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THE HONG KONG INSTITUTE OF CHARTERED SECRETARIESTHE INSTITUTE OF CHARTERED SECRETARIES AND

ADMINISTRATORS

International Qualifying Scheme Examination

HONG KONG FINANCIAL ACCOUNTINGJUNE 2016

Suggested Answer

The suggested answers are published for the purpose of assisting students in theirunderstanding of the possible principles, analysis or arguments that may be identifiedin each question

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SECTION A

1.

Alpha Cheng and Toby Chau are engineers who were made redundant in 2013.Whilst working together they often discussed the idea of setting up a company ontheir own. They believed that there was a niche in the market for the manufactureof high-end aerial digital video platforms. Following their redundancy, they agreedto put their idea into practice.

They prepared a business plan which showed that after start-up losses thebusiness would be profitable. They estimated that they would need $1,400,000 tofinance the business. They presented their plan to their bank, Good Deal Bank,which agreed to provide an overdraft facility of $700,000 for two years on conditionthat they raised share capital of $700,000.

Alpha and Toby formed a company, Dragonfly Ltd (Dragonfly), and started tradingon 1 August 2014. Dragonfly was financed by the issue of 400,000 shares fullypaid (worth $400,000) to Alpha and Toby and 300,000 shares (worth $300,000) totheir relatives and friends.

Statements of profit or loss for the nine months ended 30 April 2015 and the yearended 30 April 2016 are set out below:

Nine monthsended 30April 2015

Year ended30 April

2016$ $

Revenue 1,218,000 2,198,000Cost of sales (1,011,148) (1,772,680)

Gross profit 206,852 425,320Administrative expenses (60,400) (72,200)Selling expenses (145,960) (157,472)

Operating profit 492 195,648Finance costs (15,688) (73,820)

(Loss)/ Profit before tax (15,196) 121,828Tax - (26,548)

(Loss)/ Profit after tax (15,196) 95,280

Statements of financial position as at 30 April are set out below:

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2015 2016$ $ $ $

ASSETSNon-current assetsPremises - cost 420,000 420,000Accumulateddepreciation (6,400) (12,800)

Carrying amount 413,600 407,200Machinery – cost 350,000 490,000Accumulateddepreciation (35,000) (84,000)

Carrying amount 315,000 406,000Office furniture –cost 14,000 21,000Accumulateddepreciation (2,800) (7,000)

Carrying amount 11,200 14,000Motor vehicles -cost 84,000 84,000Accumulateddepreciation (15,748) (36,748)

Carrying amount 68,252 47,252

808,052 874,452Current assetsInventories 191,100 553,500Trade receivables 604,800 762,156Prepaid expense - 35,000Cash and cashequivalents - 5,012

795,900 1,355,668

Total assets 1,603,952 2,230,120

EQUITY ANDLIABILITIESEquity and reservesOrdinary shares 700,000 700,000

(Accumulated deficit) / Retainedearnings (15,196) 80,084

684,804 780,084

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Non-currentliabilitiesDeferred income –Grant

72,000 64,000

Deferred tax - 3,144Current liabilitiesTrade payables 373,780 502,700Accrued expenses 175,100 156,789Tax payable - 23,404Bank overdraft 298,268 699,999

847,148 1,382,892

Total equity andliabilities 1,603,952 2,230,120

Note: Agreed credit terms were 90 days for customers and suppliers.

In May 2015 Alpha and Toby presented their first period’s draft accounts to thebank. At the meeting the bank manager produced ratios which he used to analysethe first period’s results during their discussions. The ratios prepared by the bankas at and for the nine months ended 30 April 2015 were as follows:

Profitability

Gross profit % 17.00%

Operating profit % 0.04%

Profit before tax % (1.25%)

Profit after tax % (1.25%)

Return on equity and reserves* (2.22%)

Net asset turnover (also known as asset efficiency) * 1.78

Liquidity *

Current ratio 0.94

Quick ratio 0.71

Collection period (days) 136

Inventory period (days) based on cost of sales 52

Payment period (days) based on purchase 85

Leverage *

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Total liabilities/tangible net worth 1.34

Bank borrowing/tangible net worth 0.44

Profit cover for interest 0.03

* Period-end balances are used for computation of the above ratios, as required.

It was agreed that Alpha and Toby would discuss the position with the bank again

in June 2016. At that meeting they will ask for a restructuring of the bank facility to

take the form of a term loan of $800,000 repayable over three years. They intend

to suggest a repayment schedule of $400,000, $200,000 and $200,000 on 30 April

2017, 30 April 2018 and 30 April 2019 respectively.

They have produced projected statements of profit or loss and othercomprehensive income for three years ended 30 April as follows:

2017 2018 2019$’000 $’000 $’000

Revenue 2,680 3,000 3,840Cost of sales (2,180) (2,400) (3,040)

Gross profit 500 600 800Administrative expenses (72) (80) (84)Selling expenses (148) (160) (168)

Operating profit 280 360 548Finance costs (108) (56) (20)

Profit before tax 172 304 528Tax (36) (80) (132)

Profit after tax 136 224 396

Their projected statements of financial position as at 30 April are as follows:

2017 2018 2019$’000 $’000 $’000

ASSETSNon-current assets 920 920 920Current assetsInventories 480 680 760

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Trade receivables 580 504 800Prepaid expense 40 40 40

Total assets 2,020 2,144 2,520

EQUITY AND LIABILITIESEquity and reservesOrdinary shares 700 700 700Retained earnings broughtforward

80 216 440

Retained profit for the year 136 224 396

916 1,140 1,536Non-current liabilitiesTerm loan 400 200 -Deferred tax 20 36 56Deferred income 56 48 40

Current liabilitiesTrade payables 560 610 735Accrued expenses 32 36 40Tax payable 16 64 108Bank overdraft 20 10 5

Total equity and liabilities 2,020 2,144 2,520

REQUIRED:

You are a recently qualified chartered secretary and act as the business adviser

for Alpha and Toby. They would like you to help them with their request for the

restructuring of the bank facility.

1. (a) Draft a report on the company’s performance during the first period fromincorporation to 30 April 2015 and for the year ended 30 April 2016 for Alphaand Toby to present to Good Deal Bank. The report to the bank shouldanalyse the company’s performance in the first period from incorporation to30 April 2015 and for the year ended 30 April 2016, concentrating onprofitability, return and asset turnover, liquidity and gearing.

(15 marks)

Ans (a) Report

To: Good Deal Bank

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From: A business advisor on behalf of Alpha Cheng and Toby Chau

Subject: Dragonfly trading performance for the nine months ended 30 April 2015and the year ended 30 April 2016

Date: XX June 2016

This report looks at the trading performance of Dragonfly during the first period,from incorporation to 30 April 2015, and for the year ended 30 April 2016.

Liquidity

The current ratio has risen slightly from 0.94 to 0.98, but the quick ratio has fallenfrom 0.71 to 0.58 as a result of the substantial lengthening of the inventoryturnover period. In addition, the overdraft has more than doubled. In fact thecompany is now close to its overdraft limit of $700,000.

The payable payment period has remained almost static while the receivablecollection period has reduced by 9 days to 127 days. However although thepayable payment period is within the 90 day normal credit period, the receivablecollection period is much longer at 127 days in 2016. This may indicate thatreceivables are not being collected efficiently and that the company is havingdifficulty obtaining payment. A reduction in the collection period to match thatrelating payments to suppliers would have improved cash flow by $762,156 –($2,198,000 x 86/365) = $244,272. This would reduce the overdraft to well withinits limit.

Profitability, Return and Asset Turnover

As would be expected now that trading has become established, profitability forthe year ended 30 April 2016 is far better than that for the nine months ended 30April 2015.

Return on shareholders’ interests and asset turnover have reached respectablelevels. The gross profit percentage has risen by over two percentage points andthis has partly contributed to the rise in operating profit percentage from almostzero to 8.9%. It can be assumed that parts of the administrative and selling costsare fixed, and as these have been spread over 12 months rather than ninemonths. The annualised administrative and selling costs for the nine monthsended 30 April 2015 are higher than for the year ended 30 April 2016. As a result,

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this has boosted the operating margin.

The rise in the profit before tax and profit after tax percentages has been dilutedby the increase in interest expense and the fact that the company has incurred atax charge for the year (at an effective rate of 21.8% ($26,548/$121,828).

Gearing

In spite of the increase in the interest expense, the increase in operating profitshas produced a much better interest cover figure for the year ended 30 April 2016.

The steep rise in the bank overdraft has, however, had a significantly adverseimpact on the bank borrowing/total liabilities vs. net assets ratios. The improvedinterest cover should reassure the bank that although the lending position of thebusiness is now almost the same as that of the owners, profits appear sufficient topay the current level of interest expenses.

Conclusion

The company seems to have established itself quite well in its market. Profitabilityfigures are all reasonably healthy, particularly the 15.6% return on net assets and19.3% gross profit. It is, however, still rather early to say that the company hassettled into a steady trading pattern.

The increase in revenue has put pressure on liquidity due to increased workingcapital requirements and particularly because of the longer inventory period.Although this has increased the bank’s risk from a gearing perspective, it has thecomfort of a relatively high interest cover, showing that the company is currentlyable to meet its overdraft payments.

1. (b) Calculate FIVE ratios relevant to your discussion in (a).

(5 marks)

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Ans (b)12 months to

30 April 2016

9 months to

30 April 2015

Current ratio (1,355,668/1,382,892) and

(795,900/847,148)

0.98 0.94

Quick ratio [(1,355,668 – 553,500)/1,382,892] and

[(795,900 – 191,110)/847,148]

0.58 0.71

Supplier payment [502,700/(1,772,680 +

553,500 – 191,110)] x 365 and

[373,780/(1,011,148 + 191,110 – 0)] x 365 x 9/12

86 days 85 days

Receivable collection (762,156/2,198,000) x 365

and (604,800/1,218,000) x 365 x 9/12

127 days 136 days

Inventory turnover period (553,500/1,772,680) x

365 and (191,100/1,011,148) x 365 x 9/12

114 days 52 days

Return on equity (121,828/780,084) and

(-151,967/684,804)

15.6% -2.22%

Net asset turnover (2,198,000/780,084) and

(1,218,000/684,804)

2.82 1.78

Gross profit % (425,320/2,198,000) and

(206,852/1,218,000)

19.3% 17%

Operating profit % (195,648/2,198,000) and

(492/1,218,000)

8.9% 0.04%

Profit before tax % (121,828/2,198,000) and

(-15,196/1,218,000)

5.5% -1.25%

Profit after tax % (95,280/2,198,000) and

(-15,196/1,218,000)

4.3% -1.25%

Interest cover (195,648/73,820) and (492/15,196) 2.65 0.03

Total liabilities/tangible net worth 1.86 1.34

Bank borrowings/tangible net worth 0.97 0.44

1. (c) Draft a report to Alpha and Toby analysing and evaluating the financialinformation in the projected financial statements for the three years ending30 April 2019 and evaluating their request for a restructuring of the bankfacility.

(20 marks)

(Total: 40 marks)

Ans (c) Report

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To: Alpha and Toby

From: Your business advisor

Subject: Forecasts and loan application

Date: XX June 2016

As instructed by you I have examined the forecasts prepared by you for the threeyears to 30 April 2017, 2018 and 2019 on the basis that these will be used to applyfor a restructuring of bank finance, namely a term loan.

Growth

The company is forecasting revenue growth of 21.9%, 11.9% and 28% in 2017,2018 and 2019 respectively. Given the early stage of the company’s development,the bank may accept this variability in growth, but the company should presentvalid reasons for its forecasts. In particular, the large rise in 2019 should beexplained, e.g. an expected new large contract, as the later figures in the forecast,while being less accurate, are more likely to indicate future performance.

Overall, the growth figures must be shown to be realistic and based onassumptions which can be verified at the current time. The bank wants to see aquality earnings stream from which interest and loan capital will be paid.

Profitability

The forecast gross profit ratios are 18.7%, 20.0% and 20.8%, for 2017, 2018 and2019, showing very modest improvement. However, the relevant operating profitfigures are 10.5%, 12.0% and 14.3%, showing much greater improvements thanin the gross margin. This is mainly due to projected, relatively steadyadministration and selling expenses over the three years. It may be unrealistic toassume that these expenses will rise less than or on a par with inflation or evendecline (2016 vs 2017), particularly when the company is so new and increases insuch expenditure might be expected. Also, since these expenses rosesubstantially in 2016 vs 2015 (pro-rata), the company will need to explain whyfurther rises are not envisaged.

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Interest cover

As the company is forecasting a fall in debt to zero over the next three years,interest cover is predicted to rise substantially. This does depend, however, on thecompany’s ability to repay the loan as envisaged.

Working capital management

This was the cause of most of the increase in the overdraft in 2016 and the bank islikely to examine your figures in detail. There is scope for improvement in mostareas, but any forecast improvement must be realistic and must involve practicalproposals for action.

Inventory turnover period

The inventory turnover lengthened dramatically in 2016 to 114 days. In 2017,however, it is forecast to fall to 480/2,180 x 365 = 80 days, rising to 680/2,400 x365 = 103 days in 2018 and back down to 760/3,040 x 365 = 91 days in 2019. Thecompany will have to provide evidence to the bank that the fall in 2017 andfluctuation in 2018-2019 is realistic.

Receivables collection period

The receivable collection period fell a little in 2016, to 127 days, but the companyis projecting a substantial fall to 580/2,680 x 365 = 79 days in 2017, a further fall to504/3,000 x 365 = 61 days in 2018 and a rise again to 800/3,840 x 365 = 76 daysin 2019. Again, the large fall predicted in 2017 appears unrealistic and thecompany should aim for an achievable steady fall, say to around the 90 day creditlimit over three years. The bank is likely to prefer steadily improving figures ratherthan volatility.

Suppliers’ payment period

The suppliers’ payment period was at a reasonable level in 2015 and 2016,

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commensurate with suppliers’ trading terms. This is forecast to continue in 2017which is acceptable and realistic.

Non-current assets / security

Non-current assets are not projected to change; however, depreciation shouldhave been charged (unless expected additions are exactly equal to thedepreciation charged) and the profit projection should be adjusted accordingly.

The level of non-current assets is not high and you should consider what type ofsecurity you can offer the bank. The bank may accept a floating charge over theassets of the company or may require personal guarantees from the directors.

Please contact me if you have any queries regarding this report or if you requireany further information.

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SECTION B

2. At 1 May 2015 Clever Ltd (Clever) held 80% of the ordinary share capital of SuperLtd (Super), its sole subsidiary, in accordance with HKFRS 10 ‘ConsolidatedFinancial Statements’. On 1 August 2015 Clever acquired 30% of the ordinaryshare capital of Ultra Ltd (Ultra), giving Clever significant influence over Ultra inaccordance with HKAS 28 ‘Investment in Associates and Joint Ventures’. Theprofits and losses of Ultra accrued evenly over the year ended 30 April 2016.

The draft summarised statements of profit or loss of the three companies at 30April 2016 are:

Clever Super Ultra

$ $ $

Revenue 1,105,000 864,900 763,000

Cost of sales (353,600) (389,200) (305,300)

Gross profit 751,400 475,700 457,700

Operating expenses (290,400) (98,650) (168,300)

Profit from operations 461,000 377,050 289,600

Investment income 96,000 - -

Profit before tax 557,000 377,050 289,600

Tax (167,000) (110,000) (85,000)

Profit after tax 390,000 267,050 204,600

Additional information:

(i) Clever acquired its holding in Super on 1 May 2013. The fair values of all

assets and liabilities of Super at the date of acquisition were the same as their

carrying amounts, with the exception of an intangible asset which was

estimated to have a fair value of $10,000 in excess of its carrying amount.

The intangible asset was assessed as having a remaining useful life of eight

years at 1 May 2013. Amortisation of intangibles is presented in operating

expenses.

Super’s retained earnings at the date of acquisition were $160,700. During the

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current year Super paid an interim dividend of $50,000. The non-controlling

interest and goodwill arising on the acquisition of Super were both calculated

using the proportionate method.

(ii) At 1 August 2015, the date of acquisition by Clever, the fair values of Ultra’s

assets and liabilities were the same as their carrying amounts.

(iii) Since 1 August 2015 Ultra has invoiced $90,000 of sales to Clever, all at a

mark-up of 20%. One quarter of these goods were still in Clever’s inventories

at the year end.

(iv) On 1 May 2015 Clever sold a machine to Super for $120,000. The machine

had a carrying amount in Clever’s books of $95,000 at the date of sale. The

estimated remaining useful life of machine was reassessed at the date of sale

as five years. Depreciation on plant and machinery is presented in cost of

sales. Profit on disposal is presented against operating expenses.

(v) At 30 April 2016 Super had received $45,000 in deposits from customers to

secure the purchase of its latest electronic game, which went on sale on 1

June 2016. Super recognised the amount in revenue for the year ended 30

April 2016 and deposited the money in a separate deposit account.

(vi) At 30 April 2015 an impairment loss of $15,000 in respect of goodwill arising

on the acquisition of Super was recognised. An impairment loss of $8,000

needs to be recognised in respect of Clever’s investment in Ultra for the year

ended 30 April 2016.

REQUIRED:

2. (a) Determine the relevant figures from the consolidated statement of profit orloss of Clever group for the following items for the year ended 30 April 2016:

(i) Revenue

(ii) Cost of sales

(iii) Operating expenses

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(iv) Investment income

(v) Share of associate’s profit

(vi) Tax

(vii) Profit attributable to non-controlling interest

(15 marks)

Ans (a)

(ii) Costs of sales$

Clever 353,600Super 389,200Less: Depreciation on PPE (120,000 – 95,000) x 1/5 (5,000)

737,800

(iii) Operating expenses$

Clever 290,400Super 98,650Add: Unrealised profit on PPE (120,000 – 95,000) 25,000Less: fair value adjustment (10,000/8) (1,250)

412,800

(iv) Investment income$

Clever 96,000Less: Super’s dividend (50,000 x 80%) (40,000)

56,000

(v) Share of associate’s profit$

Ultra’s profit for the year (204,600 x 9/12) 153,450

Clever’s share @ 30% 46,035Unrealised profit [(90,000 – 75,000) x 1/4 x 30%] (1,125)Less: Impairment for the year (8,000)

(i) Revenue$

Clever 1,105,000Super 864,900Deposit adjustment (45,000)

1,924,900

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36,910

(vi) Tax$

Clever 167,000Super 110,000

277,000

(vii) Profit attributable to non-controlling interest$

Revenue (864,000 – 45,000) 819,900Cost of sales (389,200)Operating expenses (98,650 + 1,250 FV adj) (99,900)Tax (110,000)

Profit after tax 220,800

NCI share of Super @ 20% 44,160

2. (b) Explain the concepts underlying the preparation of consolidated financialstatements, illustrating these concepts with reference to the consolidatedfinancial position of the Clever group.

(5 marks)

(Total: 20 marks)

Ans (b) Group financial statements reflect the results and net assets of group members topresent the group to the parent’s shareholders as a single economic entity (singleentity concept). This reflects the substance of the group arrangement as opposedto its legal form, where each group member is a separate legal person.

In the consolidated statement of financial position of Clever all of the assets andliabilities of the group companies are added together and shown as one. However,the single entity concept also means that any intra-group transactions need to beeliminated, as otherwise items would be double counted in the context of the groupas a single entity.

The other principle underlying the preparation of consolidated financial statementsis the distinction between control and ownership. Control is reflected by includingall of the subsidiary’s assets and liabilities in the consolidated statement offinancial position, even where the parent does not own 100% of that subsidiary.So, for Clever, 100% of Super’s net assets are added in even though, in effect,Clever only ‘owns’ 80% of them.

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Ownership is then reflected by showing that part of the subsidiary’s net assetswhich is not ‘owned’ by the parent as a non-controlling interest.

Where an investor (Clever) does not have control but does have significantinfluence over an investee (Ultra), line-by-line consolidation is not appropriate. Butbecause Clever has this influence, it is reflected in the consolidated statement offinancial position as a single line item – being cost plus the group’s share of Ultra’spost-acquisition increase in net assets less any impairments in the value of theinvestment.

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3. Below are extracts from Outreach Ltd (Outreach)’s draft financial statements forthe year ended 31 March 2016.

Extract from statement of financial position as at 31 March

2016 2015ASSETS $ $Non-current assets

Property, plant and equipment 1,616,880 1,243,000EQUITY AND LIABILITIES

Share capital 1,014,000 240,000Current liabilities

Bank overdraft* 68,000 49,400

* Bank overdraft represents the cash and cash equivalents of Outreach

A review shows that the figures in the above statement of financial position havebeen calculated correctly.

Extract from draft statement of cash flows for the year ended 31 March 2016

$Net cash flow operating activities

Cash generated from operations (84,470)

Cash flows from investing activitiesProceeds from disposal of property, plant and equipment 92,000

Cash flows from financing activitiesDividends paid (193,500)

A review shows that the statement of cash flows is incomplete and contains anumber of errors. The relevant information needed to correct and complete thestatement of cash flows is as follows:

(i) During the year ended 31 March 2016 the following occurred in relation toproperty, plant and equipment:

– Machinery which had a carrying amount of $77,400 was sold for $92,000.

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In the reconciliation of profit before tax to cash generated from operationsthe only adjustment the assistant accountant made relating to thistransaction was to deduct the sale proceeds.

– A number of new items of plant and equipment were acquired during theyear. These new items were acquired for cash except for one item of plantwhich was purchased on credit and which cost $16,000.

– Total depreciation of $222,950 was charged and has been correctlyadded back in calculating cash generated from operations.

– An impairment of an item of equipment was identified and was correctlyrecognised in the statement of profit or loss for the year ended 31 March2016. The equipment’s carrying amount at 31 March 2016 was $18,400and its recoverable amount was $9,400. No adjustments have been madein the draft statement of cash flows for this impairment.

(ii) After preparing the draft statement of cash flows it was discovered that tradeand other payables at 31 March 2016 included accrued interest of $9,800(2015: $nil) and the cost of the plant purchased on credit referred in (i) above.

(iii) The assistant accountant did not have details of the share issues which hadbeen made during the year so could not calculate the relevant figure forinclusion in the statement of cash flows. On further investigation it wasdiscovered that in addition to 330,000 ordinary shares being issued for cashat a price of $2 per share, a bonus issue was subsequently made out ofretained earnings.

(iv) The only dividend paid by Outreach in the year was an interim dividend. Theassistant accountant calculated the interim dividend of $193,500 included inthe draft statement of cash flows by simply adjusting opening and closingretained earnings by the loss for the year.

REQUIRED:

In accordance with HKAS 7 ‘Statement of Cash Flows’:

3. (a) Prepare a statement of cash flows for Outreach for the year ended 31 March2016, using the indirect method.

(15 marks)

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Ans (a) Statement of cash flows for the year ended 31 March 2016

$ $

Cash flows from operating activities

Cash generated from operations (23,870)

Net cash from operating activities (23,870)

Cash flows from investing activities

Purchase of property, plant and equipment(W1)

(667,230)

Proceeds from sale of property, plant andequipment 92,000

Net cash used in investing activities (575,230)

Cash flows from financing activities

Proceeds from issue of ordinary share capital(W2)

660,000

Dividends paid (W4) (79,500)

Net cash from financing activities 580,500

Net decrease in cash and cash equivalents (18,600)

Cash and cash equivalents at 1 April 2015 (49,400)

Cash and cash equivalents at 31 March 2016 (68,000)

Workings $

Draft cash generated from operations (84,470)

Equipment impairment (18,400 – 9,400) 9,000

Adjust proceeds on disposal of machinery by carryingamount (to give profit) 77,400

Adjustment for trade and other payables (-9,800 –16,000) (25,800)

Cash generated from operations (23,870)

W1 = 1,243,000 (b/f) + 16,000 (non-cash addition) – 77,400 (disposal) – 9,000(impairment) – 222,950 (depreciation) – 1,616,880 (c/f)

W2 = 330,000 x 2

W3 = 240,000 (b/f) + 660,000 (W2) – 1,014,000 (c/f)

W4 = 193,500 (movement) - 114,000 (W3)

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3. (b) Based on your results in (a), comment on the cash flow position of Outreach.

(5 marks)

(Total: 20 marks)

Ans (b) – The decrease in cash and cash equivalents position for the year to 31 March2016 is mainly due to investing and operating activities.

– Outreach invests heavily in property, plant and equipment and suchinvestment is mainly financed by the issue of ordinary share capital.

– However, the major factor contributing to the increase in overdraft is thecurrent year’s deficit in operating activities.

– This is alarming as Outreach’s overdraft increased over the year. IfOutreach’s working capital is negative as at 31 March, it may no longer be agoing concern.

– It would be wise not to declare/pay a dividend while the company’sprofitability is bad unless Outreach’s decision is to choose such a dividendpolicy to fulfil shareholders’ expectations.

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4. Ocean Ltd (Ocean) is a listed company in Hong Kong that manufactures and sellsits own brand name smart phones and electronic tablets. The executive director,Abby Cheung, is known for her commercial experience rather than her technicalability. She is therefore seeking your advice on four particular accountingtransactions.

(i) Ocean has recently appointed a new head of smart phone designer, RonSamson. Ron recently won an annual design award winner for his smartphones and has recently worked for one of Ocean’s key competitors. Abby issure that Ron will design trendy smart phones which can attract marketattention and demand. Abby believes that Ron is therefore of great value toOcean and that this value should therefore be recognised in the statement offinancial position in the form of an asset.

(ii) Abby is aware that one of Ocean’s tablet designers, David Tam, is beingaccused of ‘including ideas in his design that have previously been used byother designer’. Abby is certain a legal case will ensue and therefore, beingprudent, wishes to recognise a liability in the financial statements now for anydamages that are likely to arise. Up to now, there has been no opinion fromOcean’s lawyers as to the likelihood of the case or estimate of the possiblevalue of any claim.

(iii) Ocean has sold an office building to a financial institution. The sale price was$40 million and the current market value is $60 million. Ocean can buy theoffice building back at any time in the next five years for the original sellingprice plus an annual commission of 1% above the current bank base rate.During the five-year period, Ocean has the sole rights to use the building. Abbywould like to treat this transaction as a sale in the financial statements.

(iv) Ocean also sells desktop personal computers (PCs) on behalf of Fortune Ltd(Fortune), a best-selling PC manufacturer. Ocean has to pay a monthly fee of$100 per PC for the privilege of displaying them in its showroom and isresponsible for insuring the PCs. When a PC is sold to a customer, Ocean hasto pay Fortune the purchase price of the PC when it was first supplied. Oceancan only return the PCs to Fortune on the payment of a fixed penalty charge of10% of the cost of the PC. Ocean has to pay the sales price for PCs if they

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remain unsold within a four-month period. Fortune cannot demand the return ofthe PCs from Ocean. Abby would like to treat the PCs unsold for less than fourmonths as Fortune’s assets and not show them as Ocean’s inventory in thefinancial statements.

REQUIRED:

Using the HKICPA’s Conceptual Framework for Financial Reporting:

4. (a) Discuss whether transactions (i) and (ii) can result in an asset or liability andwhether they should be recognised in the financial statements.

(10 marks)

Ans (a) Under the HKICPA’s Conceptual Framework for Financial Reporting, an item isrecognised when it is included in the statement of financial position, statement ofprofit or loss and other comprehensive income.

Recognition is the process of incorporating an item that meets the definition of anelement and satisfies the following criteria for recognition:

– It is probable that any future economic benefit associated with the item willflow to or from the entity; and

– The item has a cost or value that can be measured with reliability.

An asset is a resource controlled by an entity as a result of past events and fromwhich future economic benefits are expected to flow to the entity.

A liability is a present obligation of the entity arising from past events, thesettlement of which is expected to lead to the outflow from the entity of resourcesembodying economic benefits.

Transaction (i) – if we apply the definition of an asset from the HKICPA’sConceptual Framework for Financial Reporting to the head of smart phonesdesigner, Ron Samson, it is possible to argue that he has the characteristics of anasset.

As a full-time employee, Ron is likely to have a contract which was signed prior tothe end of the reporting period. The legal contract will prevent Ron working for anyother company, giving Ocean unrestricted access to any benefits he may provide.

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If Ron is able to attract marketing attention and create demand for sales of smartphones, he is creating a flow of future economic benefits on the assumption thatthe demand will prove to be valid.

However, there is uncertainty over:

– The enforceability of Ron’s contract: he may attract market attention andcreate demand, but Ocean can control him physically but not mentally. Roncan choose to leave.

– The revenue stream to result from the demand of new design of smartphones: there are no guarantees that the economic benefits can flow into thecompany.

Therefore, at this stage we cannot conclude that an asset exists.

An item is recognised when it is included in the financial statements at a monetaryvalue. Abby is proposing to include Ron as an asset in the statement of financialposition. However, certain criteria should be applied prior to recognition, e.g. isthere sufficient evidence of the existence of the asset and can the asset bemeasured at a monetary amount with sufficient reliability?

Transaction (ii) – David Tam has been accused of breach of copyright. From theinformation given, there is no opinion from lawyers as to the likelihood of the caseor estimate of the possible value of any claim. Therefore, whilst a past transactionhas allegedly occurred, there is insufficient evidence of and uncertainty overwhether an obligation exists.

To recognise the liability in the financial statements there must be sufficientevidence of the existence of the liability and it should be probable that an economicbenefit will flow from the entity. In this case, there is insufficient evidence of aliability and we are unable to measure any potential liability reliably.

The case is at far too early a stage to estimate the possible loss. It would thereforebe over prudent and inappropriate to recognise the liability in the financialstatements.

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4. (b) Discuss the proposed treatment of transactions (iii) and (iv) in the financialstatements with reference to relevant qualitative characteristics.

(10 marks)

(Total: 20 marks)

Ans (b) Financial reports represent economic phenomena in words and numbers. To beuseful, financial information must not only represent relevant phenomena but mustfaithfully represent the phenomena that it purports to represent. The user must beable to depend on it being a faithful representation.

A perfectly faithful representation should be complete, neutral and free from error.

A complete depiction includes all information necessary for a user to understandthe phenomenon being depicted, including all necessary descriptions andexplanations.

A neutral depiction is without bias in the selection or presentation of financialinformation. This means that information must not be manipulated in any way inorder to influence the decisions of users.

Free from error means there are no errors or omissions in the description of thephenomenon and no errors made in the process by which the financial informationwas produced. It does not mean that no inaccuracies can arise, particularly whereestimates have to be made.

Substance over form is not a separate qualitative characteristic under theHKICPA’s Conceptual Framework for Financial Reporting. The HKICPA says thatto do so would be redundant because it is implied in faithful representation. Faithfulrepresentation of a transaction is only possible if it is accounted for according to itssubstance and economic reality.

Transaction (iii) – Ocean has the option of buying the office building back at anytime in the next five years but is not compelled to do so, and therefore is protectedfrom any collapse in the value of the building below $40 million.

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This risk has therefore been transferred to a financial institution in return for theannual commission of 1% above the current bank base rate. However, Ocean hasretained the benefits of ownership and can also benefit from any increase in thevalue of the office building by exercising its option.

At the time of the agreement, both parties must have anticipated that the optionwould be exercised. Ocean would presumably not sell the office building at belowthe current market value.

The financial institution must have anticipated that any profit from the contractwould be derived from the receipt of the ‘commission’ payment from Ocean. It isunlikely that the building’s value would fall below one-third of its present value andtherefore the degree of risk transferred to the financial institution is quite minimal.

The suggested treatment does not provide a faithful representation because itdoes not reflect the economic substance of the transaction.

The essence of the contract is effectively a loan of $40 million secured on the officebuilding held by Ocean. The conceptual framework would incline to show thecommercial substance of the transaction reflected a financing deal rather than thelegal form of a sale.

Transaction (iv) – The main problem surrounding this transaction is thedetermination of the substance of the agreement. Abby has to determine whetherOcean has bought the PCs or whether they are on loan from Fortune.

There are certain factors which point towards the treatment of the PCs as Ocean’sinventory. Ocean has to pay a monthly rental fee of $100 per PC and after fourmonths has to pay for the PCs if they are unsold. This could be regarded as afinancing agreement as Ocean is effectively being charged interest by Fortune; thisinterest varies with the length of time for which Ocean holds the inventory.

Ocean also bears any risk of slow movement of the PCs. The PC purchase price isfixed at the price when the PC was first supplied. Thus any increase in the price of

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the PCs is avoided by Ocean, indicating that there is a contract for the sale ofgoods. Ocean has to insure the PCs and partially suffers some of the risks ofownership of the PCs.

Fortune cannot require Ocean to return the inventory to it and further, Oceaneffectively bears the obsolescence risk as a penalty is charged if Ocean returns theinventory to Fortune. In conclusion, the above factors indicate that the PCinventory is an asset of Ocean from the time of delivery and it should be accountedfor accordingly.

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5. eXtra is the parent of a small listed group reporting under HKFRSs. eXtra has twosubsidiaries, Zebra and Yuma, and an associate, Abyss. eXtra owns 100% ofZebra and 60% of Yuma.

The following information relates to the year ended 31 March 2016:

(i) The management of eXtra also manages Zebra, which they set up. Nomanagement fee is charged to Zebra.

(ii) Yuma has its own board of directors. Yuma made a loan to one of itsdirectors during the year at 2% below market interest rates to allow thedirector to purchase shares in the company. The loan was repaid before theyear end.

(iii) 30% of the ordinary shares of Yuma are owned by Karen Lam, who originallyset the company up. Karen also has significant influence over another entity,Victor Ltd, which supplies components to Yuma.

(iv) Yuma purchases parts from Zebra.

(v) Danny Leung, a director of eXtra, arranged (with the approval of the otherdirectors) for eXtra to purchase supplies from Twist Ltd, a company overwhich he has significant influence.

(vi) Danny Leung's former wife (who is financially dependent on Danny)purchased goods for cash at one of Yuma's stores at normal retail prices.

(vii) Towards the end of the year an investment fund purchased 48% of eXtra'svoting shares on the open market. The other shares are held by unrelatedindividuals who do not know or communicate with each other. No othershareholder owns more than 1% of eXtra's voting shares.

(viii) Zebra had a debt outstanding with Abyss at 31 March 2016 relating to salesmade in 2015.

REQUIRED:

5. (a) Discuss why related party transactions should be disclosed in thefinancial statements.

(5 marks)

Ans (a) Reasons for disclosing related party transactions in financial statements include:

– To know who is the controlling party of the company

– To bring attention to the fact that profit or loss and financial position may have

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been affected by transactions and outstanding balances with related partieswhere these transactions may not have been on an arm’s length basis

– To identify transactions that may otherwise have not taken place, e.g.transactions between group companies

– So that the shareholders are aware of sensitive transactions with directors

– To identify situations that have benefited related parties at the expense of thecompany

– To identify additional costs that would be incurred if the related party did notexist, e.g. if a subsidiary is sold by its parent which provided managementactivities at no cost

– To identify factors other than market price in transactions that have been madewhich benefit the company or related party

5. (b) For each of the items (i) to (viii) above, discuss whether disclosure of anyrelated party relationships and/or transactions needs to be made in eXtra's,Zebra's or Yuma's individual financial statements for the year ended 31March 2016. Disclosure notes are NOT required.

(15 marks)

(Total: 20 marks)

Ans (b) (i) The management service at no fee would need to be disclosed in botheXtra's and Zebra’s financial statements as it is a transaction betweengroup members, irrespective of how much is charged.

Disclosure of the related party relationship is also required in Zebra’sfinancial statements irrespective of whether any transactions took place, asZebra is a subsidiary of eXtra. Zebra must therefore disclose that its parentis eXtra (by name).

(ii) The loan to the director of Yuma is a transaction with key managementpersonnel. It is not outstanding at the year end, but it must be disclosed inYuma's financial statements as it occurred during the year.

Disclosure of the related party relationship is also required in Yuma'sfinancial statements irrespective of whether any transactions took place, asYuma is a subsidiary of eXtra. Yuma must therefore disclose that its parent iseXtra (by name).

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(iii) Karen Lam is a related party of Yuma as she has significant influence. Thisneed not be disclosed as no transactions have occurred between her andYuma during the period.

Significant influence over an entity by a person who has significant influenceover another is not considered sufficient influence to be considered a relatedparty relationship, so no disclosure is required of the transaction with Victor.

(iv) Yuma is purchasing parts from a fellow subsidiary. As members of the samegroup both parties are related, but disclosure is only required whentransactions occur.

Both must disclose the aggregate amount of any transactions during the yearas well as any outstanding balances and any bad or doubtful debts.

(v) Twist is an entity in which a director of eXtra has a significant interest. Twist isnot considered a related party of eXtra as for a related party relationship toexist the director would need to have control or joint control over Twist.

No disclosure is therefore required in eXtra's financial statements of thesupplies purchased from Twist.

(vi) Danny Leung is key management personnel of the parent of Yuma. As such,both he and his ex-wife (she is considered close family due to her economicdependence on Danny) are related parties of Yuma.

The cash sales made to Danny Leung must therefore be disclosed in Yuma'sfinancial statements. The fact that they were at normal retail prices does notnegate the need for disclosure.

(vii) The fact that the investment fund owns the major shareholding in eXtra whilethe other shareholders have small holdings which will not be pooled is likelyto indicate a sufficiently dominant voting interest to meet the power criterionin the HKFRS 10 definition of control.

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HKAS 24 requires disclosure of the controlling party of an entity and thereforethe investment fund would be disclosed as the controlling party in eXtra'sfinancial statements.

(viii) Abyss is an associate of eXtra, and Zebra is a subsidiary of eXtra. As suchthey are not considered members of the same group for related partypurposes.

No disclosure is required of the transaction or the debt (and outstandingbalances) in either eXtra's or Zebra's financial statements.

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6. StarTech Ltd (STL)’s draft financial statements for the year ended 30 April 2016were completed by 25 May 2016 and were expected to be authorised for issue on12 June 2016. The following events have arisen since the year end and thefinancial director has asked you to comment on the final financial statements.

(i) STL’s investments in listed shares of another entity are measured at fairvalue through profit or loss in accordance with HKFRS 9 ‘FinancialInstruments’. As at 30 April 2016, these investments were recorded at themarket value at that date, which was $750,000. During the period leading upto 12 June 2016, there was a steady decline in the market values of all theshares in the portfolio to $600,000.

(ii) STL had disclosed a contingent liability in notes at 30 April 2016 in respectof a lawsuit against it by a director who was injured during 2016. The casewas not heard until the first week of June 2016. On 11 June 2016, the judgeruled against STL, and determined that STL was liable for payment ofdamages and costs totalling $4,500,000.

(iii) STL declared a final ordinary dividend of $0.50 per share on 31 May 2016based on the results for the year to 30 April 2016. The dividend is payableon 5 June 2016.

(iv) One of the plants with a carrying amount at 30 April 2016 of $30,000 wasclassified as held for sale in accordance with HKFRS 5 ‘Non-current AssetsHeld for Sale and Discontinued Operations’ in April 2016. Its fair value lesscosts to sell was then estimated as $27,000 on 15 May 2016.

(v) On 1 April 2016 STL entered into negotiations with employeerepresentatives to restructure its operations and close down two of its fiveretail outlets. Broad agreement was reached on 5 May 2016 with a detailedplan and the plan publicly announced on 7 May 2016. Relevant employeeswere sent letters on 8 May 2016 offering them redundancy or redeployment.

REQUIRED:

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6. (a) Discuss the requirements of HKAS 10 ‘Events after the Reporting Period’for events occurring after the reporting period but before the date onwhich the financial statements are authorised for issue.

(10 marks)

Ans (a) Financial statements are prepared to the end of the reporting period. Thepreparation of financial statements however, will normally continue for a periodafter this date. During this time lag, events may occur which provide additionalinformation that is relevant to the preparation of the financial statements.

The objective of HKAS 10 ‘Events after the Reporting Period’ is to prescribewhen the financial statements should be adjusted for these events and anydisclosures that may be required.

Events after the reporting period are those events, favourable and unfavourable,that occur between the end of the reporting period and the date when thefinancial statements are authorised for issue.

The date on which the financial statements are authorised for issue is the keycut-off point. Any event which takes place after this date is outside the scope ofHKAS 10.

There are two different classes of events after the reporting period:

– Adjusting events

– Non-adjusting events

Adjusting events are those events that provide evidence of conditions thatexisted at the end of the reporting period. They require either:

– adjustments to amounts already recognised in the financial statements; or

– recognition of items which did not previously meet the recognition criteria.

Non-adjusting events are those events that are indicative of conditions that aroseafter the reporting period. Adjustments to amounts in the financial statements arenot made to reflect non-adjusting events. However, where the effect of thenon-adjusting event is material such that non-disclosure could influence users’

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economic decisions, the following information should be provided in the notes tothe financial statements for each event:

– the nature of the event; and

– an estimate of the financial event

6. (b) Advise STL on how to account for the above events as at 30 April 2016with reference to HKAS 10 ‘Events after the Reporting Period’.

(10 marks)

(Total: 20 marks)

Ans (b) (i) It is a non-adjusting event.

The company measures its investments at fair value, which must bedetermined as at the end of the reporting period. The change in fair value willbe recorded in the next reporting period. If the investments were measuredat cost, however, this could be an adjusting event if it provided evidence ofimpairment at the end of the reporting period.

(ii) It is an adjusting event.

The settlement after the reporting period of a court case confirms that anentity had a present obligation at the end of the reporting period. The entityadjusts any previously recognised provision related to this court case inaccordance with HKAS 37 ‘Provisions, Contingent Liabilities and ContingentAssets’ or recognises a new provision.

(iii) It is a non-adjusting event.

Dividends on equity shares declared after the reporting period but before thefinancial statements were authorised for issue should be treated inaccordance with HKAS 1 ‘Presentation of Financial Statements’ as follows:

– They cannot be shown as a liability as there is no obligation at the endof the reporting period.

– The amount of dividend payable should be disclosed in the notes to thefinancial statements as an appropriation of distributable profits

(iv) It is an adjusting event.

This is the subsequent determination of the proceeds of sale of assets soldbefore the end of the reporting period. The plant should be measured at

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$27,000 as a held for sale asset in the financial statements as at 30 April2016.

(v) It is a non-adjusting event.

The restructuring is not provided for as it was agreed by Board after thereporting period. If an entity starts to implement the plan or announces itsmain features to those affected after the end of reporting period, disclosureis required under HKAS 10 if the restructuring is material.

END