 64 32

How s Under SME-FRS? Mainly fallback to to the requirements of HK SSAP 11 with resulting major difference from HKAS 21 SME-FRS Section 15 HK SSAP 11 2005-06 Nelson 65 SME-FRS Section 15: F. Exchange Rate The concept and approach of functional currency in HKAS 21 has not been adopted in SME-FRS Foreign currency In In HKAS 21, foreign follows the definition in HK SSAP 11, and currency is is a currency is re-defined as a currency other than other than the functional the reporting currency of an entity. currency of of the entity. Is there significant impact? 2005-06 Nelson 66 33

SME-FRS Section 15: F. Exchange Rate Translation of foreign currency transactions Initial recognition at the exchange rate at the date of transactions At each balance sheet date foreign currency monetary items retranslated by using the closing rate Translation of a foreign branch Follows the superseded Closing Rate/Net Investment Method in the superseded HK SSAP 11 a) assets and liabilities for each balance sheet presented (i.e. including comparatives) should be translated at the closing rate at the date of that balance sheet; b) income and expenses for each income statement (i.e. including comparatives) should be translated at average rate for the period, or closing rate at that balance sheet date; and c) all resulting exchange differences should be recognised as a separate component of equity. 2005-06 Nelson 67 SME-FRS Section 15: F. Exchange Rate The accounting for forward foreign contracts is largely based on HK SSAP 11 Accounting treatment depends on whether the forward contract is speculative or non-speculative Difference and calculation should be derived in respect of gain/loss and premium/discount on the contracts In In Main HKFRS, such accounting treatment is is set out in in HKAS 39 However, gain/loss and premium/discount on the contracts are not defined in in SME-FRS 2005-06 Nelson 68 34

SME-FRS Section 15: F. Exchange Rate Where a non-speculative forward contract is used as a hedge of a net monetary asset or liability the gain or loss on the contract should be taken to the income statement and the discount or premium may be either amortised over the period of the contract or taken to the income statement. Where a non-speculative forward contract is used as a hedge of a firm commitment no gain or loss need normally be recognised during the commitment period. at the end of that period any gain or loss will be added to, or deducted from, the amount of the relevant transaction. the discount or premium should be either amortised over the period of the contract or deferred with the gain or loss. Where a forward contract is speculative the gain or loss should be credited or charged to the income statement. 2005-06 Nelson 69 Financial Instrument (HKAS 32 and 39 vs. SME-FRS Section 6) 2005-06 Nelson 70 35

Summary of Changes Scope Definitions Initial Recognition Measurement Extended the scope to all contract to buy and sell of non-financial items that meet the scope. Financial instruments, including derivatives, are clearly defined. All financial instruments, including derivatives, are recognised in the balance sheet (on balance sheet). Except for strict conditions are fulfilled, all financial assets are measured at fair value 2005-06 Nelson 71 Initial Recognition Scope Definitions Initial Recognition All financial instruments, including derivatives, are recognised in the balance sheet (on balance sheet). 2005-06 Nelson 72 36

Initial Recognition Financial instrument Financial asset Financial liability Initial Recognition Trade Date Accounting Regular Way of purchase or sale An entity shall recognise financial instruments on its balance sheet when and only when the entity becomes a party to the contractual provisions of the instruments Implies trade date accounting for all cases Only a regular way purchase or sale (e.g. purchase of derivatives is not a regular way of purchase) can be accounted for by either trade date accounting or settlement date accounting 2005-06 Nelson 73 Initial Recognition & Measurement Financial instrument Financial asset Financial liability Initial Recognition Trade Date Accounting Regular Way of purchase or sale When a financial asset or financial liability is recognised initially, an entity shall measure the financial asset or a financial liability at its fair value plus transaction costs (except for those classified at fair value through profit or loss) Initial Measurement Fair Value + Transaction Cost 2005-06 Nelson 74 37

Initial Recognition & Measurement Example Fair value at Initial Recognition Low Interest Loan Entity A grants a 3-year loan of HK$50,000 to an important new customer in 1 Jan. 2005 The interest rate on the loan is 4% The current market lending rates for similar loans to customers with a similar credit risk profile is 6% Entity A believes that the future business to be generated with this new customer will lead to a profitable lending relationship. On On initial recognition, Entity A should recognise the the carrying amount of of the the loan loan at at the the fair fair value of of the the payments that that it it will will receive from from the the customer. How How is is the the fair fair value of of the the payments at at initial recognition calculated? 2005-06 Nelson 75 Initial Recognition & Measurement Example 31.12.2005 31.12.2006 31.12.2007 Cash inflow Discount factor $ 50,000 x 4% = $ 2,000 1 / (1 + 6%) 1 $ 2,000 1 / (1 + 6%) 2 $ 52,000 1 / (1 + 6%) 3 Fair value at initial recognition Present value $ 1,887 $ 1,780 $ 43,660 $ 47,327 Discounting the the interest and and principal repayments using the the market rate rate of of 6%, 6%, Entity A will will recognise an an originated loan loan of of HK$47,327. The The difference of of HK$2,673 is is expensed immediately as as the the expectation about future lending relationships does not not qualify for for recognition as as an an intangible asset. 2005-06 Nelson 76 38

Measurement after Recognition Scope Definitions Initial Recognition Measurement Except for strict conditions are fulfilled, all financial assets are measured at fair value 4-category classification will affect the subsequent measurement of of financial assets (but not the initial measurement). 2005-06 Nelson 77 Measurement Classification FA at FV through P/L AFS financial assets HTM investments Loans and receivables Financial instrument Financial asset Financial liability 4-category classification will affect the subsequent measurement of of financial assets (but not the initial measurement). 2005-06 Nelson 78 39

Measurement Classification FA at FV through P/L Definition for Financial Assets at Fair Value through P/L A financial asset that meets either of the following 2 conditions. a) It is classified as held for trading, if: An entity has NO choice i) it is acquired/incurred principally for the purpose of selling or repurchasing it in the near term; ii) there is evidence of a recent actual pattern of shortterm profit-taking on it; or iii) a derivative (except for a designated and effective hedging instrument) b) Upon initial recognition it is designated by the entity as at fair value through profit or loss, except for investments in equity instruments that do not have a quoted market price in an active market, and whose fair value cannot be reliably measured. An entity has a choice But new requirements for 2006 2005-06 Nelson 79 Measurement Classification Financial asset A Financial Held for trading (or Asset derivative)? No Upon initial recognition, designated at FA at FV through through P/L (if P/L? allowed)? Yes Yes Derivative? No Yes Designated and effective hedging instrument? No Yes Hedge Accounting New requirements in 2006 The Fair Value Option (Jul. 2005) To be discussed later Restrict a company s option in designating a financial asset (or financial liability) at FV through P/L Only allow to designate if conditions are met 3 Conditions to Designate FA at FV 2005-06 Nelson through P/L 80 40

Measurement Classification Financial asset FA at FV through P/L Definition for Financial Assets at Fair Value through P/L Effective from 1.1.2006: Upon initial recognition, an entity may designate a financial asset or financial liability as at fair value through profit or loss only: when permitted by paragraph 11A of HKAS 39 (in order to avoid separation of embedded derivative from hybrid contract), or when doing so results in more relevant information, because either i) it eliminates or significantly reduces a measurement or recognition inconsistency ii) financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis 1. Embedded Derivative Condition 2. Eliminates Inconsistency 3. Managed on Fair Value Basis 3 Conditions to Designate 2005-06 Nelson 81 Measurement Classification FA at FV through P/L AFS financial assets Definition for Available-for-sale financial assets Those non-derivative financial assets that are designated as available for sale, or An entity has a choice Those not classified into other categories Implies Except for those held for trading, all the remaining financial assets can be designated as AFS financial assets Loans and receivables and HTM investments can also be initially designated as AFS financial assets 2005-06 Nelson 82 41

Measurement Classification FA at FV through P/L AFS financial assets HTM investments Definition for Held-to-Maturity Investments Non-derivative financial assets with fixed or determinable payments and fixed maturity That the entity has the positive intention and ability to hold to maturity, other than those initially designated as FA at FV through P/L those designated as AFS financial assets those that meet the definition of loans and receivables A debt instrument with a variable interest rate can satisfy the criteria for a HTM investment. Equity instruments cannot be HTM investments either because they have an indefinite life (such as ordinary shares) or because the amounts the holder may receive can vary in a manner that is not predetermined (such as for share options, warrants and similar rights). 2005-06 Nelson 83 Measurement Classification Subject to to Tainting Rule below HTM investments Definition for Held-to-Maturity Investments An entity shall not classify any financial assets as held to maturity if the entity has, during the current financial year or during the two preceding financial years, sold or reclassified more than an insignificant amount of held-tomaturity investments before maturity (more than insignificant in relation to the total amount of held-tomaturity investments) Any Any implication to to those adopting SME-FRS? 2005-06 Nelson 84 42

Measurement Classification FA at FV through P/L AFS financial assets HTM investments Loans and receivables Definition Non-derivative financial assets with fixed or determinable payments that are not quoted in an active market, other than those the entity intends to sell immediately or in the near term (which shall be classified as held for trading) those initially designated as FA at FV through P/L those initially designated as AFS financial assets those for which the holder may not recover substantially all of its the initial investment, other than because of credit deterioration, which shall be classified as AFS financial assets An interest acquired in a pool of assets that are not loans or receivables is not a loan or receivable (for example, an interest in a mutual fund or a similar fund). Examples include: loan assets, trade receivables, rental deposits, deposits held by banks 2005-06 Nelson 85 Measurement after Recognition Classification determine Subsequent Measurement FA at FV through P/L AFS financial assets HTM investments Loans and receivables at Fair Value at Fair Value at Cost at Amortised Cost at Amortised Cost Except for investments in equity instruments that do not have a quoted market price in an active market, and whose fair value cannot be reliably measured Amortised cost of a financial instrument is: amount at which the financial instrument is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method, and minus any reduction for impairment or uncollectibility. 2005-06 Nelson 86 43