SECTION A CASE QUESTIONS (Total: 75 marks) Answer 1(a) Possible valuation range of TCL using the PE ratio approach: Market value = Net profit x PE ratio Market value at a PE of 7x = HK$52 million x 7 = HK$364 million Market value at a PE of 10x = HK$52 million x 10 = HK$520 million Valuation range = HK$364 million to HK$520 million Answer 1(b) Possible valuation range of TCL using the discounted cash flow approach: FCFF 1 = EBIT (1 t) + Depreciation Capex increase in net working capital = 70 (1 0.15) + 10 20 8 = HK$41.5 million V 0 = FCFF1 WACC - g (V= value and g =growth rate) Enterprise value at 3% growth rate = Enterprise value at 5% growth rate = 41.5 0.12-0.03 41.5 0.12-0.05 = HK$461.1 million = HK$592.9 million Equity value = Enterprise value (or firm value) Net debt Net debt = Interest-bearing debt cash = 35 10 = HK$25 million Equity value at 3% growth rate = HK$461.1 25 = HK$436.1 million Equity value at 5% growth rate = HK$592.9 25 = HK$567.9 million Valuation range = HK$436.1 million to HK$567.9 million Final Examination (June 2014 Session) Paper II 1 of 12
Answer 1(c)(i) Limitations in using PE ratio approach in business valuation: It may be difficult to find a listed company with similar business activities. A single year s PE ratio, which may be subject to abnormality, may not be a good basis. Historical data will be used to value how the business will do in the future especially when historical PE is used. The listed company may have a different capital structure to the company under valuation. Answer 1(c)(ii) The following can be done in selecting an appropriate PE ratio: Forward PE can be used to apply to the forecast profit of the company under valuation. A discount can be made to the PE of the industry or listed companies with similar business activities to reflect the normally more risky private company nature, the smaller business scale or the less dominant market position. Answer 1(d) The reasonable valuation range: The valuation ranges are as follows: PE ratio approach - HK$ 364 million to HK$ 520 million DCF approach - HK$ 436.1 million to HK$ 567.9 million PE 364 million 436.1 million 520 million 567.9 million The reasonable valuation range would be HK$ 436.1 million to HK$ 520 million. DCF Final Examination (June 2014 Session) Paper II 2 of 12
Answer 1(e) Possible reasons that using WACC of CKM to value TCL may not be appropriate: The business risks of TCL may not match with that of CKM so that the cost of capital (or the required rate of return) for them may be different. The capital structure (or method of financing) of TCL may not match with that of CKL, which may have an impact on the cost of capital (or required rate of return) to be used. Answer 1(f) The valuation range can be checked against the market EV/EBIT multiples. Enterprise value = Equity value + Net debt Lower end of equity value = HK$436.1 million Lower end of EV = HK$436.1 million + HK$25 million = HK$461.1 million Lower end of EV/EBIT = HK$461.1/66 = 7.0x Higher end of equity value = HK$520 million Higher end of EV = HK$520 million + HK$25 million = HK$545 million Higher end of EV/EBIT = HK$545/66 = 8.3x EV/EBIT multiples of similar listed companies = 6x 9x Since the EV/EBIT multiples calculated (7x 8.3x) fall within the market range of 6x 9x, the valuation range appears to be reasonable. Answer 2(a) To : The Board of Directors and the Audit Committee of CKM From : Chief Financial Officer of CKM Report on accounting issues in the acquisition of TCL Determination of acquisition date: Under HKFRS 3 (Revised), Business Combination, the acquirer should identify the acquisition date, which is the date on which it obtains control of the acquiree. Final Examination (June 2014 Session) Paper II 3 of 12
Based on the information as provided, the acquisition date for accounting purposes cannot be before 28 February 2014 because: the acquisition date is the date on which the acquirer obtains control of the acquiree, irrespective of any date specified under the sale & purchase agreement; CKM was not able to obtain control over TCL as a result of the purchase of shares of TCL from Mr. Andrew Chan, Mrs. Yvonne Lee and ABC Company in December 2013; the acquisition date would not be before the date of shareholders meeting approving the acquisition of the controlling stake of equity interests in TCL because the passing of control is conditional on shareholders approval; and the acquisition date is generally the date on which the acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of the acquiree the closing date. Based on the case background information, assuming control over TCL is also passed on the date when the final sales and purchase agreement was signed between XYZ Trust and CKM, the acquisition date is 28 February 2014. However, if CKM obtain controls over TCL on a date that is later than 28 February 2014, the acquisition date would be later than 28 February 2014. An acquirer should consider all pertinent facts and circumstances with judgement in identifying the acquisition date in certain circumstances. Answer 2(b) Financial reporting implications for year ended 31 December 2013 and for the year ending 2014: HKFRS 3 (Revised) refers to the transactions as described in the case background information as a business combination achieved in stages or step acquisition. XYZ Trust owned 55% equity interests in TCL which enabled it to control TCL and therefore before XYZ Trust sold its controlling stake of equity interests in TCL to CKM, CKM has no control over TCL and should not consolidate the financial information of TCL in its consolidated financial statements. CKM should evaluate the nature of its investments in TCL as to whether it has significant influence or joint control over TCL when preparing its consolidated financial statements for the year ended 31 December 2013. Final Examination (June 2014 Session) Paper II 4 of 12
As XYZ Trust had control over TCL, CKM would likely have significant influence over TCL, it accounts for its investment in TCL as an associate as from the date on which significant influence is obtained (i.e. not earlier than 16 December 2013) and applies the requirements under HKAS 28 (2011), Investments in associates and joint ventures. If CKM has joint control over TCL, it accounts for its investments in TCL as a joint venture as from the date on which joint control is obtained (i.e. not earlier than 16 December 2013) and applies the requirements under HKFRS 11, Joint arrangements, and HKAS 28 (2011). Equity method as described under HKAS 28 (2011) applies if the investment in TCL is regarded as either an associate or a joint venture. If CKM has no significant influence or joint control over TCL, the investment in TCL would likely be accounted for as a financial asset measured at fair value under HKFRS 9, Financial Instruments. If CKM successfully obtains control over TCL in early 2014 before the issuance of the annual consolidated financial statements for the year ended 31 December 2013, CKM should also provide disclosures about the business combination in accordance with HKFRS 3 (Revised) and HKAS 10, Events after the Reporting Period. Upon CKM successfully acquires the rest of equity interests in TCL from XYZ Trust during 2014, the following considerations would be relevant for the year ending 31 December 2014: CKM should apply the requirements under HKFRS 10, Consolidated Financial Statements, to evaluate whether CKM obtains control over TCL. Given that TCL conducts a business and CKM obtains control over TCL as a result of the acquisition, the acquisition constitutes a business combination and hence HKFRS 3 (Revised) is applicable. Under HKFRS 3 (Revised), CKM as the acquirer should identify the acquisition date, which is the date on which it obtains control of TCL as the acquiree. CKM should measure the identifiable assets acquired and the liabilities assumed at their acquisition-date fair values. CKM should recognise, separately from goodwill, the identifiable assets acquired, the liabilities assumed and any non-controlling interest in TCL as of acquisition date (i.e. as of 31 December 2013) in accordance with HKFRS 3 (Revised). Final Examination (June 2014 Session) Paper II 5 of 12
Assets transferred or liabilities assumed by the acquirer as part of the consideration transferred in a business combination are generally measured at their acquisitiondate fair values; any gain or loss is recognised in profit or loss in accordance with the relevant HKFRS. Upon CKM obtains control over TCL, CKM should remeasure its 45% equity interests in TCL at its acquisition-date fair value and recognise the resulting gain or loss, if any, in profit or loss or other comprehensive income, as appropriate and apply the requirements under HKFRS 3 (Revised) to account for the business combination in TCL. If CKM has recognised any changes in the values of its equity interests in TCL in other comprehensive income during 2013, the amount that was recognised in other comprehensive income should be recognised on the same basis as would be required if the acquirer had disposed directly of the previously held equity interest. If CKM accounts for the investment in TCL as an investment in associate or an investment in joint venture before obtaining control, unrealised gains or losses may have been recognised in other comprehensive income, e.g. foreign exchange gains or losses, and revaluation surpluses on property, plant and equipment. The treatment of these amounts on obtaining control is consistent with how they would be treated if the previously held equity interest was disposed of to a third party. For example, foreign exchange gains or losses previously recognised in other comprehensive income are reclassified from equity to profit or loss on the date control over TCL is obtained, while revaluation surpluses on property, plant and equipment may be reclassified within equity (e.g. from PPE revaluation reserve) to retained earnings. If the investment in TCL is accounted for as a financial asset under HKFRS 9 before obtaining control, on the date of obtaining control over TCL, CKM should remeasure its previously held (45%) equity interest in TCL at the acquisition date and recognise the resulting gain or loss, if any, in profit or loss. Answer 2(c) For the preparation of the consolidated financial statements for the year ended 31 December 2013, CKM should: applies the requirements under HKFRS 10 to evaluate whether CKM obtains control over TCL as a result of the acquisition; applies the requirements under HKFRS 3 (Revised) to account for the business combination, instead of going through 2-step acquisition as described above (item 2(b)); Final Examination (June 2014 Session) Paper II 6 of 12
comprehensive disclosures of the business combination should be made in accordance with HKFRS 3 (Revised) to enable users of the financial statements to evaluate the nature and financial effect of the business combination; and applies the requirements under HKFRS 10 to consolidate the financial information of TCL as from the date of acquisition. Signed XXXX Chief Financial Officer of CKM Answer 3 The interest of the shareholders and that of management might not always be aligned. Corporate governance refers to managing the relationships among the many parties interested in an entity and providing transparent and responsible management practices to meet the entity s objective. Changes in ownership The Group s management has always been the Chan family, however, because of the changes in shareholdings and capital structure over the years, the Chan family now owns less than 10% interest in the Group. Listing The Group will be required under the listing rules to fulfil some minimum requirements on corporate governance for listed companies. Over the years, the Group should have improved in the following areas to enhance its corporate governance. Organisational structure The Group might have included talents other than those from the family to broaden its board of directors, e.g. appointing people with specific professional expertise or industry knowledge to join as non-executive directors. Risk management and control The Group might have enhanced its system of internal control, for example by adding a standard operating manual for key activities or building an internal audit function to oversee risks and controls. Any other valid example (setting up an Audit Committee to oversee internal control and other financial reporting matter, or setting up appropriate limit for transactions exceeding certain amount for approval by management, board of directors and shareholders, according to the significance). Final Examination (June 2014 Session) Paper II 7 of 12
Answer 4 HKSA560 (Clarified) Subsequent Events discusses the responsibilities of the auditors in these situations. Before auditor s report date If the judgement is issued before the auditor s report date, the auditor has the responsibility to perform audit procedures to obtain sufficient appropriate audit evidence for this subsequent event. As the financial statements did not make any provision for this dispute, the auditor should discuss with management if the financial statements shall be adjusted for this event; and consider modification of the opinion taking into account the up to date evidence obtained and the decision from management as to whether the financial statements shall be adjusted. After auditor s report date If the judgement is issued after the auditor s report date but before the financial statements are published, the auditor does not have any obligation to perform procedures, or make inquiries regarding the financial statements. However, given that a different audit opinion may result had the judgement been known to the auditor earlier, the auditor shall notify management and, unless all of those charged with governance are involved in managing the entity, those charged with governance, not to issue the financial statements to third parties before the necessary amendments have been made. If the financial statements are nevertheless subsequently issued without the necessary amendments, the auditor shall take appropriate action to seek to prevent reliance on the auditor s report. Answer 5 In respect of the web-based interface, automatic transfer of information to fellow subsidiaries and generation of invoices, the typical controls shall include information technology general controls and specific application controls. Information technology general controls (ITGC) The Group shall have a proper system development process where the design of the system is reviewed before it is approved for use. For any system change or programming request, it is only implemented after proper review, approval and testing before it is rolled out to the live system. Final Examination (June 2014 Session) Paper II 8 of 12
The system should also include password controls or physical access control restricting unauthorised persons from gaining access to read, utilise and amend data captured by the system. Access rights of individuals are set with proper segregation of duties in mind, such that different users have different reading, reviewing or amendment rights for their respective roles and responsibilities. Specific application controls (AC) The system might only allow invoices to be generated for pre-approved customers; and the system might only allow MPL fellow subsidiaries to select suppliers from the approved list and reject any other manual input of suppliers. In respect of the potential cut-off error in sales and purchases, usually management would implement both automatic controls and manual controls to address the potential cut-off risk. For example, the trade terms for each of the suppliers and customers could be inputted in the standing data of the system, requiring any invoices generated to be matched against the date of the transfer of title according to their respective trade terms. Furthermore, there might be manual checking of the invoice date by accountants against the date for the title to be transferred according to the trade terms before they are posted into the accounting system. Proposed audit procedures to address the risks: The auditor shall understand and evaluate the design of the ITGC and AC and conclude whether their design could provide the necessary comfort in the intended way. If the control design is effective, the auditor shall validate these controls to ensure operating effectiveness before they can rely on these controls. Specifically for the cut-off risk, the auditor can also perform cut-off tests, such as reviewing sales and purchases invoices against their supporting documents, and including the shipping documents and trade terms, to verify if there is any cut-off error. * * * END OF SECTION A * * * Final Examination (June 2014 Session) Paper II 9 of 12
SECTION B ESSAY QUESTIONS (Total: 25 marks) Answer 6(a) Tax implications: The amount of service fee received by MPL as agreed under the Field Audit will be taxable. If MPL is found to have no reasonable excuse for submitting an incorrect return and the government prosecuted MPL under s.80, a fine of HK$10,000 and additional tax up to 3 times the tax undercharged (s.80) may be imposed on MPL. Alternatively, if no prosecution is constituted, the Commissioner of Inland Revenue ( CIR ) or Deputy CIR may impose additional tax of up to 3 times the tax undercharged under s.82a. Holdover interest for the tax which is completely heldover and is now payable as a result of the settlement (being the total tax payable less the amount for which the tax reserve certificate has been purchased). Possible penal actions: The level of additional tax depends on whether the understatement of assessable profits is intentional / reckless / one-off and also whether MPL voluntarily discloses the information or there is a delay or denial in the disclosure of information. Commercial restitution - best lending rate monthly compounded to be included in the additional tax. Answer 6(b) If MPL and the IRD failed to reach a compromise to settle the tax dispute, the IRD would issue the assessments for the relevant years of assessment and MPL would lodge an objection to the said assessments. The CIR shall then make a determination on MPL s objection. If the determination outcome is unfavourable, MPL can appeal the decision to the Board of Review and then to the Court of First Instance or Court of Appeal. Final Examination (June 2014 Session) Paper II 10 of 12
Answer 6(c) Strengths operation test - operations that generate profits for MPL are conducted by Charming Limited ( CL ) outside Hong Kong; the functions of MPL in Hong Kong, e.g. negotiation and signing of agency agreement, could be argued as incidental or antecedent, and in ING Baring case / Li & Fung case, it was held that such incidental/antecedent activities should not be the determining factor in determining source of profits in Hong Kong; the scheme has commercial substance and is not solely and dominantly designed for avoidance of tax, as such s.61a should not apply; and it can be argued that CL is an agent of MPL and provides service to clients on behalf of MPL Answer 7 MPL can apply for an Advance Ruling under s.88a of the IRO. MPL should submit an Application for Advance Ruling (Form IR1297) with the necessary information, such as person/corporation to which the ruling applies, the relevant provision in the IRO, the arrangement in which advance ruling is sought, relevant assumptions, draft ruling, and period in which the ruling will apply. A cheque payment of HK$30,000 for the application fee is also required. The Commissioner may decline to make a ruling or ask the applicant to withdraw the ruling application in certain cases, e.g. the ruling sought is related to an objection, an appeal case or the Commissioner is required to determine / establish a question of fact. The ruling to be issued is legally binding on the Commissioner if MPL adheres precisely to the facts as submitted in the ruling application. Otherwise, if the actual transaction carried out is materially different from the application and/or there is material misrepresentation in the ruling application, the ruling will not be binding on the Commissioner. Generally, the ruling will be in force until the end of the period as indicated in the initial ruling, and generally it will last for more than 2 years of assessment from the year of issue of the ruling. Answer 8 Normally dividend declared by a China entity to its shareholder in Hong Kong is subject to dividend withholding tax of 10%. Under the Double Taxation Arrangement ( DTA ) between Hong Kong and China, such rate could be reduced to 5% if MPL holds at least 25% equity interest in the China subsidiary at all times within any 12 month period before receipt of the dividend. Final Examination (June 2014 Session) Paper II 11 of 12
Answer 9 Mary Siu is employed by MPL and her employment is considered as Hong Kong employment. As she visits Hong Kong for more than 60 days, she can only be exempted from Hong Kong Salaries Tax if she can demonstrate to the satisfaction of the IRD that all of her services were rendered outside Hong Kong. However, if she cannot substantiate the same (e.g. she needs to report to MPL s management in Hong Kong), she may need to pay Hong Kong Salaries Tax for her compensation. However, as she has also paid IIT in China, the income attributable to her services performed in the Mainland can be exempted according to s.8(1a)(c). Alternatively, the income tax she has paid in the Mainland can be claimed as tax credit against her Hong Kong Salaries Tax under s.50 according to the Hong Kong-Mainland DTA. * * * END OF EXAMINATION PAPER * * * Final Examination (June 2014 Session) Paper II 12 of 12