SECTION A CASE QUESTIONS (Total: 75 marks) Answer 1(a) Under the dividend growth model, do(1 g) Ke = g, where do is the current net dividend Po Po is the current share price g is the expected dividend growth rate 0.5(1 0.08) = 0.08 10 = 13.4% Weaknesses of the dividend growth model include: It does not incorporate risk No allowance is made for the effect of taxation It does not take capital gains into account Dividends do not grow smoothly in reality It assumes no issue costs for new shares Answer 1(b) Bond market value Interest net of tax (Note) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 (HK$ million) (180) 10.02 10.02 10.02 10.02 10.02 Bond repayment 200 Net cash flows (180) 10.02 10.02 10.02 10.02 210.02 Discount factor @6% 1.000 0.9434 0.8900 0.8396 0.7921 0.7473 Present value (180) 9.4529 8.9178 8.4128 7.9368 156.9479 NPV @6% 11.6682 Discount factor @9% 1.000 0.9174 0.8417 0.7722 0.7084 0.6499 Present value (180) 9.1923 8.4338 7.7374 7.0982 136.4920 NPV @9% (11.0463) Final Examination (December 2013 Session) Paper II 1 of 12
The cost of debt is the interest rate under which the NPV of the bond is zero. 11.6682 Kd (after-tax) = 6% x9% 6% 11.6682 11.0463 = 7.54% Note: Interest net of tax = $200 million x 6% x (1-0.165) = $10.02 million Answer 1(c) Computation of the cost of equity using CAPM: R e = R f +β(r m -R f ), where R e is the cost of equity = 3%+0.9(10%-3%) R f is the risk-free rate of return = 9.3% R m is the market rate of return β is the beta factor of the stock Advantages of CAPM: It produces a discount rate which is based on the systematic risk of the individual investment. It can be used to compare projects of all different risk classes. Limitations of CAPM: It is difficult to estimate the expected market return. It may be difficult to determine the risk-free rate of return. The CAPM is only a single period model. To extend the use of the return estimated from CAPM to more than one time period would require both project performance relative to the market and the economic environment to be reasonably stable. There may be errors in the statistical analysis used to calculate betas. Betas may also change over time. Answer 1(d) Computation of the weighted cost of capital (WACC): WACC = Ve Vd Ke Kd (1 t) Ve Vd Ve Vd where K e is the cost of equity K d is the cost of debt V e is the market value of equity in the firm V d is the market value of debt in the firm t is the rate of corporate tax Final Examination (December 2013 Session) Paper II 2 of 12
As CAPM is a more widely used and acceptable model for calculating cost of capital or required rate of return than the dividend growth model, the cost of equity as calculated by CAPM is used. Market value (HK$' million) Cost of funding (after tax) Equity 1,000 9.3% Debt 180 7.54% 1,180 1,000 180 WACC = 9.3%x 7.54%x 1,180 1,180 = 9.03% Note: market value of equity = $10 x 100 million shares = $1,000 million Answer 1(e) MM stated that, in a perfect market (including in the absence of tax), a firm s capital structure would have no impact upon its value (or its WACC). The total market value of a firm, in the absence of tax, will be determined by just two factors, the total earnings of the firm and the level of operating risk attached to those earnings. MM (including tax) As debt finance is increased, the WACC would continue to fall, up to gearing of 100%. Benefit of tax should outweigh the increased cost of equity due to gearing risk. Under the traditional view of capital structure, there is an optimal mix of debt and equity. The optimal capital structure will be the point at which WACC is lowest. Answer 2(a)(i) Under Hong Kong Financial Reporting Standard 11 ( HKFRS 11 ), Joint arrangements, joint control is the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. As defined in Hong Kong Financial Reporting Standard 10 ( HKFRS10 ), Consolidated financial statements, relevant activities are activities of the investee that significantly affect the investee s returns. The activities as listed are a range of operating and financing activities which would significantly affect returns and would be regarded as relevant activities under HKFRS 10. The requirement for unanimous consent means that one party can prevent another party from making unilateral decisions about the relevant activities without its consent. Final Examination (December 2013 Session) Paper II 3 of 12
In this case, Precision and the Investor must act together to direct the operating and financing activities that significantly affect the returns of the arrangement and hence joint control exists. Given that Robotic is a separate vehicle and neither Precision nor the Investor has rights to the assets, and obligations for the liabilities, relating to Robotic, the investment in Robotic would be considered as a joint venture under HKFRS 11; and it would be accounted for using the equity method in accordance with Hong Kong Accounting Standard 28 ( HKAS 28 ), Investments in associates and joint ventures, unless the exemption criteria from applying the equity method as specified in HKAS 28 are met. Answer 2(a)(ii) Under HKFRS 11, if the requirement for unanimous consent relates only to decisions that give a party protective rights and not to decisions about the relevant activities of an arrangement, that party is not a party with joint control of the arrangement. Protective rights are designed to protect the interests of their holder without giving that party power over the investee to which those rights relate. In this case, the decisions on activities requiring unanimous consent only give the Investor protective rights, the Investor cannot have power or prevent Precision from having power over Robotic. Therefore, under this scenario, Precision has the ability to control Robotic and should consolidate the financial information of Robotic in its 2013 consolidated financial statements. Final Examination (December 2013 Session) Paper II 4 of 12
Answer 2(b)(i) Under HKFRS 9, the loan should be recognised and measured initially at fair value and subsequently at amortised cost using the effective interest method. Assuming the prevailing market interest rate of the loan is 8%, the table below provides information about the amortised cost, interest expenses and cash flows of the loan in each reporting period. Year Amortised costs Interest Amortised cost Opening calculated Closing balance at 8% Cash flows balance 31Dec $ $ $ $ 1/6/2013 1,361,166.39 63,521.10 0 1,424,687.49 1/1/2014 1,424,687.49 113,975.00 0 1,538,662.49 1/1/2015 1,538,662.49 123,093.00 0 1,661,755.49 1/1/2016 1,661,755.49 132,940.44 0 1,794,695.93 1/1/2017 1,794,695.93 143,575.67 0 1,938,271.60 1/1/2018 1,938,271.60 61,728.40 (2,000,000) 0 The fair value of the loan as determined under HKFRS 9 = $1,361,166.39. Under HKFRS 9, the loan is initially recognised at $1,361,166.39. The interest expense is recognised in profit or loss at 8% in accordance with HKFRS 9. Note: The suggested answers will still be the same under HKAS 39, the existing applicable accounting standard for this question. According to the six-month rule for QP examinations, the examinable accounting standard for this question is HKFRS 9 but not HKAS39. Answer 2(b)(ii) Under HKAS 20, the benefits of a government loan at a below-market rate of interest is treated as a government grant which is accounted in accordance with HKAS 20. Benefit of the below-market rate of interest = proceeds received (i.e. $2,000,000) initial carrying value of the loan as determined under HKAS 39 (i.e. $1,361,166.39) = $638,833.61 Final Examination (December 2013 Session) Paper II 5 of 12
The benefit would be recognised in accordance with HKAS 20 as deferred income. Therefore, on 1 June 2013 (i.e. the date that the loan is received), the following entries are recognised: $ $ Dr Cash 2,000,000 Cr Government loan 1,361,166.39 Cr Deferred income (government grant) 638,833.61 Being initial recognition of the loan at below-market rate of interest. Under HKAS 20, the amount of government grant ($638,833.61) would be recognised in profit or loss, on a systematic basis, over the period of the interest-free loan, or in the period Robotics recognises as expenses the related costs for which the grant is intended to compensate. Answer 3 Potential ethical dilemmas include: (i) The accountants of Precision received specific instructions from the Controller to ignore facts and circumstances requiring adjustments to purchases and payables. As a professional accountant, Sam should prepare or present financial and other information fairly, honestly and comply with professional standards. If he believes that ignoring the facts and circumstances requiring adjustments to the books will be falsifying financial information, he may consult with respect to the matter with superiors (e.g. the Chief Financial Officer) and agree on a resolution that he is comfortable with. (ii) The audit partner of Robotic is the wife of the CFO of Precision. As Precision acquires Robotic, it poses a familiarity threat as the CFO would be in the chain of command of the financial reporting process of Robotic where his wife is going to audit. This familiarity threat can be mitigated if the audit could be handled by another partner of the audit firm without a close relationship with any individuals in Precision and Robotic. (iii) ABC CPA acted as tax advisor in helping Precision to structure the acquisition in the most tax efficient manner, where the position is considered as aggressive and potentially attracting challenges from tax authorities. When ABC CPA audits the financial statements which include the acquisition and the acquired Robotic, the selfreview threat arises as it audits the aggressive tax structure it designed and helped Precision to implement. Final Examination (December 2013 Session) Paper II 6 of 12
This self-review threat can be mitigated through engaging separate independent tax teams to handle the tax advisory work and the audit of tax work. Other valid threats and safeguards or ways to mitigate the threats identified, for example: Furthermore, the audit team can also suggest that Precision engages one additional tax advisor for a second opinion to reduce the risk. The personal holding of shares in Robotic by Peter, the audit partner of Precision, poses a self-interest threat as soon as the acquisition of Robotic is completed. The audit partner should dispose of the shares immediately before he continues his role as the audit partner of Precision. Answer 4 The benefit of having a parallel run entails lowest risk in terms of data, in case anything goes wrong, the entity can still fall back to the old system. The drawbacks of a parallel run are the additional costs and resources involved. The entity must pay license fees for both systems for the one month period and will need to deploy additional resources to support the parallel run. The Information Technology Manager might focus mainly on the following: (i) (ii) (iii) (iv) Complete a mapping of the chart of accounts of the new system and the old system and decide how to integrate the data of Robotic using the chart of account in the new system; Train relevant staff adequately to use the new system, and provide information technology support as necessary; Ensure data are properly transferred from the old system to the new system as opening figures by performing manual checking before accepting the transfer as final; and Cross-match the results of the parallel run of the two systems and identify errors or bugs in the new system before accepting the system. Final Examination (December 2013 Session) Paper II 7 of 12
Answer 5(a) The audit approach and procedures for the related party transactions of Precision include: (i) Control environment and controls The auditor shall first understand the entity s internal controls in identifying a related party and the transactions with a related party for disclosure in the financial statements. From the case, though there is no specific identifier in the system to locate the related party and transaction with it, the Finance Manager is responsible for keeping a list of related parties and tracking the related party transactions for the year. The auditor should understand the above controls, evaluate them and validate the controls for operating effectiveness before they can place reliance on the controls. (ii) Substantive procedures The auditor should obtain the list of related parties from the management, compare it against the list obtained last year; and/or cross-match against understandings obtained elsewhere in the audit for completeness, e.g. from a review of the minutes and significant contracts, circularisation of bank and legal confirmations or meetings with management. The auditor can also circularise confirmations directly with the related party to confirm the balances and transactions with the related party. The auditor should also be particularly skeptical regarding transactions with a related party not at market terms. For these transactions, the auditor should review the specific agreement and terms of the arrangement to understand the business rationale for the transactions and trace samples of the transactions with the related party. Furthermore, the auditor should check if there is appropriate approval for such transactions. Final Examination (December 2013 Session) Paper II 8 of 12
Answer 5(b) The auditor shall select a sample of trade payable balances from the payable listing for confirmation circularisation. This addresses most of the audit assertions through one single procedure. Further to the above, to address the completeness assertion, the auditor shall select additional suppliers for confirmation circularisation from a list of active suppliers as indicated in the purchase ledger. The auditor shall trace samples of the outstanding invoices to underlying supporting documents (e.g. delivery / receipt notes, shipping documents). The auditor shall review a sample of the reconciliations of trade payables balances to balances in suppliers statements in order to identify unusual or long-aged balances. For each of the reconciling items, the auditor shall trace to supporting documents (e.g. suppliers invoice, goods receipt note) to ensure they are proper reconciling items, The auditor shall perform substantive analytical procedures, for example, by developing expectations for turnover payables from industry information (or even the company s last year financial information if there is no significant change in business scale and nature), comparing it against the actual payables turnover, obtain relevant explanations and reasons for the changes, and seek to validate the reasons against the knowledge obtained. The auditor shall perform a search for unrecorded liabilities or a cut off test by examining listings of unmatched purchase orders and suppliers' invoices for any unrecorded payables. * * * END OF SECTION A * * * Final Examination (December 2013 Session) Paper II 9 of 12
SECTION B ESSAY QUESTIONS (Total: 25 marks) Answer 6(a)(i) Depreciation allowance / deduction for prescribed fixed assets. Plant and machinery under a lease should be excluded from prescribed fixed asset deduction according to section 16G(6) of the IRO. Lease, as defined in section 2 of the IRO, includes any arrangement under which a right to use the machinery or plant is granted by the owner of the machinery or plant to another person. Despite the fact that the assets were provided without charging lease rentals, the Departmental Interpretation and Practice Notes 15 (revised) adopt the view that the plant and machinery provided to the entities outside Hong Kong under processing arrangements should constitute a lease. As such, section 16G is not applicable to these fixed assets. As further explained in DIPN 15 (revised), as the plant and machinery were used by a Mainland entity outside Hong Kong, a depreciation allowance is not allowed by the IRD in accordance with section 39E. Answer 6(a)(ii) Interest expenses As GTL has significant amounts due from related companies which are neither trading in nature nor interest bearing (i.e. non-assessable-income producing), a portion of the interest expenses as attributable to financing those non-income producing assets for the years 2010/11 and 2011/12 may be disallowed in accordance with section 16(1)(a) of the Inland Revenue Ordinance. As it is difficult to identify the actual interest expenses incurred by GTL to finance the nonassessable-income producing assets, the IRD generally will use an apportionment method to identify the ratio of non-assessable-income producing assets to total assets and use such ratio to disallow a portion of interest expenses incurred. Analysis of non-assessable income producing asset/liabilities 2012 2011 HK$ HK$ Interest in subsidiary 52,000,000 52,000,000 Amount due from immediate holding company 112,321,212 97,231,313 Amounts due from fellow subsidiaries 212,334,421 234,599,861 376,655,633 383,831,174 Amount due to ultimate holding company 421,232,177 350,412,131 Final Examination (December 2013 Session) Paper II 10 of 12
For 2011, as the interest free borrowings from group companies is insufficient to finance the non-assessable-income producing assets, a portion of bank overdraft expenses is likely to be disallowed by the IRD. For 2012, unless GTL can prove with supporting documents that the whole of the Amount due to ultimate holding company was used to finance the interest free borrowing, the IRD will disallow a portion of interest expenses incurred. If GTL can prove otherwise, GTL may try to argue that no bank overdraft interest should be disallowed. Such an argument is subject to agreement by the IRD. Answer 6(b)(i) The business partner of GTL has entered into a contract processing arrangement with the processing party in the Mainland. Generally, under such an arrangement, the Mainland party is responsible for the provision of factory premises, labour, water and electricity in return for a processing fee from the business partner of GTL in Hong Kong. On the other hand, the business partner of GTL in Hong Kong is required to provide raw materials, technical know-how, production skills and machinery as well as to manage the production process conducted in the Mainland. The business partner of GTL in Hong Kong will consign the raw materials to the Mainland party for processing, i.e. the legal title to the raw materials and finished goods will remain with the business partner of GTL throughout the manufacturing process. Pursuant to Departmental Interpretation and Practice Notes No. 21 (Revised) ( DIPN 21 (revised) ), the operations of GTL s business partner in Mainland China complement its operations in Hong Kong. Recognizing the operations of the Hong Kong company in the Mainland, an apportionment of profits on a 50:50 basis is usually accepted. Answer 6(b)(ii) For GTL, as it entered into an import processing arrangement with its wholly owned subsidiary in the Mainland, GTL will be considered as a trading company by selling raw materials to its Mainland subsidiary for processing and purchasing of finished goods from it after the processing. For trading profits, the IRD will look into where the purchase and sales contracts are negotiated, concluded and executed. However, please note the IRD will also look into all of the relevant operations and not just the purchase and sale of the products in accordance with CIR v Magna Industrial Co Ltd [1997]. As these operations are very likely to be carried out in Hong Kong, it is not likely that GTL can enjoy such a tax exemption as its business partner. Final Examination (December 2013 Session) Paper II 11 of 12
Answer 6(b)(iii) Meanwhile, as a 50:50 apportionment of assessable profits was allowed in the contract processing arrangement in accordance with DIPN 21 (revised), the IRD will allow a 50% depreciation allowance / deduction of prescribed fixed assets. Answer 7 As Alan is a Hong Kong resident, the Hong Kong/China DTA potentially provides exemption from China Individual Income Tax ( IIT ) where the tax resident of Hong Kong fulfils all of the following criteria: 1. the individual is present in China for a period or periods not exceeding the aggregate 183 days in any twelve month period commencing or ending in the taxable period concerned; 2. the remuneration is paid by, or on behalf of, an employer who is not a resident of China; and 3. the remuneration is not borne by a permanent establishment which the employer has in China. It seems that Alan is present in China for more than 183 days in any twelve-month period even if there is no information given as to whether conditions 2 and 3 are satisfied. Therefore, Alan will be subject to IIT in China. * * * END OF EXAMINATION PAPER * * * Final Examination (December 2013 Session) Paper II 12 of 12