THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES Suggested Answers Level : Professional Subject : Hong Kong Financial Accounting Diet : June 2006 The suggested answers are published for the purpose of assisting students in their understanding of what may be expected from a good candidate in the time allowed for each paper. They are in no way exhaustive nor model answer to the questions. They do not reflect the opinion of HKICS.
HONG KONG FINANCIAL ACCOUNTING JUNE 2006 Suggested Answers SECTION A 1 (a) Hong Kong accounting standards are set by the Financial Accounting Standards Committee (FASC) and the Council of the Hong Kong Institute of Certified Public Accountants (HKICPA). Accounting standards in Hong Kong were called Statement of Standard Accounting Practices (SSAPs) before 2005. However, the HKICPA has moved to fully converge Hong Kong accounting standards with the international accounting standards set by the International Accounting Standards Board (IASB) since 2002. With effect from 1 January 2005, the new accounting standards in Hong Kong are called the Hong Kong Financial Reporting Standards (HKFRSs), and they include Hong Kong Accounting Standards (HKASs) and Hong Kong (IFRIC or SIC) Interpretations. (b) The four valuation models are: (1) Historical cost (HC). Assets are recorded at the amount of cash or cash equivalents paid at the time of their acquisition and liabilities are recorded at the amount of proceeds received in exchange for the obligations. (2) Current cost (CC). Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligations currently. (3) Realisable value (RV). Assets are carried at the amount of cash or cash equivalents that would currently be obtained by selling an asset in an orderly disposal. Liabilities are carried at their settlement values, e.g. the undiscounted amount of cash or cash equivalents expected to be paid to satisfy the obligations in the normal course of business. (4) Present value (PV). Assets are carried at the present discounted value of the future net cash inflows that are expected to be generated in the normal course of business. Liabilities are carried at the present discounted value of future net cash outflows that are expected to be required to settle the obligations in the normal course of business. (c) According to HKAS 2, inventories should be measured at the lower of cost and net realisable value. However the net realisable value should be determined by comparing individual items or groups of inventories; the comparison of aggregated total amounts is not acceptable. 2
Thus the value of inventories to be reported in the balance sheet should be $27,500 as calculated below: Cost Net realisable value Amount to be reported $ $ $ Item 1 5,000 4,000 4,000 Item 2 8,000 9,500 8,000 Item 3 6,000 5,500 5,500 Item 4 12,000 10,000 10,000 Total 31,000 29,000 27,500 ===== ===== ======= (d) In both Poon s and Chang s financial statements, the fact that Ming is the parent and that Honan is the ultimate controlling shareholder will have to be disclosed. Ming's consolidated financial statements will also have to disclose that the company is under the control of Honan. The requirement to disclose Honan as the ultimate controlling party is included in HKAS 24. Poon and Chang are related parties because they are subject to common control. If the transaction is material, Chang s financial statements should disclose all relevant details of the sale, including a description of the transaction and the price. Poon s name as the other party to the transaction should also be stated, together with its relationship with Chang. If the price were materially different from the price obtainable from a sale to an unrelated third party, this fact would also need to be disclosed. Poon and Chang will each have to disclose any balances due to or from related parties at the balance sheet date. (e) According to HKAS 18 Revenue, where the receipt of cash from a sale is deferred beyond normal commercial terms, the total amount receivable represents: (1) consideration for the sale, and (2) interest revenue. Thus the revenue to be recognised by Photocopying Equipment Ltd can be determined as follows: Year Cash inflows Discount factor Present value of cash inflow $ $ 0 5,000 1.000 5,000 1 5,000.909 4,545 2 5,000.826 4,130 15,000 13,675 ====== ====== Therefore, Photocopying Equipment Ltd should recognise sale revenue of $13,675 in current period (year 0) while $1,325 ($15,000 - $13,675) should be recognised as interest revenue. 3
(f) According to HKAS 17, if the present value of the minimum lease payments amount to at least substantially all of the fair value of the leased asset at the inception of the lease, a lease transaction should be treated as a finance lease. ABC Company s transaction can be analysed as follows: Minimum lease payment = 4 x $10,000 + $5,000 Present value of the minimum lease payment =$10,000 x 3.3121 + 5,000 x.7350 = $36,796 Fair market value of the equipment = $38,000 Since the present value of the minimum lease payment is about 96% ($36,796/$38,000) of the fair market value of the equipment, ABC Company should treat the lease transaction as a finance lease. (g) According to HKAS 16 Property, Plant and Equipment, the cost of this equipment should include all expenses directly attributable to making the equipment ready for operation in the manner intended by management. Thus the cost of the equipment should be $260,000 as determined below: $ Direct manufacturing costs 250,000 Overhead charge 5,000 Related interest expense 3,000 Installation and testing expense 2,000 Total 260,000 ====== (h)(1)the effect of the change in accounting estimates should be recognised prospectively by including it in the profit or loss in: (a) the period of change if the change affects that period only; or (b) the period of the change and future periods if the change affects both. (2)The correction of prior period errors should be accounted for retrospectively in the first set of financial statements authorised for issue after their discovery by: (a) restating the comparative amounts for the prior period(s) presented in which the error occurred; or (b) if the error occurred before the earliest prior period presented, restating the opening balance of assets, liabilities and equity for this earliest prior period. 4
(i) Cash received from customers: 2004 2005 Increase $ $ $ Accounts receivable 200,000 240,000 40,000 Cash received from customers = Sales increase in accounts receivable bad debts written-off sales discounts = $2,100,000 $40,000 $50,000 $17,000 = $1,993,000 (j) (1) This event requires no adjustment because there is no change to conditions existing at balance sheet date the amount is still owing, albeit a longer term has been given, but not so long as to cause it to be reclassified to non-current. If amount is significant, however, additional disclosure will be necessary. (2) This post balance sheet event requires no adjustment if the investment was carried at fair market value, which must be determined as at the balance sheet date. The change in fair value will be recorded in the next reporting period. However, this could be an adjusting event as the investments were being measured at cost if there were evidence of impairment at the balance sheet date. 5
SECTION B 2. Assets Wanan Ltd Balance Sheet as at 30 June 2005 $ 000 Non-current Assets Property, plant and equipment 6,174 Goodwill 2,530 Other intangible assets patents 110 Available-for-sale investments 52 Total non-current assets 8,866 Current assets Inventories 1,683 Trade and other receivables 1,984 Other current assets (prepayments) 141 Cash and cash equivalents 211 Total current assets 4,019 Total assets 12,885 Equity and Liabilities Equity Share capital 3,500 Reserves 106 Retained earnings 1,481 Total equity 5,087 Non-current liabilities Long-term borrowings 3,390 Deferred tax 420 Provisions (employment benefit & warranty) 103 Total non-current liabilities 3,913 Current liabilities Trade and other payables 2,332 Short-term borrowings (bank overdrafts) 350 Current portion of long-term borrowings 425 Current tax payable 152 Short-term provisions 626 Total current liabilities 3,885 Total liabilities 7,798 Total equity and liabilities 12,885 6
Explanations (workings): Property, plant and equipment comprises: $ 000 Land 250 Buildings 1,030 Accumulated depreciation buildings (120) Plant and equipment 8,275 Accumulated depreciation plant & equipment (3,726) Leased assets 775 Accumulated depreciation leased assets (310) 6,174 Goodwill has been separately disclosed on the face of the balance sheet given its materiality and comprises cost $3,200,000 accumulated impairment $670,000 = $2,530,000. Inventories comprise raw materials $490,000 + work in progress $151,000 + finished goods $1,042,000 = $1,683,000. Trade and other receivables comprises trade receivables $1,744,000 allowance for doubtful debts $80,000 + other receivables $320,000 = $1,984,000 Cash and cash equivalents comprises cash $175,000 + deposits at call $36,000 = $211,000. Long-term borrowings comprise: $ 000 Banks loans 2,215 Debentures 675 Repayable within 12 months (300) Other loans 575 Lease liabilities 350 Repayable within 12 months (125) 3,390 Long-term provisions comprise provision for employee benefits $275,000 portion currently payable $192,000 + provision for warranty to be incurred beyond one year $20,000 = $103,000. Trade and other payables comprises trade payables $1,617,000 + other payables and accruals $715,000 = $2,332,000. Current portion of long-term borrowings comprises $300,000 + $125,000 (refer above) = $425,000. Short-term provisions comprises $192,000 (refer above) + provision for restructuring $412,000 + provision for warranty $42,000 - $20,000 (refer above) = $626,000. 7
3. HKAS 12 Income Taxes paragraph 24 states that deferred tax assets shall be recognised for all deductible temporary differences (DTD) to the extent that it is probable that taxable profit will be available against which the deductible temporary differences can be utilized. The same recognition criteria apply to deferred tax assets arising from tax losses carried forward (paragraph 34). In determining whether it can recognise deferred tax assets with respect to: tax losses of $12,500, and deductible temporary differences of $17,000, XYZ Ltd will need to consider the following factors. (1) Taxable profit against which tax losses and DTDs can be utilised will be available if taxable temporary differences (TTD) reverse in the same period in which the deductions are available. Thus, the extent and period of reversal of TTDs will need to be considered. (2) If insufficient TTDs exist to recoup the DTDs and tax losses, XYZ Ltd will need to consider whether the company will earn sufficient taxable profit in the periods of reversal against with the deductions can be made. (3) HKAS 12 paragraph 35 states that the existence of unused tax losses is strong evidence that future taxable profits may not be available. XYZ Ltd will need to examine the cause of the loss to determine whether it is due to factors which are unlikely to recur (b) As XYZ Ltd has incurred a tax loss in the current year, deferred tax assets can only be recognised to the extent that TTDs exist and will reverse in the same period as the DTDs and tax losses, and to the extent that convincing evidence exists that future taxable profits will be made. An analysis of the temporary differences at 30 June 2005 reveals: Existing Reversal Reversal 2005 2006 2007 DTD 17,000 14,500 2,500 TTD 11,500 11,500 - (1 ) As there is no indication that the losses incurred in 2005 are a one-off item, XYZ Ltd can only recognise a DTA of $3,450 ($11,500 x 30%), representing the deductions which can be made against taxable profit arising in 2006 from the reversal of taxable temporary differences. (2) The DTA of $5,250 raised in the prior year will need to be written down to $3,450. 8
4. (a) The cost of inventory on hand and cost of goods sold (calculated using the moving average) are as below: Date Details 01/03 Inventory balance No. units Purchases COGS Balance Unit Total No. Unit Total No. Unit Total Cost Cost units Cost Cost units Cost Cost $ $ $ $ $ $ 393 82.3 32,356 3 01/03 Sales 300 82.33 24,699 93 82.3 3 7,657 03/03 Sales return (5) (82.33 ) (412) 98 82.3 3 8 069 09/03 Purchases 55 91.0 0 10/03 Purchases 76 96.0 0 5,005 153 85.4 4 7,296 229 88.9 5 13,074 20,370 15/03 Sales 86 88.95 7,650 143 88.9 5 12,720 17/03 Purchase return (1) 91.0 0 (91.00) 142 88.9 3 12,629 22/03 Sales 60 88.93 5,336 82 88.9 3 7,293 26/03 Purchases 72 98.0 0 7,056 154 93.1 7 14,349 29/03 No entry* 19,266 37,273 154 14,349 * The damaged goods returned would not be placed back into inventory stock. Therefore: Cost of goods sold is $ 37,273 based on the moving average (before adjusting for returned damaged inventory) Cost of closing inventory is $ 14,349 at 31 March. 9
(b) The general ledger inventory account at 31 March 2006 is as shown below: Inventory Control Date Details Ref Date Details Ref $ 2006 2006 01/03 Balance b/d 17/03 A/c payable (2) 32,356 91 31/03 Cost of goods (1) 412 31/03 Cost of goods (4) 37,685 30/03 A/c payable (3) 19,357 31/03 Balance c/d 14,349 52,125 52,125 01/04 Balance b/d 14,349 (1) 0n 3 March 2006, cost of the five returned bicycles: 5 x $82.33 = $412.00 (2) On 17 March 2006, cost of one returned bicycle: 1 x $91 = $ 91 (3) Cost of inventory purchased in March (before deduction of returns): $5,005 + $7296 + $7,056 = $19,357 (4) Cost of goods sold in March (before reduction due to sales returned inventory): $24,699 + $7,650 + $5,336 = $37,685 Alternatively, the cost of goods sold in March can be determined after the reduction due to returned inventory, i.e., $24,699 + $7,650 + $5,336 - $412 - $182 = $37,091. (c) Gross profit for the month of March 2006: $ Sales revenue (300x$120 + 86x$135 + 60x$125) 55,110 Less sales returns (5 x $120 + 2 x $125) 850 Net sales revenue 54, 260 Less: cost of goods sold ($37,685-$412-$182)* 37, 091 Gross profit 17,169 ===== * Cost of goods sold can be $37,901 if the alternative figure is calculated in the prior step. The following journal entry is required in respect of the two damaged bikes returned on 29 March $ $ 31 March 2006 Inventory losses and write downs Dr 182 cost of goods sold Cr 182 (damaged inventory written off) 10
5. (a) Goodwill determination: At 1 January 2005: Net fair value of identifiable assets, liabilities and contingent liabilities of Nanzhou Ltd = $10,000 + $3,000 (equity) + $400 (1 30%) (inventory) = $13,280 Cost of acquisition = $20,000 - $3,000 (dividend receivable) = $17,000 Goodwill = $17,000 - $13,280 = $3,720 (b) Chengdu Ltd Consolidated Income Statement for the financial year ended 31 December 2005 $ $ Revenue: Sales 50,600 Other 1,000 51,600 Expenses: Cost of sales 39,360 Other 5,160 44,520 Profit before income tax 7,080 Income tax expense 2,352 Profit for the period 4,728 11
Workings: Sales revenue Other revenue Dividend revenue Cost of sales Other expenses Consolidation Worksheet Chengdu Nanzhou Adj Adjustments Adj Group Ltd Ltd # Dr Cr # $ $ $ $ $ 30,000 25,600 4 50,600 5,000 1,500 22,000 5 500 1,000 6 22,000 500-3 500 -- 32,000 47,600 51,600 25,000 18,000 1 360 4,000 4 39,360 3,000 21,000 2 1,860 500 20,000 200 5 6 7 5,160 28,000 39,000 44,520 4,000 8,600 7,080 Profit before tax Tax expense 1,350 1,950 7 60 108 300 600 1 4 6 2,352 Profit 2,650 6,650 4,728 Retained earnings (1 Jan 05) 6,000 3,000 2 3,000 6,000 Transfer from BCV reserve Dividend paid Retained earnings (31 Dec 05) -- -- 2 252 252 1 -- 8,650 9,650 10,728 2,500 1,000 500 2 2,500 500 3 6,150 8,650 8,228 Worksheet adjusting entries 1. Business combination valuation entries: Cost of sales $400 x (1-10%) Dr 360 Income tax expense Cr 108 Transfer from business combination Valuation reserve Cr 252 Inventory Dr 400 Deferred tax liability ($400 x 30%) Cr 120 Business combination val n reserve Cr 280 12
2. Pre-acquisition entries: Retained earnings (1/1/05) Dr 3,000 Share capital Dr 10,000 Business combination valuation reserve Dr 280 Goodwill Dr 3,720 Shares in Nanzhou Ltd Cr 17,000 Shares in Nanzhou Ltd Dr 500 Dividend paid (pre-acquisition) Cr 500 Transfer from business combination Valuation reserve Dr 252 Business combination val n reserve Cr 252 Impairment loss Dr 1,860 Accumulated impairment losses Cr 1,860 3. Dividend paid: Dividend revenue Dr 500 Interim dividend paid Cr 500 4. Sales: Sales revenue Dr 5,000 Cost of sales Cr 4,000 Inventory Cr 1,000 Deferred tax asset Dr 300 Income tax expense Cr 300 5. Management services: Other revenue Dr 500 Other expenses Cr 500 6. Sale of machinery: Other revenue Dr 22,000 Other expenses Cr 20,000 Machinery Cr 2,000 Deferred tax asset ($2000 x 30%) Dr 600 Income tax expenses Cr 600 7. Depreciation: Accumulated depreciation Dr 200 Depreciation expense Cr 200 (20% x $2000 x 1/2) Income tax expense Dr 60 Deferred tax asset Cr 60 13
6. a) Disagree. The total revenue of the three segments is only 69% ($550 million / $800 million) of the total consolidated revenue and therefore additional reportable segments must be identified (HKAS 14 paragraph 37). b) Disagree. Segment revenue includes revenue from other segments (HKAS 14 paragraph 16). Therefore the $50 million revenue from the toy stores segment is included and the figure to be used is $400million ($350 million + $50 million). c) Agree. Segment revenue, segment expense, segment assets, and segment liabilities are determined before intra-group balances and intra-group transactions are eliminated as part of the consolidation process, except to the extent that such intra-group balances and transactions are between group entities within a single segment (HKAS 14 paragraph 24). d) Disagree. The balances between the legal entities are within the same segment and must be eliminated in determining segment assets in accordance with paragraph 24 of HKAS 14. e) Disagree. The $45 million receivable from the toy stores segment must be included in segment assets in accordance with HKAS 14 paragraph 24. f) Disagree. The $45 million receivable from the toy stores segment must be included in segment assets in accordance with HKAS 14 paragraph 24. g) Agree. The balances of $23 million between the legal entities are within the same segment and must be eliminated in determining segment assets in accordance with paragraph 24 of HKAS 14. -END- 14